For a moment, let’s keep aside the discussion of investing in large-cap stocks and dedicate next few sentences to the over-glamorized concept of ‘Thinking outside the box’. As per generally agreed definition, thinking outside the box is a metaphor that means to think differently, unconventionally, or from a new perspective. This phrase often refers to novel or creative thinking.
Now you will agree with me that even referring to this phrase makes one sound smart. Even though it’s not at all easy and infact, a grossly misunderstood concept.
Now lets come back to what this website is about – Investing + Common Sense.
To an extent, it’s true. When investing, it does auger well for an investor if he can look outside the box and correctly identify change in trends, businesses, demands, etc.
But when markets continue to do well, market participants (lets ignore whether they are investors or traders) need to increase their efforts to find their next investment thesis. Why is an increase in efforts required? It is because due to rise in markets, good investment opportunities become hard to find.
Now by definition, good investment ideas are rare. So one essentially needs to look in unexplored pockets of stock markets to find good investment worthy stocks. This works well for really good analysts and investors.
But when this trend of finding multibaggers catches the fancy of common investors (who might get attracted to terms like value investing, moat investing, special situations investing, etc.), I feel that the possibility of stocks of well established, large-cap companies getting ignored and falling off the radar, increases.
What I am saying is that when everyone is looking outside the box, it might be a good idea to turn around and look into the box again. Its because there is a good chance that there might be a few good, investment worthy stocks, lying there in plain sight.
To be more specific, it’s possible that when you are looking for the next multibagger among small-caps and other exotic stocks (outside the box), some seriously undervalued stocks might be available in the large-cap space (inside the box).
I was reading an article by John Huber of Saber Capital Management (Base Hit Investing), where he talks about why stocks get mispriced in general. Here is what he had to say, especially about large-caps:
Large caps stocks that get mispriced are almost always due to disgust. These stocks are large companies that are widely followed by investors and analysts. There is very little information that is not widely known by all market participants. However, sometimes these large companies run into a temporary problem and investors sell the stock because the outlook for the next quarter or the next year is poor. Investors can take advantage of this situation by a) accurately analyzing the situation and determining that the nature of the problem is in fact temporary and fixable, and b) be willing to hold the stock for 2 or 3 years—a timeframe that most individual and institutional investors are not willing to participate in.
Some investors refer to this concept as “time arbitrage”. It just means that you’re willing to look out further than most investors and willing to deal with near term volatility and negative (but temporary) short-term business results.
In addition to a company specific “disgust”, these large caps can also get beaten down when the general market environment is pessimistic. In bear markets, companies with no problems at all often see their stock prices get beaten down because of macroeconomic worries or general market pessimism.
So although many value investors look at small caps because they feel this is where they can gain an informational advantage, I think taking advantage of this “disgust” factor is just as effective and is an important arrow to have in the quiver.
These are some really wise words for common investors, looking to build their own direct stock portfolio, in addition to mutual funds portfolio (highly recommended thing to do).
What John is trying to say is that as a common investor, it’s really tough to find the next set of multibaggers (especially in small-cap universe). Common investors by definition do not have the time or the skill to correctly analyse real businesses behind stocks. And honestly speaking, the best they end up doing is to get a tip from here and there, and invest their money, hoping to be right.
Sometimes, it works. But most of the times, it doesn’t.
It can work beautifully in Bull markets as a rising tide lifts all boats. But it can cause big losses when Bulls give way to Bears.
Think about it. When almost everyone is ignoring large cap stocks and looking in the mid-cap and small-cap universe, isn’t it possible that some good, solid and established businesses might be available at throwaway prices? I think, its possible.
A common investor’s best bet when dealing with stock markets, is to use their Common Sense.
So read the paragraphs by John (italicized above) again. Don’t ignore large-cap stocks just because everyone else is saying that they don’t move much. Apart from focusing on upsides, its also very important to protect the downsides when investing. And large caps can help you do that. They generally* don’t fall as sharply as most small-caps.
* There is no guarantee that large-caps won’t fall a lot. It did happen in 2009-2009. It’s just that it doesn’t happen with large-caps as frequently as it happens with small- and mid-caps.