Value Investing in Large Caps

The 'Intelligent Investor' by Benjamin Graham has often been called the Bible for Value Investors. In an earlier post, I had mentioned it as one of the must-read books for value investors. The link to that post is available here.

In this book, Benjamin Graham has laid out in great detail why investing in large cap stocks going through a temporary difficulty, is a low risk way to achieve good returns.

In his own words:

"If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue — relatively, at least — companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising. The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown. "

In essence, Graham is suggesting that investing in large cap companies going through difficulties (i.e. quoting at low p/e multiples relative to their usual valuation & relative to peers), is a good strategy. Large caps have greater resources and hence are unlikely to go bankrupt. Hence, by virtue of mean reversion, large caps are likely to reward the patient investor. Also, large caps are typically more diversified and hence a problem in one division/ product/ geography may not be large enough to drag down the whole firm.

Small and mid caps on the other hand, have lower capacity to face bad times. Hence, in the event of a recession/ fall in earnings, they are more likely to suffer higher erosion in earnings, and hence greater fall in stock price.

Some of Warren Buffett's greatest gains have come from exactly this strategy. For eg: his investments in Coca Cola, American Express, Washington Post, etc. I will post case studies on some of these investments in future posts.