Don't Trust. Measure.

You are small. You deserve bigger. Demand it.

While almost all those who practice “professional investing” – which Peter Lynch labels an oxymoron in the same line as military intelligence, jumbo shrimp, and learned professor – are trained and conditioned well at college to believe that the quest to beat the market is a fool’s errand, few if any hold this belief in their career.

Not only because it would be professionally hazardous (for what is your job then?), but also because in between college education and their early career years, common sense and observation (pratyaksha pramaan or direct evidence) revolted against this “wisdom” of worthlessness of effort in generating superior returns. And the common sense found support from people who had actually beaten the market for decades together. Warren Buffett and other “monkeys of Grahams and Doddsville”, provided dollar-backed evidence that a framework with common sense, and using some (not all) tools you were taught at your schools, can beat markets. Not only did they beat markets – several investing greats such as Buffett and Soros made it a point to poke fun at the idea that markets couldn’t be beaten consistently.

It is also interesting that when Buffett eventually did stop outperforming the market, the most likely reason was perhaps size. As Buffett says (quotes from 1999, 2005): “It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1mn. No, I know I could. I could guarantee that”…“I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments….I could do the same thing today with smaller amounts. It would perhaps be easier to make that much money in today’s environment because information is easier to access.” (Source: Buffett-2005-University-of-Kansas-Sears-Discussion.pdf).

Peter Lynch says, in a similar vein: “My biggest disadvantage is size. The larger the equity fund, the harder it gets to outperform the competition…Big funds have the same built-in handicaps as big anything – the bigger it is, the more energy it takes to move it.” In the next paragraph, Lynch says that Fidelity Magellan could be big and still outperform peers due to fast growers, turnaround opportunities, and out-of-favour companies. “The stocks I try to buy are the very stocks that traditional fund managers try to overlook. In other words, I continue to think like an amateur as frequently as possible.”

 The quotes from two greats mentioned above both refer to two things: a/ the size of capital you have to manage is an important determinant of the returns you will make (all other things remaining equal), b/ smaller companies, out-of-favour companies offer better opportunities for greater returns.

Not having a lot of money to manage, or to be a modestly sized-retail investor, brings many benefits to your table. The opportunity set available to a small investor (say, managing 1 crore) is very different from that available to a fund that is, say, Rs 75,000 crores. The market is always teeming with opportunities, but the number of relevant opportunities will decline as the fund size becomes larger. Remember, the number of opportunities that the market offers is large, but nobody is equipped to avail all of them. For a large equity fund, the number of opportunities is therefore considerably reduced. But that is only half the problem.

Peter Lynch says in his classic “One Up on Wall Street”: “With every spectacular stock I have managed to ferret out, the virtues seemed so obvious that if 100 professionals were free to add it their portfolios, I’m convinced 99 would have done so. But for reasons I am about to describe, they couldn’t. There are simply too many obstacles between them and their tenbaggers”. Then under titles such as “Street Lag”, and “Inspected by 4”, he provides reasons why most institutions fail to capitalise opportunities. I think it is fair to summarise such sections as follows: The average Wall Street/ Dalal Street professional fund manager has at least one more important thing to do than to get you your best return -- to ensure he does nothing wrong and is not even perceived to be doing wrong, and continues to keep his job and grow in his career. Keeping your career doesn’t just mean you do the right things, but also that your superiors and peers agree with your judgment. Thus, leaf subsides to leaf, and over a period most fund managers are doing the same safe things, which is unlikely to be optimal in a risk:return framework.

As Lynch says: “Whoever imagines that the average Wall Street professional is looking for reasons to buy exciting stocks hasn’t spent much time on Wall Street. The fund manager is likely looking for reasons not to buy exciting stocks, so that he can offer the proper excuses if those exciting stocks happen to go up”.

Thus, given his advantage of managing a small amount of capital, there is a lack of flexibility in investing in a large fund that an investor can side-step, by investing directly into equities. There are a few problems, and questions that arise that the average intelligent person will ask: 1/ how do I choose where to invest? 2/ how do I know I am not barking up the wrong tree?

To the first, Peter Lynch’s advice is to buy into businesses that you understand. And then adds a couple of helpful chapters on how to research the company that has attracted your attention, and writes in bold: “Investing without research is like playing stud poker and never looking at the cards”.

Not everyone who has money to invest is able to think of his workplace as an idea generation centre, and most people barely get past the idea generation stage, let alone go through the research required to ensure they are not barking up the wrong tree.

But one thing that they can do (and in fact do already, while facing some criticism for it) is look at the returns generated by their fund, their advisor, and judge whether their chosen vehicle is providing them enough reason to stay invested/ invest more. Not every investor has the inclination for direct equity participation, but those who do should make a judgment about whether their returns seem adequate considering their greatest advantage – their small size. I am glad to report that (in my opinion) small investors have done exactly that by voting on their feet and choosing small-caps over large caps, in recent years. Various vehicles, including direct equity, small cap funds, PMS funds, have been used by a large chunk of people to generate superior returns, via opportunities that are exclusive for the small investor.

The retail investor is doing the right thing. Investing need not be an act of great penance with infinite patience and trust in the judgment of the fund manager. A 10-years wait is too long to decide whether your investments were right. There are vehicles that can help you play to your strengths much better, and you ought to use those vehicles.

My message to the retail investor: Don’t trust. Measure. Say it clearly that you know you are in a position to do better, and you have no obligation to toe their beliefs or their comfort zones. Don’t get upset by some veterans screaming at you. They are upset that at last, the retail investor is demanding that his return be equal to the advantages he has; they are furious that you the Principal in the Principal-Agent situation here, have called their failure to their face, and used those two famous Donald Trump words on them: YOU’RE FIRED.

P.S: If you are a retail investor who is thinking about Rs 25 lakh+ direct equity participation, and are thinking of firing your fund manager/ advisor for not using your advantages sufficiently, give me a call.