Do it yourself

Some famous finfluencers of social media have recently commented that some large-cap stocks have underperformed the benchmark Nifty50 in the past couple of years, while the earnings and balance sheets of these companies have improved decently. These stocks are trading well below their peak valuations. Many of these stocks are trading well below their 5-year median valuations. The finfluencers are arguing that valuations of these stocks shall witness a “mean reversion” soon and these could give 30 to 40% return without any further improvement in earnings or balance sheet matrices. The most popular example cited by these finfluencers is the share price behavior of ITC Limited in 2022-2023.

I have no issues with these social media stars. I will be happy if large-cap stocks like HDFC Bank, Kotak Bank, Hindustan Lever, etc., outperform the benchmark indices and yield a 35-40% return. I am happy to ignore the fact that ITC has yielded a negative return in the past year. My small inquisition to these self-proclaimed market experts is whether they have evaluated the proposition that perhaps the underperformance of many of these large-cap stocks might be a part of their reversion to mean on a much longer timescale.

To understand my point in more simple terms, consider this. If the news headline tomorrow says that Delhi witnessed its highest daytime temperature in six decades, what would be your first thought? It is more likely that your first thought would be “Climate change is for real, and global warming is hitting us all”. You may not consider that six decades ago when Delhi’s population was much less, carbon emission was a fraction of the present level, the ozone shield was much stronger, and climate control was not even a buzzword – Delhi had witnessed a similar high temperature. Maybe the current high temperature is also due to a longer climate cycle; not merely because of damage to the ozone shield.

We would perhaps know the correct answer in another four decades. Till then we may continue to endeavor to cut carbon emissions. Similarly, whether we are reverting to mean valuations for many large-cap stocks or an up move is needed to converge with the mean would be known in 2-3 years.

In this context, it is also important to consider that business dynamics have changed significantly in the past decade. For example-

1.    Most new-age businesses have a larger proportion of intangible assets. The share of intangibles is rising even in conventional businesses.

2.    Many new-age businesses do not differentiate between operating cash-flows and financing cash-flows. They burn capital for revenue expenses.

3.    Most platform businesses are consistently evolving. They do not have a predictable revenue model.

4.    Many large businesses in India have transformed into conglomerates with diverse business profiles.

5.    The current rate environment is too unpredictable to assume a fair long-term rate for DCF.

It’s a challenge to incorporate these factors optimally in the valuation models. Traditional consideration of these factors may not be relevant under the latest circumstances.

As an investor I have always been fond of stories. My strong belief has been that if the story is good, numbers will definitely chase it. To the contrary, if the story is bad, no matter how good the numbers look presently, it may not be worth investing in.

Like in any other method of investing, this method also has its own limitations. Sometimes, good stories fail to sustain the momentum and lose the track midway. Sometimes, bad stories change the course and get on the right path with the help of good numbers.

Nonetheless, I like the story method of investing, as it suits better to my aptitude. In following this method of investing, I just need to keep my eyes & ears open to the happenings around me and look for stories worth investing. New product in my kitchen; new appliance in my bathroom, new or larger hoarding on street corner, an attractive advertisement in newspaper, a shopkeeper pushing some product harder than usual, some management on magazine cover, your children or wife insisting too much to buy a particular product, a news about new technological invention, a motivational story about some innovation changing the life of some people, etc. are some of the signs that could lead you to a potential investment story.

This method of investing saves me from bothering about mundane things like monthly sales & production numbers, quarterly accounts, RBI policy announcements, daily price changes in stock markets etc. It also save me from staying awake till midnight to hear what US Federal officials have to say about inflation and interest rates in US.

I also avoid quantitative (or number driven ) approach to investment for two simple reasons—(i) I am not good at mathematical and statistical techniques of analysis (read MS Excel); and (ii) it makes me dependent on other analysts for my investment decisions. If I have to follow this approach, I would rather entrust my money to a professional fund manager and live in peace.

If you are wondering why am I sharing this thought with the readers, let me explain the trigger. Recently, there has been a debate on social media about the portfolio of very famous fund manager. The critics argued that the earnings of the companies included in much spoken about portfolio of this fund manager would need to grow @20-21% CAGR for next 20years to justify the current PE ratio of the portfolio. The critics also highlighted that if the investment time horizon of an investor is not long enough to match the assumptions of the fund manager, the chances of poor returns are significant.

The supporters of the fund manager argued that for his analysis he used “compounding of cash flows” rather than “compounding of earnings” and therefore the criticism is invalid. The cash flow of a business may compound much faster than earnings (profit after tax or PAT). Since the critics are viewing the portfolio from a totally different vista point, their criticism need not be taken seriously.

My point is that when you use the quantitative method of analysis, it is possible to use a variety of tools for analysing a business. The analysts using different tools may get an entirely different outcome. For example, using different method for calculating the terminal value of a business (e.g., GGM vs Exit value) may give entirely different fair value for the same underlying business. This problem is less likely in using qualitative (or story) method in investment decision making. A good mix of these two would though be panacea for an investor. Find a story emotionally and test that mathematically.