Size Of Opportunity Matters

Indian infrastructure company GVK Power & Infra recently received approval from the Australian government for a USD 10 billion investment in a coal block in Northern Queensland. Earlier this year Vale of Brazil launched its first megaship, called Valemax , with the capacity to carry 350,000 tonnes of iron ore to China.

There is such a thing as too big or too much for a market and almost every market has that threshold. As small participants in large and liquid global financial markets we often tend to forget this fact.

I read about this the first time in Reminiscences of a Stock Operator by Edwin Lefevre. In the book, young Larry Livingston starts out a boy trader in the bucket shops of the earlier 20th century. However, as he graduates and moves on to trading on the stock exchanges, he realizes that his own trading influences the prices of the stocks he trades.

I see professional investors and money managers routinely ignore this attribute when looking at valuations and opportunities. Every opportunity is finite. Extrapolations in Excel will always breakdown at some point.

When one values a land bank, the size of the land bank matters. If a company owns entire potential towns like DLF does in Gurgaon near New Delhi in India or the Irvine Company does in Irvine near Los Angeles, valuation becomes a function of the growth in income and output in the area rather than a multiple of the value of the most recent small parcel transaction. In such cases the time cost of money has the potential to outstrip and burn any potential growth in valueof output in the area.

I know asset managers that have set up India dedicated funds with billions of dollars under management. To prudently deploy that much capital given India's current market size is just not possible. Just because you can raise that much money does not mean you can deploy that much money with high expected returns.

Warren Buffett has repeatedly spoken about the problem of size at Berkshire Hathaway. He has lowered his multi-year expected rate of return on future investments to 7%. His large capital intensive investments in Mid American and Burlington Northern, are admission of the fact that his equity investments are now likely to look more like quasi fixed income investments. Buffett has mentioned on several occasions that with a million dollars to manage, he can guarantee a 50% return per year even in the current environment.

The larger funds in the world specialize and focus on debt/fixed-income markets. The equity markets are just not large enough for them to operate in without creating significant ripples. Debt markets are larger and deeper than equity markets and foreign exchange markets are even larger than debt markets.

However, even foreign exchange markets are finite. China and Japan with their multi trillion dollar foreign exchange reserves have realized that they cannot exit the US dollar into alternate currencies. Economies and currencies of the world are not big or deep enough to absorb the flows that an exit from the US dollar would potentially create.

It is therefore imperative to assess the size of a market opportunity and the potential distortion that an excessively large scale player or a large pool of capital can create in that market.