Investments and false impressions

I like magic and magic shows that create illusions. Therefore I was fascinated to watch the movie “Now you see me” again. Illusions can distort thinking, by creating an optical delusion on which everyone focuses on. What we see is not what we eventually get.

One of the main characters in the movie says “The more you think you see, the less you'll actually notice”. The other memorable dialogue was, “What is magic? Focused deception. But deception meant to entertain”.

The main message from the movie seems to be that magic should not be used to trick people out of their money.

Illusions distort thinking in every field from philosophy to physics. To give some examples;

Government budgets give an illusion of GDP growth while in reality much of the growth could come from inflated prices or price growth instead of volume growth, and this price growth or inflation seriously distorts wealth distribution among the population.

Illusions distort thinking in the field of investments too. The focus on near term performance distorts the ability to think rationally and can encourage investors to make poor judgments and investments. For example; the near term performance of mid cap and small cap companies could make an investor take undue risks in his portfolio allocation. Here is the near term performance chart of the different indices.

This graph is very appealing and inducing enough to invest. Beware...there are potential pitfalls...

The temptation to invest in mid cap and small cap is based on
1. The stock price performance since August 2013 (since the markets has gone up), ignoring the longer term performance of these stocks.

2. The hidden gem syndrome plays a very important role here. Many investors assume that many mid and small cap stocks are not well followed. Hence a smart manager may be able to identify and invest in these stocks, which are mispriced or (under-valued). These above assumption and a tempting graph on performance is enough to drive many investors to take undue risks.

3. The assumption that mid sized and small companies are more nimble and therefore can grow faster than the larger companies. It is also assumed that every investment will be a multi-bagger.

While many of the assumptions might be true, there are several challenges which are not visible.

1. It is assumed that small companies can grow fast and eventually become very large. While some investment in small and mid-sized companies can be multibaggers they ignore the fact that it is challenging to construct a portfolio of stocks for a mid cap / small cap fund where all of them could be multibaggers.

2. This broad assumption on superior growth opportunities for mid and small companies ignores the reality that not all mid-sized companies can grow fast. It ignores the challenges that these companies face in terms of access to capital, ability to recruit and retain talent, management bandwidth, execution skills and many others. These challenges are a serious bottleneck to growth.3. Moreover, generally the liquidity in these stocks tends to be low, as there are very few buyers and sellers. Therefore if more and more money is poured into these companies either directly or through mutual fund, the more difficult it would be to exit these stocks.

Now the fund manager of a mid cap fund has the following options:
• Since exit in mid cap and small cap stocks can be difficult if redemption pressures are high the fund manager could sell the more liquid names in the portfolio and hold on to the less liquid names. This is dangerous for investors who are not redeeming.

The fund manager is desperate to raise the cash, and is not worried about share price; so he sells aggressively. The share price could decline sharply and the NAV of the investors who continue to hold the fund takes a massive hit.

Therefore be cautious. Have a prudent diversification between large cap, mid cap and small cap segments.

Ignore delusions and look at data very carefully. If mid cap and small cap stocks look attractive in the short run, they may not look so attractive when you look at it over a longer term horizon.

Over long periods the larger companies have generated better returns as shown in the graphs below.

S&P BSE 30, Mid cap and Small cap Index since December 2004

Note: Data in the graph is plotted for performance every four months

Conclusion
Mid cap and small cap stocks hold great potential returns, but also pose huge risks at the same time. Therefore it is prudent to limit the exposure to these kind of stocks within the overall exposure to equities. Fake NAVs get generated when large pools of money is invested in these stocks , creating an illusion about returns. Beware of this deception. Analyze longer term return patterns before making any investment. Kindly consult a financial advisor for your investment needs.

Above article is authored by Quantum.

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