How to think about picking stocks in India

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What do Ess Dee Aluminium, Ushdev International, ICSA (India), Zylog Systems, Asian Electronics, Surana Industries, Hanung Toys & Textiles and Rainbow Papers have in common?

Five years ago, these 8 companies had market caps over 500 Crores each. Ess Dee was worth over 2,000 Crores and Ushdev was worth almost half that at one point. Every one of those 8 has lost between 99 and 100% of its value since then. Market caps of another 143 companies have dwindled to zero or close enough to zero in the same time.

That’s not surprising. Companies fail.

What is not intuitive, especially to those of us primarily looking at companies as stock codes is how many fail as investments.

We look at how the universe of stocks has done over the last five years and what that means for those of us looking for that portfolio of winning stocks.

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What are the chances of any stock in your portfolio being a failed investment?

It depends on how you define “failed investment”

1. 30%: If it means suffering an erosion massive enough to mean significant and permanent loss of capital
2. 47%: If it also includes stocks that fail to offer some positive return over 5+ years
3. 53%: If it also includes stocks that fail to beat cash sitting in your savings account

Here’s why. We did an aggregate analysis of companies from a little over five years ago. There are ~1,500 companies in our sample, accounting for the bulk of the listed stock universe in terms of market capitalisation.

The 80:20 Pareto rule gets magnified here.

Just 10% of the companies accounted for 90% of total Indian Market Cap

Note that this list does not include new companies that went public in the intermittent period. It also does not include stocks that stopped trading on the exchanges over that same period.

Here’s a sector-wise view of those companies, their Sales and Net Profit for the year.

To view the full list: click here

The final column “Market Cap / Profit After Tax” is essentially the Price-Earnings of the sector. i.e. How much was the market willing to pay for each ₹ of Net Profit at the time.

Yes yes, Price-Earnings is a blunt instrument that offers no insight into the future cash-generating capacity of a business and should not be used to pick stocks. But in a relative context it offers a point-in-time range of optimism to pessimism built into valuations

For example, consider Pharmaceuticals and Mining & Minerals. Both generated similar aggregate net profits of about 22,500 Crores. The market valued the former at 30x earnings and Mining at 11x earnings even though Mining had a significantly higher profit margin that year.

That is not to say that Mining was undervalued and should have been bought but to observe how certain levels become generally accepted for companies in certain sectors. For the most part markets get it right so there’s a good reason for some companies to trade at single-digit Price-Earnings.

So what has happened to that starting set of 1,492 companies over the last five years?

Let’s take a minute to understand what this chart means, to put this entire article in perspective.

The first table in this post showed the split of companies by category of market cap going from category 0 (market cap < ₹ 10 Cr) to 9 (market cap > ₹ 100k Cr). This chart here shows how those 1,492 companies have moved across market cap categories over five years.

Take a look at the bottom of the first column in the table. Five years ago, 142 companies were in category 0 (Market cap above 0 but under ₹ 10 Cr). Of those 142, 92 continue to be in category 0 as of today, while 39 moved up to Category 1 (Market Cap between 10 and ₹ 100 Cr), 9 to Category 2 (Market Cap between 100 and ₹ 500 Cr), 1 to Category 3 (500 to ₹ 1,000 Cr), and one company grew all the way to Category 4 (1,000 to ₹ 3,000 Cr). That one exceptional performer is IFB Industries (Market Cap ₹ 1,958 Cr as of writing this).

Similarly, the other columns show how companies have done over the last five years. Some have fallen, some have stayed close to where they were, while some exceptions have grown to higher market cap i.e. their stocks have delivered exceptional returns.

5 takeaways from this chart

Some exceptional performers

• The number of large market cap companies has increased. Five years ago, Of the 1,492 companies, 96 were in categories 7, 8, 9 (MCap > ₹ 15k Crores). Today, 126 out of those 1,492 make the cut. The 4 additions to the 100k+ Crore category have been: Ultratech Cement, the Bajaj twins, and Asian Paints
• Other excellent performers that were not small to start with include Berger Paints (up 7x), Info Edge (6x), Tata Consumer Products (5x), Biocon (5x), and IDBI Bank (4x)

But the traffic has been far from one-way

• J&K Bank (-98%), Jet Airways (-92%), PC Jewellers (-88%), Amtek Auto (-98%), Unitech (-93%), Videocon (-99%), IL&FS Transportation Networks (-99%), Educomp Solutions (-99%), anything in the ADAG stable, have all gone from fighting mid and large caps to nothing

In case you read that list and thought “Aah, Corporate Governance!” think again.

• Blue Dart Express (-73%), Oil India (-64%), Lupin (-53%), Cummins India (-50%). All largish, reasonably well-regarded companies that have also lost big.

It’s been tough for the small companies

• At the start of the timeline, 10% of the 1,492 companies had market caps under 10 Cr. Now 17% of them do. 17 companies went from ₹ 1,000+ Cr market. caps to under ₹ 100 Cr. Names like Punj Lloyd, Castex Technologies, ABG Shipyard, Cox & Kings were hailed as future large caps at one point.

