The reverse swing: Small data more important than Big Data

At that time as a freshly-minted graduate, I had gone to my then manager, Steve Norton, and requested him to give me time off to learn Java. To my chagrin, Steve had sat me down and given me a lecture on why I needed to focus on understanding how to analyse businesses and corporate strategy rather than joining the web bandwagon.

Twenty years on as I see today’s graduates climb the Big Data bandwagon, I realise how right Steve was.

Steve’s insight is apt today as it was 20 years ago – small data i.e. an understanding of how companies and industries operate is far more powerful for investors than any amount of big data crunching. Let me illustrate with an example.

The world presents itself to us as small data

Let us begin with a simple game. Assume that we have two buckets: A and B. Each bucket has balls of two colours: red and black. Each of us gets one chance to pick one ball from one bucket (we can choose which bucket to pick from). Whoever picks the first black ball, wins the game.

Bucket A has 100 balls of which 90 are red and the rest are black. Bucket B has 1,000 balls of which 990 are red and the rest are black.

If the goal is to pick a black ball then obviously you should pick from bucket A since the probability of drawing black is 10 percent in bucket A versus 1 percent in bucket B. In other words, you are 10x more likely to win the game if you focus on Bucket A rather than Bucket B.

Sounds simple enough, doesn’t it? Now, let’s bring this game to the real world. Bucket A is the paints sector in India and Bucket B is the NBFC sector in India. Black balls are like Rob Kirby’s Coffee Can stocks (see Kirby’s celebrated paper  from 1984 or my book ‘Coffee Can Investing’ from 2018 for more details) which can give you high returns with low volatility. Red balls are like typical Nifty stocks i.e. you will get returns of around 13 percent per annum over 10 years (i.e. half as much as the black balls) with moderate-high volatility.

If the NBFC sector is like Bucket B, which is 10x less likely to be a winning bet than Bucket A, then why do so many smart investors bet on the NBFC sector?

Conversely, if the paints sector is like Bucket A, why do so few investors bet on paint companies? [I can think of only one private equity (PE) company in India who has invested in the paints sector in the past five years whereas nearly every PE company has an NBFC investment.] In other words, why don’t investors understand the basic probabilities of successful investing?

Investment implications

There are a number of reasons why so much capital flows into the NBFC sector and so little into the paints sector:

1. The barriers to setting up an NBFC in India are relatively low (in what remains a country with scarce provision of credit) compared to setting up a paint company. In paints, thanks to Asian Paints, it is a big challenge for a new entrant to get its distribution into a competitive position [to understand more about this, read Chapters 2 & 3 of my book ‘The Unusual Billionaires’ (2016)]. As a result, there are many more NBFCs clamouring for capital than there are paints companies. [Remember, Bucket B has 10x as many balls as Bucket A.] Economists call it “adverse selection” i.e. the inferior agent more proactively seeks the money. The same thing happens when hospital blood banks offer cash for blood donations.


2. NBFC companies – even the most successful ones – are highly capital consumptive because they rarely generate enough surplus on an annual basis to finance their loan book growth. Paint companies – even second rung ones – typically have return on capital (RoC) above their cost of capital, which means they routinely generate free cash flow. Hence, paint companies seldom need money while NBFCs routinely need money.


3. In the game that I sketched out at the beginning of this note, I assumed that we could easily distinguish whether you had picked a red ball or a black ball. But what if you could fool me into believing that the red ball you had drawn was actually a black ball? If you can easily fool me, then it is no longer obvious that you should choose Bucket A (90 percent of balls are red) over Bucket B (99 percent of balls are red). Applying this to the real world, it is far easier for NBFCs to fool investors about the quality of their business (by evergreening their bad debts) than it is for a paint company (whose free cash flows or RoC will give a pretty clear indication of its health). Hence, in the real world, investors get drawn to the NBFC sector thinking that it is like Bucket A (not Bucket B). In other words, investors see a Bajaj Finance or a Cholamandalam and end up being fooled by other NBFCs into believing that they are the next BAF or Chola.


4. Leaving aside accounting jugglery, the fact that NBFCs are unlikely to produce as high a proportion of black balls as the paints sector takes time to hit home because of the capital structure of NBFCs. As we wrote in our 20 November 2018 blog "...investing in NBFCs is like playing European roulette. You will make money most of the time – Typically in large, free market economies, NBFCs go bust once every decade or so. But then, one day you will (yes, “will” is the apt word) lose everything you invested in the NBFC.
   To cite a more prosaic game that most of us played as kids – investing in NBFCs is like playing Snakes & Ladders. There is that super long snake in the penultimate cell who brings you back to zero (although only a minority of the cells contain snakes). On the other hand, investing in clean, well-managed companies in the real world is like playing Ludo – it is more laborious but we know where we are going and ultimately get there."

In fact, what legendary investors do is read the annual reports of thousands of companies over the course of several decades. That allows them to build a mental database of the base probabilities of successful investing in any given sector. Looking at the world this way, you realise that successful investing is essentially the translation of years of reading/absorbing reams of data into probabilities. In effect, it is when big data becomes small data that you actually get value out of it.

Saurabh Mukherjea is the author of ‘The Unusual Billionaires’ and ‘Coffee Can Investing: the Low Risk Route to Stupendous Wealth’. He’s the Founder of Marcellus Investment Managers, a SEBI regulated provider of Portfolio Management Services.

Disclaimer: Marcellus Investment Managers’ clients own Asian Paints and Bajaj Finance in their PMS portfolios. The views are personal.