Even the most seasoned investors can sometimes make the mistake of believing that the size of the company and its earnings are the only two indicators of its growth potential. However, that's not true, and we landed on a brilliant analogy in Bharat Shah's book - "Of Long-Term Value & Wealth Creation from Equity Investing" that explains why.
Shah argues that investors should also pay equal attention to the growth opportunity present in a sector. To elaborate, he draws parallels between a fish in a pond and a company and its sector, with the fish being the company and the pond representing the sector.
- Large fish in a large pond: This represents a large-cap company in an industry with a lot of room for growth and low competitive intensity. These companies are often excellent wealth creators and carry low risk. A great example is Maruti Suzuki, the market leader in India's underpenetrated four-wheeler market.
- Small fish in a small pond: This is one of the worst positions for a company to be in. It is small, and there's not enough room to grow in the industry. In addition, the industry also has a high level of competition. For instance, small auto ancillary companies primarily cater to petrol- and diesel-engine cars. Not only do they have to survive against much larger companies, but they also have to fight a rapidly shrinking market due to the widespread adoption of hybrid and electric cars.
- Large fish in a small pond: These are usually market leaders in the later stages of their growth cycle in a saturated industry. Often these companies pay out dividends regularly as there are no major avenues to reinvest the profits. For instance, despite being the market leader, Colgate-Palmolive has struggled to grow its revenue and earnings due to a lack of growth opportunities.
- Small fish in a large pond: These are companies at the early stages of their growth cycle, operating in an industry with strong growth potential. While this sounds similar to the first scenario, investing in these companies is riskier as they are usually younger, and the sector they operate in has high competitive intensity. A perfect example is the Indian IT industry. There is enough room for growth opportunities and many small IT companies. However, to get to the top, they have to compete with the likes of TCS, Infosys, Wipro, etc.
What investors should do
This is not to say that the efficiency of the company and the excellence of the business model doesn't matter. No matter how prosperous an industry or a sector might be, if the company is not efficient and isn't led by competent management, it cannot create wealth for its investors.
In addition, even after you have considered the size of the company, growth opportunities and management, it should not automatically trigger an investment call. Always remember that valuations are also an important factor. Also, always check for macro factors that can be disruptive to the industry and its growth potential.
Suggested read: How to identify winners like Bharat Shah
This article was originally published on April 07, 2023.
Ask Value Research 
New episodes every Friday 
New Process Alert 
Seems like you've uploaded a wrong QR code. Please upload the QR code downloaded from MF Central platform.