But being already big does not offer immunity from massive value erosion

• Tata Motors (-77%), ONGC (-64%), Coal India (-56%) are proof. That’s 3 out of the 20 companies that started off this analysis with 100k+ Crore Market Caps and are worth far less than that today.

It’s not the big failures we need to watch out for

The spectacular crash-and-burn cases automatically draw our attention. The ones with flashing warning lights and dubious promoters.

Having the common sense to avoid the Videocons of the world leads us to believe we are well placed to avoid all value destroyers.

Having the common sense to avoid the Videocons of the world leads us to believe we are well placed to avoid all value destroyers. Click To Tweet

But it is the companies that stagnate or gradually subside into insignificance that should worry the long-term investor more.

More than the obvious problem companies, it is owning companies that stagnate or gradually subside into insignificance that should worry the long-term investor more. Click To Tweet

These companies generally appear at the top of value investor lists year after year either because

• they have management with a long if not spectacular track record and
• are cleaning up the balance sheet and poised for a turnaround, or
• are expecting massive capital infusion that will guarantee long-term survival, or
• have no-growth cash-generating cores funding new more lucrative businesses that are just another 2-3 quarters from paying off, or
• a combination of the above and other factors

Go back five years in time. Canara Bank, Ashok Leyland, Tata Power look like sound buy-and-hold picks. They have solid business histories and the India growth story in the backdrop to make them look that way.

They look cheap, and over time they get cheaper, drawing investors to allocate more and more. Until they are such a big part of the portfolio, that now there’s nothing to do but hold onto belief. That the rest of the market will come to its senses some-day.

The names above are purely incidental. Picked using the benefit of hindsight.

The broader point is picking winners is incredibly hard. I’ll rephrase.

Picking winners and being meaningfully allocated to them is incredibly hard.

When it comes to actively picking stocks, picking winners and being meaningfully allocated to them is incredibly hard. Click To Tweet

Here’s the same sector-wise view from earlier updated for how they look today.

Five years ago, our sample of companies traded at 19x Earnings. Today they trade at 32x earnings. Cement & Construction Material stocks went from 44x Earnings to 29x Earnings. While Consumer Food went from 28x to 548x.

What would you have picked five years ago based on information and themes of the time? What would you pick today? How much would you allocate?

Chart below shows the percentage of stocks by market cap category and what kind of returns they delivered over five years. Any row totals to 100.

Making sense of this table: For example see Category 9 (stocks that were ₹ 100k+ Crore Market Cap five years ago)

• 20% of those stocks delivered extraordinary returns i.e. > 15% annualised
• 35% of them beat savings account returns
• 10% failed to beat savings account and gave non-negative returns over five years
• 20% ended lower than five years ago but lost less than half their starting value
• 15% suffered catastrophic erosion in value, losing more than 50% of starting vaue

This means 45% of mega-cap stocks failed to beat savings account returns of which 1/3rd lost more than half their value.

Overall, chances are more than half your stock picks will fail to beat the cash in your savings account. Click To Tweet

Bottomline

Just like we all think we’re better than average drivers, we probably overrate about ability to pick individual stocks. Professional asset managers included.

Just like we all think we're better than average drivers, we probably overrate about ability to pick individual stocks. Professional asset managers included. Click To Tweet

While not an exhaustive historical analysis by any means, our analysis over the last five years says more than half of all stocks failed to outperform even savings accounts. A third of them caused catastrophic loss of capital.

Note that because of a limitation in our data source, our starting data already excludes stocks that are no longer listed. So, the rate of catastrophic loss is underestimated by a good few hundred basis points.

Even without the adjustment, this horrendous base rate applies to not only micro-caps but to the mega-caps as well. The saving grace of large cap stocks is they are less likely to suffer catastrophic loss of capital compared to smaller cap stocks.

Investors picking stocks should take the above two points into account before looking for a portfolio of winning stocks. Especially one that they intend to buy and hold forever.

So what then?

• Start with this pyramid in mind. To increase your chances of meeting your financial goals, start with picking the right asset allocation. Then pick a low-cost combination of index funds that offer exposure to those assets. Revisit periodically to rebalance back to target weights.

• And then. Only then, if you still want the thrill of picking “winning stocks” allocate a component to an actively managed stock portfolio. But do this knowing there are no “one-decision” stocks i.e. to buy and forget. Yes, you can reduce your chances of catastrophic loss by filtering stocks for governance and capital structure criteria. But even “good” companies lose their way, not necessarily spectacularly, but gradually.

Unless you enjoy the process of picking stocks actively, stay with combinations of passive funds. And even if you do like picking stocks, be realistic about your expected returns. Click To Tweet

• Be realistic about your expectations. We manage a couple of actively managed portfolios in our PMS, and also to our Premium subscribers (LT Multicap, Momentum), and while they have both done reasonably well by outperforming the market in difficult times, we spend a lot of time toning down expectations of future return.

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At Capitalmind, we like active investing, even while being aware that it’s not easy to beat low-cost passive combination of a broad range of assets. But we enjoy the process, and so have a few active equity and debt portfolios. We are constantly trying to improve what we do: Why subscribe.  For access to our research, portfolios, and the incredibly rich member forum.Upgrade to Capitalmind Premium.