Benefits of investing in large cap stocks
SEBI defines large-cap companies as those whose market cap rank, based on average market capitalization over the previous 6 months, is within 100. For this article, large-cap stocks are those with a market capitalization greater than or equal to Rs.30,000 cr. These companies together account for ~80% of the market capitalization of all NSE-listed companies.
Large-cap companies are usually well-established in their sector and have an agile business model and stable fundamentals. These factors allow large caps to better weather business / economic cycles. In addition, large-cap companies are more in the public gaze due to high analyst coverage. For example, large-cap companies listed on NSE have an average analyst coverage of 20. The number drops down to 1.7 for the rest. Hence these companies are more transparent about business updates and it is easier to find information about large caps. Last but not the least, large-cap companies are stable and profitable. Hence they tend to pay dividends consistently, creating passive income for investors. 82% of large-cap companies, listed on the NSE, have consistently paid dividends during the previous 3 financial years. The number is just 52% for the rest.
What is factor investing?
A factor is a broad and persistent driver of stock returns.
Let’s start right at the beginning. In the 1960’s William Sharpe and his friends introduced the Capital Asset Pricing Model (CAPM), to explain stock market returns.
The model states that the beta or returns of markets drives stock returns. So here market return is the factor. Subsequent research indicated that this was not always true.
In 1992, Eugene Fama and Kenneth French built on the original CAPM and came up with the Fama French 3 factor model.
In addition to stock market returns, the model attributed stock returns to 2 additional factors:
- Size (SMB) : smallcap companies provide greater returns compared to large cap ones.
- Value (HML) : Value stocks provide excess returns compared to growth stocks
In 2014, Fama and French further refined the model and came up with a 5 factor model. In addition to market returns, size and value, this model stated that profitability and investment patterns also affect stock returns.
All this seems familiar right? In the above section we had just discussed small cap stocks. Further, the idea of picking up value stocks usually represented via low PE and more profitable companies is common knowledge even among novice investors.
So which factors actually work? It depends on the asset manager’s research. The table provides a board list of factors that are usually accepted by all asset managers.
More about quality factor
The “Quality” factor has its root in fundamental analysis and has been around for some time. In recent times, issues such as the Enron scandal, revived interest in it. A major drawback of this factor is that there is no consistent definition of what is considered quality.
The Windmill Capital team, after intense research, created the proprietary quality score. We used 4 pieces of financial information to calculate the score :
- Management Effectiveness is determined using Return on Equity (ROE)%
- Financial Strength is evaluated using the Debt/Equity ratio
- Earnings quality is estimated using an accrual ratio ((Net income – Free Operating Cash Flow) / Total Assets)
- Consistency in performance is gauged through earnings variability over the past 5 years.
When calculating quality scores for banks and NBFCs we use capital adequacy ratio instead of gearing ratio. In case of insurance companies, gearing ratio is substituted by insurance leverage ratio.
Based on the quality score, companies can be assigned to any of the 4 quartiles. Companies in quartile 1 (Q1) are the best and so on.
How important are weights in a portfolio?
When it comes to creating and maintaining a portfolio one important aspect that is often ignored is the weights assigned to constituents of the portfolio. Weights of the constituents impact both the returned earned and risk of the portfolio. Let us understand how that is possible. Portfolio return is calculated as:
Rp – Expected return of the portfolio, n – Number of securities in the portfolio, w – Weight of the asset, r – Return of the asset.
Consider a two asset equi-weighted portfolio.
Total returns is calculated as a sum of proportional returns and hence is 16%.
Let’s consider a 2nd scenario with different weights.
Since in this case the weight of the underperforming asset was higher, the portfolio returns dropped. On the contrary if the weights of underperforming assets were lower, the portfolio returns would have increased.
Riskiness of a portfolio is calculated using variance. Higher the variance, higher the riskiness and vice versa. The formula to calculate portfolio variance is follows :
Consider a two asset equi-weighted portfolio and its variance, calculated using the above formula.
The portfolio variance now is 1.48%.
Let’s consider a 2nd scenario with different weights.
The portfolio variance now is 1.58%. Increasing the weight of the stock with higher standard deviation, led to increase in portfolio variance i.e riskiness.
What is Quality Smart Beta smallcase?
Investors interested only in buying large-cap stocks can do so via the ETF or mutual fund route. What is unique about the Quality Smart Beta smallcase is that it shortlists high-quality companies from the large-cap universe. This is done by applying the quality score filter on the top 150 companies by market cap rank.
In addition, the smallcase uses a weighting scheme called Sharpe maximization. Sharpe ratio measures the returns generated per unit of risk. If a portfolio has a higher Sharpe compared to another portfolio, it means that it has generated more returns for every unit of risk taken on. Higher the Sharpe, the better the portfolio performance. The weighing method decides the weights of the stocks in the smallcase in a manner that maximizes the Sharpe ratio.
The ‘Quality Smart Beta’ smallcase aims to systematically beat the large-cap universe of stocks by quantitatively selecting stocks exhibiting strong quality fundamentals. It aims to further enhance returns by adopting the Sharpe maximization weighing scheme. The smallcase is best suited for investors looking to take exposure to quality large-cap stocks for passive long-term investing.