Letter # 51

Equity markets have a way of surprising us. Yes, they did fall more than they arithmetically should have during covid. But there is another undercurrent that is often missed– the 2-plus years’ underperformance of small-cap stocks ended with the market’s bottoming. Since April 2020 till as of writing this letter, while the Sensex has jumped 79%, the BSE Small-cap Index has catapulted 175%. If that sounds like a lot, let me tell you that by historical standards, it’s NOT. But, more on that when we return from this brief detour; one that involves the story of David and Goliath.

While the biblical account of this story is rather well known, I shall still briefly summarize it. As per the Book of Samuel, Israelites were in a standoff for over 40 days with Philistines at the valley of Elah. They eventually decided to settle it based on the outcome of a single fight (less bloodshed that way). Goliath (appearing for Philistines) was a six-footed giant and came bearing heavy armour and many weapons; he was expecting a hand-to-hand combat. David (appearing for Israelites) had a rather small frame and came to the fight with no armour and just a stick, a few stones and a sling. As soon as the fight began, instead of engaging in a close encounter, David hurled a stone at the only part of Goliath’s body not covered with armour (the centre of his forehead), instantly killing him.

While this is interesting, Malcom Gladwell in his book David and Goliath has a more nuanced take on how this story translates into today’s life. He explores two ideas: one, that all what we consider valuable in our world arises out of these lopsided conflicts because the act of facing overwhelming odds produces greatness and beauty. And second, we consistently misread such conflicts. What appear as weaknesses often translate into great sources of strengths; and in that, the fact of being an underdog transforms people in ways we often fail to appreciate. It is a fascinating read, which provides a template of sorts for defeating giants. Let me share a story from the book.

The story of Vivek Ranadive, an MIT graduate who grew up playing cricket, but had to later coach his daughter (12-year old) Anjali’s team at basketball. Initially, he thought that basketball is a mindless game. Team A scores and immediately retreats to its side of the court and team B dribbles the ball from its side of court to A’s side. The length of court is 90 feet, but majority of the game is played in just 24 feet! Only occasionally, teams played ‘full court press’, i.e., contest their opponent’s attempts to advance the ball.

It was rare, but Ranadive had a problem–his girls weren’t tall, couldn’t shoot, weren’t adept at dribbling and there wasn’t a lot of time to teach these skills. He knew that if they played in the conventional way, they were sure to lose. But then Ranadive wasn’t the one to give up easily (he went to study at the MIT in the 1970s–during that time, RBI had to approve the use of forex for studies of individual students. If he could get RBI to bend, how difficult could this be).

Ranadive’s strategy was built around two deadlines that must be met. First, when a team scores, a player from the other team takes the ball outside the play area and has five seconds to pass it on to a teammate in the court. If the team can’t make it in five seconds, the other team gains possession of the ball. Normally it is not a problem since the other team always retreats to its side of the court. The second deadline was to advance the ball across mid-point to the other team’s side within 10 seconds.

Ranadive’s girls decided to play it man-to-man defence (shadow your opponent) and made sure the other team was unable to pass the ball from outside the court. Eventually, the other team missed both its deadlines. This is still ‘little league’ of basketball and 12-year old girls, known to play a certain way, didn’t know how to cope with this unorthodox strategy. Ranadive made sure that his girls were better trained; they had to survive the ‘full court press’ for the entire game. With this little innovation, Anjali’s team managed to reach the nationals despite their known inabilities. They changed the traditional rules of how the game was played, just like David changed the rules of engagement.

Malcom also mentions the story of Lawrence of Arabia’s conquest of Aqaba and how they took on the Turks from the direction where they least expected. I think India’s final assault on Tiger hill during the Kargil war was also based on similar strategy.

Now coming back to markets. Before the onset of the Covid-triggered market fall (and during the time when small caps were underperforming i.e., December 2017 to March 2020), a section of investors (professional and otherwise) had formed this opinion that “large companies will keep getting larger and at the expense of smaller companies.” That meant that the investible universe in India had come to be narrowly defined as a few companies, beyond which investments were considered pariah. That made sense, right? After all, look at small-cap stocks getting decimated for more than 2 years now. It didn’t matter that history stated otherwise, and therefore, these investors were arguably not ready for what was coming.

See the exhibit below; the relative 100ppt outperformance since April 2020 by small caps is the lowest on record since the inception of these indices in April 2003.

Five distinct upcycles are apparent since these indices were formed; and the small-cap index has beaten the Sensex every time. Of course, the opposite is true in downcycles, but it is the net result that should count, right? Any guesses on what that is?

Over the past five years, traditional way of doing business has been disrupted. Banking AQR in 2015, Demonetisation in 2016, GST in 2017, NBFC crisis in 2018 and Covid pandemic in 2020, among others, have made it rather difficult for a lot of smaller companies to compete with larger ones. However, the resilience of Indian entrepreneurship has managed to find ways to stay relevant and be counted when the time comes. The net result: Since April 2003, the BSE Small-cap Index is up close to 30x compared to Sensex rising just 18x. In India, the “Davids” certainly have been beating the “Goliaths” more often than we know.

This letter was originally published here: Smallcaps Vs Sensex: “Davids” Beat “Goliaths” More Often Than We Know (cnbctv18.com)

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