smart money

Outperforming The Index Funds & 99% Mutual Funds

Turn the tables in the unfair investing game

Photo by Gilly on Unsplash

When I started investing, I often wondered how a retail investor like me, with a full-time job, can hope to match the performance of institutional investors (mutual funds, etc.), let alone beat them.

Institutional investors often have an army of intelligent analysts. They have time and resources to investigate how their companies are conducting business.

They can visit company offices, talk to their suppliers, customers, etc. to really understand things on the ground. And on top of it, company managements often give them preference during any interaction.

But even with this, in recent times, there has been a growing call favoring index funds over mutual funds owing to the low fees & most of the mutual funds failing to beat the index in the long term.

When institutional investors armed with such high resources are under-performing the index, how can a retail investor even dream of matching let alone outperforming the index performance?

Investing is an unfair game. Just like Brad Pitt says in Moneyball about baseball teams,

“The problem we’re trying to solve is that there are rich teams, and there are poor teams. Then there’s 50 feet of crap. And then there’s us. It’s an unfair game.”

Read this article to find out how to solve this problem!

With great power comes great responsibility

The famous Spider-Man quote applies here as well. Having talked about the powers mutual funds have, let us see what are their responsibilities!

Institutional investors (like mutual funds) have several restrictions that retail investors do not have. Some of them are:

• They can not invest in companies below a certain market cap.
• They can only allocate up-to a certain percentage of capital to one company (it varies, but is generally 10%).
• They can not own more than 5% of any company, so they can not meaningfully invest in a small company.
• They have to follow overall portfolio allocation according to their scheme type, benchmark index, etc.

Even Index has several restrictions that retail investors do not have. Some of them are:

• The index has to include a fixed number of stocks. The number varies but is at-least 30 & can go in thousands.
• The weightage assigned to each stock depends on a lot of factors like stock price, market cap, stock liquidity, etc.

These restrictions are placed not to handicap them, but rather to minimize their losses as people from all economic backgrounds have invested in them. Large losses can have devastating effects on people’s lives.

Now, let us see how can the retail investors use the absence of these restrictions to their advantage without any additional risk.

The Result depends only on what you do & not what you think

Warren Buffett has fantastically explained this in one of his speeches.

“The stock market is a no-called-strike game. You don’t have to swing at everything — you can wait for your pitch”

What this means is you do not need to be correct about every company. You just need to be correct about the companies you invest in.

For example, suppose you understand finance & have only bought shares of HDFC & Bajaj finance (taking these names to only demonstrate, these are not suggestions).

Your investment performance will only be determined by the performance of these companies. You do not need to care at all about your opinion on other companies like say Reliance, ITC, Asian Paints, etc.

There are around 5000 listed companies in India. If we include foreign companies one can invest in, the number will definitely cross 100,000.

But out of those 1,00,000 even if you can find only 10–15 businesses which you understand really well and which are attractively priced according to you, you can buy those businesses & will not need to worry about the returns you will get.

By investing only in a small number of companies that you understand really well, you automatically protect yourself from the dangers of the incomplete knowledge you might have about other companies you did not invest in.

What Does It Mean By Understanding A Business Really Well

While the above discussion is completely correct. It is really important to understand what it means to understand a business really well. Many people think they understand a company. But in reality, they only have some understanding & not the complete picture.

Let us take PayPal as an example & see what one needs to know about it before assuming complete business knowledge.

For those who do not know about PayPal, it is in the business of financial payments services & it is one of the dominant players in its industry.

Some of the questions one needs to answer about PayPal:

1. From where does PayPal’s revenue comes from (geographical as well as business-wise segmentation)? What is its market share in each of them?
2. Who are its competitors for each segment? How high is the competition intensity?
3. What is the CAGR growth rate one can expect for each of their segments for the next 10 years considering the competition?
4. What is the value proposition PayPal offers to its users that is not provided by their competitors & how difficult is it for its competitors to provide the same features?
5. What is its cost structure like? Is it an almost fixed server cost + employee cost model? Or does it have high customer acquisition & churn costs?
6. PayPal benefits significantly from the network effects, with its competitors having their own ecosystems (say Google & Apple) having a high number of users. Will the network effect benefit lower over time or will remain the same/increase even more?
7. PayPal has a Float effect (it gets paid by its customers before it needs to pay its suppliers, thus getting a revolving amount of money to do business with). How effectively is it using its float? Is the float increasing or decreasing?
8. What are the new business areas PayPal is focusing on? And what has been the management track record in executing such new business ideas?
9. How strong is PayPal’s balance sheet, how are they using their excess cash? Is its accounting clean?

This is just scratching the surface. There will be more questions I will need to answer before I can say I understand PayPal’s business.

Please note a few points:

1. I have not talked about any tech. It is not necessary for me as an investor to understand how PayPal provides its services but understand what factors affect business performance & how they are influenced.
2. The answers to these questions can not be exact. They will form a range according to your judgment.
3. I have not talked about PayPal’s share price until now. Only after I get answers to the above questions. I can determine the price (using various financial models like DCF, Residual Value, etc.)
4. Since the answers to the above questions will form a range, so will the fair share price of PayPal will be. It is important to understand that the fair value of any company can not be determined with absolute certainty and will always be a range.
5. PayPal’s current share price needs to be lower than my lower estimate of fair value for me to buy. By doing this, I reduce failure probability because of any mistakes I may have made in my assumptions for fair price calculation. This is called the margin of safety.

This is not a recommendation of any kind on PayPal. It was taken as an example to illustrate the point.

Conclusion

In this article, I talked about how retail investors like you and me can outperform major mutual funds & index funds.

The core idea is you only buy the companies which you really understand at an attractive price.

I hope you enjoyed reading this article as I definitely enjoyed writing it :)

You can follow me to read more such articles in the future. Also, if I have missed anything/ have made any mistake, feel free to reach out to me.