Demystifying Large Cap Investing
What is common in listening to music and investing in equities? Besides, the fact that equity investments value going up is “Music to Ears” there are many parallels. Just like you enjoy different genres of music at different points of time and at different stages of life, you build your equity portfolio with different categories of funds with varying allocation to fulfill different needs. And like most of us prefer listening to a professional vocalist / instrumentalist rather than an amateur, we would have our predominant equity allocation in equity mutual funds rather than direct stocks. Just like a listener chooses from music genres like Classical, Rock, Folk, Devotional, Jazz, Gazals etc. depending on one’s mood and broad understanding of what to expect; an investor chooses from Large Cap, Multi Cap, Mid Cap, Large & mid Cap, Value, Thematic, Sector Funds etc. based on the broad sense about where one’s savings need to be allocated. Better understanding emerges for a listener / an investor as one becomes aware of nuances of music and investment. At times the understanding may get clouded by the popular beliefs. In our interaction with investors, we observe certain common perception particularly about large cap companies. The most common beliefs that we have come across are:
Mid Cap companies outperform the large cap companies
Large cap companies are well researched, may not be multi-baggers
Why invest in a fund, rather just buy and hold the blue-chips?
Let us peep into history, to check what stories data has for us.
1. Mid-caps outperform Large caps
As per the categorization of the MF schemes, SEBI has mandated certain discipline about the investable universe for each category of the Fund, for e.g. large cap funds have to invest at least 80% of its assets in top 100 companies by market capitalization, Mid cap funds have to invest at least 65% of its assets in 101st to 250th companies by market capitalization and so on.
We analyzed the performance of Nifty indices; a) Nifty 50 and Nifty Next 50 representing top 100 companies by Market Capitalization (Large Cap cohort) and b) Nifty Midcap 150, Nifty Midcap 100 and Nifty Midcap 50 indices represent the mid cap companies (Mid cap Cohort). We observed from the historical performance of these indices since April 1, 2005 till Dec. 31, 2019 (Maximum common period data) that there are intermittent periods when one cohort scores over the another. The perception that the mid-caps outperform the large caps appears to be due to selective bias.
The big picture as at Dec. 31, 2019 is as seen in the chart below. Nifty Next 50 (large cap 51st to 100th companies) is the best performer generating 7.81 times the initial investment, close behind is Nifty Mid Cap 150 (101st to 250th companies by market capitalization) with 7.68 times (point to point return over ~14+ years from April 1, 2005 to Dec. 31, 2019). The other indices grew around 7 times as well except Nifty Mid Cap 50, which grew only 4.31 times.
Data source: Bloomberg
In hindsight of course, Dec. 2017 was the period when one should have sold mid cap indices (funds) and moved that money to large cap, and that too in Nifty 50 Index. This is theoretical, ‘rear-view mirror’ wisdom. Often correct timing is by chance and timing the market is futile. The circled areas indicate periods when Large cap outperformed the mid-caps, the following table has data for those periods. The period of underperformance was prolonged and more painful for mid-caps before their subsequent sharp outperformance form Oct 2014 to Dec 2017.
In point to point analysis, the outcome depends on which time period you are focusing on. Better way therefore, is to consider data on a rolling basis for a long period so that the analysis provides useful insights on the questions that investors often have: why allocate to large caps, what are the chances of negative return on the equity investments, how long is the “long term investment horizon” and so on.
Assuming that investor invests at regular monthly interval over a long period of ~14+ years from April 1, 2005 to Dec.31, 2019 for different holding periods of 1, 3, 5 and 10 years, some of the investments might have generated negative returns and some might have generated positive returns. The table below indicates the occurrences of negative returns for 1 year, 3 years, 5 years and 10 years holding period from April1, 2005 till Dec.31, 2019.
To sum up, the risk is seen to be lower in the large caps, and as the investment horizon increased the risk of negative returns reduced and the chances of generating at least 8% CAGR returns improved substantially.
CAGR: Compound Annual Growth Rate
2. Large cap companies are well researched, may not be multi-baggers
To check on the validity of this popular belief, we looked at the S&P BSE Sensex constituents’ Market capitalization as of Nov. 2019 vs the market capitalization as of March 31st, 2005, 2009, 2014. Investments made in S&P BSE Sensex companies, on March 31st 2009 turned most rewarding as more than 40% of the companies generated multi fold returns given the very attractive valuation during the global financial crisis led meltdown.
The following table lists the multi-baggers among the investments made on March 31st, 2005 and 2014 in S&P BSE Sensex companies reinforcing the fact that big can grow bigger.
3. Why invest in a fund, rather just buy and hold the blue-chips?
That’s the question you may have looking at the data above. The above data has a survivor bias, i.e. the data considers the companies which continued to be part of S& P BSE Sensex till today. There were many who got dropped and not part of the index now. The value destruction by these companies makes us realize the importance of avoiding mistakes in investment decisions and therefore importance of investment process.
From the data presentation above, one would realize that large caps can be multi-baggers, the investment process should not only lead to spot these but also avoid the potential value destroyers at an early stage. Process brings clarity and direction to the team and helps in supporting diverse investment styles by backing up the convictions through the volatile times. For e.g. At UTIAMC, our investment process emphasizes on consistency of operating cash flow generation and the average return on capital employed over the past 5 years and the likely movement in these parameters in the near future. We were able to avoid the value destroyers which got flagged out at an early stage, using our framework
To conclude, there is a merit in allocating to large cap funds. Most large cap companies have resilient business models, leading market position, scale benefits and strong financials. They typically survive multiple business cycles before they enter indices. The above analysis gives insights on why large cap/ multi cap funds should be considered as part of the core equity investments and mid cap/ other different market capitalization/ theme mandated funds should be considered as the satellite portion of equity investment. The proportion of core and satellite allocation would depend on each investor’s willingness and ability to bear the risk.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.