Cover Story: Imitation investing

In a 1675 letter, Isaac Newton, who peeked into the mathematical laws governing the motion of celestial bodies, wrote, "If I have seen further, it is by standing on the shoulders of giants". The urge to seek the guidance of experts, those who have done it before, is embedded in the very essence of what makes us human. Most choices we make are influenced by those we consider our idols. So, it shouldn't be surprising that this inherent human tendency to follow the footsteps of the greats is present in investing. Most investors closely track the buys and sells of fund managers. We, too, regularly publish interviews with market experts. But, does it work? The market is notorious for not adhering to the laws of nature. Even Albert Einstein, who figured out how space and time work, could not predict the markets and lost most of his Nobel Prize money in the 1929 Wall Street Crash. In Wealth Insight's March 2024 issue, we explore the age-old question: Can mimicking the investments of fund managers give you an edge? We explore instances where this investment strategy has worked and failed. But first, let's dive into why investors choose to follow fund managers. The allure of expertise: The psychology behind why investors seek expert advice Google any toothpaste brand. You will be bombarded with advertisements and imagery claiming that nine out of 10 dentists have recommended their toothpaste. Whether these claims are valid or not is a different tale. However, marketers know people are more likely to buy their products if a dentist endorses them. Why is that? In one simple word, the answer is trust. We trust that a dentist who has spent years learning about oral health would know better than most which toothpaste is best for our teeth. In fact, modern civilisation is built on our trust in those who have dedicated their lives to mastering their respective fields. We trust our doctors to cure us, we trust our teachers to help us grow, and we trust policymakers to drive the economy forward. Similarly, investors tend to trust fund managers who have spent years studying the market to know which stocks are the best. So, if nine out of 10 fund managers are buying a stock, chances are they know something most don't, and maybe you should also buy that stock. But, as we have previously stated, the markets are a world of their own. Their laws are different and often absurd. So, apart from society's natural trust in its experts, there exist subtler motivations for investors to follow the lead of fund managers. They are financial athletes We have all run a race at some point in our life. Some of us might even have been stars of our school track team. But, we are no Usain Bolt. Investing is often a race. To reap the highest returns, one must spot promising companies before the market euphoria kicks in. But, fund managers are the Usain Bolts of the market. Analysing the market and spotting winners is what they live for, and chances are they will spot the next multibagger before you. Take the example of Deepak Nitrite. Mutual funds started increasing their stake back in 2015 when the company was just a sodium nitrite manufacturer. But, the experts at the helm knew it had the potential to be much more. Today, it produces a wide range of chemical intermediates. It has also grown an eye-popping 25 times since fund houses spotted it. They know more More information leads to better investment decisions, and fund managers will always have more information than the average investor. Fund houses have access to doors a retail investor doesn't. In addition, they have dedicated teams working around the clock to gather information. To emulate how a fund manager picks stocks is nearly impossible for a retail investor. They can influence the market We are not discussing market manipulation or any underhanded tactics. However, it's undeniable that when investment firms begin to show interest in a particular stock, it captures the broader market's attention. Moreover, the significant levels of investment or divestment that these firms are capable of executing can impact a stock's price. Even experts follow experts Monish Pabrai, the famed Indian American investor and founder of Pabrai Investment Funds, has openly advocated copying successful investing ideas. He even conducted an exercise where he created a portfolio based on the top picks of a few value-oriented fund managers. The results? The portfolio gave 15.5 per cent annual returns in 18 years compared to the S&P 500's 4.8 per cent during the same period. A similar exercise, copying Warren Buffett's Berkshire portfolio from 1976-2006 yielded the same results. The portfolio beat the benchmark in 27 out of 31 years! The numbers favour them Even if one disregards the psychological aspects, historical data says following fund managers is rewarding. We created an equal-weighted portfolio constituting the top 10 stocks that witnessed the highest increase in mutual fund stake as of December 2018. The portfolio generated an annual return of 19 per cent in the next five years. To put that into perspective, Sensex gave an annual return of 15 per cent in the same period. That's an alpha of four percentage points! So, is the question we began with answered? Is copying fund managers a sure-shot road to success? Not quite. It is only one side of the coin. But before we explore the other side, let's delve into the stories of five multibagger stocks, showcasing how investment firms managed to identify their potential early on. Deepak Nitrite: Turning on the nitro In 2015, Deepak Nitrite was a rising Indian chemical manufacturer. Its expertise in manufacturing sodium nitrite and nitrate helped it gain several prominent clients in the textile dyeing, agrochem and petrochem industries. Its robust nitrate business alone warranted investment consideration. However, fund houses sensed a larger opportunity on the horizon. The chemical manufacturer was about to invest Rs 1,700 crore to produce phenol and acetone. There was immense domestic demand for acetone and phenol. But India was mostly importing these chemicals, with no major domestic producer. This supply gap provided an opportunity begging to be conquered. So, hearing Deepak Nitrite was up for the task, fund houses increased their stake from 0.3 per cent in December 2015 to 10.1 in December 2016. In 2019, Deepak Nitrite commenced production. Over the years, it went on to become the largest phenol and

This article was originally published on March 01, 2024.