Sticking to smaller companies can be more fruitful

Over 1991-2017, the median PE for the bottom-decile has increased from 13.6 PE in 1991 to 29.6 PE in 2017

Saurabh Mukherjea of Ambit Capital has an interesting thesis: Relatively smaller corporates will consistently outperform larger corporates over the long term. He did a data-based study of the top 100 stocks in India since 1991. More specifically he compared the top 10 stocks of the BSE100 by market cap (top-decile) with the bottom 10 stocks (bottom-decile).

The study assumed annual rebalancing and an equal-weighted portfolio. He says that, between 1991 and 2000, the top-decile outperformed in terms of delivering capital gains. Between 2001 and 2010, the performance of the bottom-decile equalled that of the top-decile. 

But, between 2011 and 2017, the bottom-decile outperformed by a huge margin. So much so that a bottom-decile, equal-weighted portfolio held since 1991 and rebalanced annually would have returned a CAGR (compounded annual growth rate) of 15 per cent where a top-decile portfolio would only have returned 10.6 per cent. That is despite the major outperformance by the bottom-decile coming only in the last 6-7 years of this period. 

Over 1991-2017, the median PE (price-to-earnings) for the bottom-decile has increased from 13.6 PE in 1991 to 29.6 PE in 2017. For the-top decile, the median PE has decreased from 22.8 (1991) to 19.9 (2017). However, median EPS growth for the bottom-decile is only marginally better at a CAGR of 10.5 per cent than median EPS growth for the top-decile (CAGR 10.2 per cent). 

Why is there such a strong price outperformance and divergence in rating attitude, given the relatively small difference in EPS growth? Mukherjea's conjecture is that the market is betting that the bottom-decile will grow much faster in future - this hope is based on the reality of faster bottom-decile growth in the last few years. 

Mukherjea also points out that large concerns have a historical edge in terms of access to capital, and in the ability to influence policy in a crony-capitalist environment. Access to capital has become much easier for smaller, hungrier concerns. Maybe the crony capitalist nature of the environment is also changing, which would erode the other advantage for large businesses. “Cronies” always change when regime changes and a new regime has allowed new players to build new influence. 

One suggestion he makes is going long on the bottom-decile (and short on the top-decile). Another implication that he points out is that most large-cap diversified-equity funds are overweight in top-decile stocks. So, they could start to underperform. 

Certainly this is all worth thinking about. One point worth making is that this cited study focussed on large companies. Even the lowest market cap members of the top 100 are very large concerns. This comparative outperfomance might not hold true for smaller concerns. In the context of the next couple of years, the ability to formalise the supply chain for GST compliance will be important. Most smaller/ mid-sized concerns will have more trouble doing this than BSE100 companies. So, that could be a retarding factor for small caps versus large caps. 

On the other hand, it is mathematically true that a smaller company can grow at quicker rates simply due to the smaller base. Infosys used to double turnover in the early 1990s; it cannot do so any longer.  

So, that base effect means that it is possible that midcaps and small caps may outperform top-decile large caps by even larger margins than bottom-decile large caps. Certainly, midcaps and small caps have beaten large caps in the last year. So, investors will have to balance off these pros and cons. Another point: If you accept the basic thesis, it would be better to move away from large-cap funds with very high exposure to the top 20 stocks (top-decile and second-decile) in the BSE100.