Vijay Kumar Gaba

 The struggle between Newton's law of gravity and global markets is perennial. Many times it appears that the markets are defying the laws of gravity and breaking out of their orbit. However, in the end, it is the law of gravity that has always won. Notwithstanding the distance covered away from the “fair value zone”, and the time spent in the away zone, the asset prices invariably tend to return to the fair value zone. In the common market parlance these digressions and eventual return to normalcy is described by the phrases like Overbought, Oversold, Overvaluation, Undervaluation, Mean Reversion, etc.

It is important to note that a long time spent away from the fair value zone could be very deceptive for investors. Sometimes it gives an illusion that the fair value zone for the subject asset may have already shifted higher or lower and the current price is actually closer to the fair value zone. The investors lacking in discipline and/or conviction may fall for this deception and buy/sell the asset in the “away zone”. Two classic examples of this phenomenon are the stock price of ITC Limited and IRCTC Limited during 2019-2021.

In the past one year, all asset prices that were trying to defy gravity, without having necessary escape velocity, are crashing back to their respective ground positions. Now since the asset prices are correcting downward, trampling the traders and investors coming in their way, the questions to ponder are:

(a)   When would the asset prices hit the rock;

(b)   Whether the rock will be soft or a hard one; meaning whether the prices will jump higher immediately after hitting the rock or they will get stuck there at the bottom, till the next high tide comes to their rescue;

(c)    Which assets are fragile enough to crash and get destroyed when these hit the rock;

(d)   Which assets are flexible enough not to get damaged by hitting the rock and bounce back faster.

History could be a good guide in analyzing these points and finding appropriate answers. However, 2008-2009 may not be a good reference point in this context, in my view. The crisis began to hurt global asset prices from early 2008 as the economic growth, fuelled by a decade of exceptionally loose credit, started to fizzle out and financial leverage became unsustainable.

The process of adjustment and correction was interrupted by innovative and audacious monetary policies of large central bankers. Surprised and enthused by the "whatever it takes" approach of central bankers, traders and investors made large bets on a faster economic revival. Consequently, many asset prices in fact scaled higher peaks than seen during the bull market of 2005-2007.

As it turned out that the comfort was false. The central bankers did manage to restore stability in the financial system; but the economic recovery remained feeble and unbalanced. The global lockdown in the wake of Covid pandemic has completely exposed the fault lines of the global economy and markets. Consequently, the asset prices are now rationalizing to factor in the prospects of even slower economic recovery and further rise in global imbalances.

The process is expected to be protracted and painful. Nothing will be achieved in a year or two.

The good news, in my view, is that India is decoupling from the global pain, as the painful economic corrections implemented in the post global financial crisis era are now beginning to yield results. In fact, as one of the worst sufferers of unfavourable terms of trade, India could be a major gainer as the global imbalances get adjusted to more fair terms of trade.

I am certainly not expecting any exceptional return from the Indian equities over the next couple of years. However, it is apparent that Indian equities can give normal returns for a much longer period than their peers.

(A couple of years ago, one central minister got confused between Isaac Newton and Albert Einstein and erroneously attributed theory of gravity to Einstein. The Enforcement Directorate of Social Media (EDSM) immediately took cognizance of the mistake and forced the minister to correct his mistake. The minister in reference also happened to be a Chartered Accountant by professional qualification, like me. It is reasonable to believe that the minister, like me, does not understand the nuances of the theory of relativity and laws of motion, and got confused. Nonetheless, learning a lesson from that episode, I want to upfront clarify that my knowledge and understanding of the theory of relativity and laws of motion is zilch. Any references to relativity and gravity herein is just plain English and should be read as that only.)

My investment advisor often motivates me to invest in stocks having “valuation cheaper than the industry average or significant valuation discount to the industry leader”.

One of the most common investment advices I get from investment gurus is “invest in quality only”.

I have observed that the most common portfolio evaluation tool used by the market participants is “returns relative to the benchmark”. This benchmark could be an index, returns made by some famous large investor, returns made by a friend or family member, etc.

“Relativity” is thus an important driving force of the investment strategy.

“Mean reversion” or the gravitational pull & push of averages is one of the strongest premises in the financial analysis, especially in the context of investment timing and forecasting prices. The entire spectrum of technical studies of trends in prices (technical analysis); future valuation forecasts (long term average of valuations; standard deviation of valuation parameters etc.); and even earnings forecasts use the “gravitational pull towards mean” as a key control point in their operation.

I think there is a need to reimagine the application of the concepts of “Quality”, “Relativity”, and “Gravity” to the businesses of equity research, investment advisory and portfolio management.

Quality is good as a noun

"Good is a noun...Good as a noun rather than as an adjective is all the Metaphysics of Quality is about. Of course, the ultimate Quality isn't a noun or an adjective or anything else definable, but if you had to reduce the whole Metaphysics of Quality to a single sentence, that would be it."- Robert Pirsig in Lila: An Inquiry into Morals

Honestly, how many of us could tell “who is Kevin Mayer?” without taking the help of St. Google. A mention of Usain Bolt though may ring many bells. If I mention both names together, most may deduce that Kevin Mayer is also a sportsperson.

Kevin Mayer is the world champion of Decathlon, a discipline involving ten track and field competitions. On the other hand Usain Bold is champion of short distance running (100m and 200m). If someone asks me “who is better athlete Kevin or Usain?”, my answer would be “it depends from which vista point I am looking at them!”.

If I am primarily looking for momentary thrill, excitement and/or extreme competitiveness in sports, I would say Usain Bolt is better, because his performance sharply raises my adrenalin level, brings me to the edge of my seat, gives me Goosebumps for 10 to 20 seconds, and then I can go back to my regular work. I would also enjoy seeing someone winning with extremely thin margin (fraction of a second) and may derive some motivation to be highly competitive in my life.

However, if I am looking for an example of stamina, endurance, consistency, multi-dimensional talent & skills, I would prefer Kevin. His performance guides me to adopt a balanced approach in life; as it shows that you do not have to win all the games to be a winner in life. He could still be a winner by a large margin, even if he performs well in 6 out of 10 events of the decathlon.

Now apply this analogy to some popular comparisons in stock market, e.g., Hindustan Unilever & ITC and HDFC Bank and Kotak Bank!

 

The stock of a company does not necessarily become “quality” if it is “relatively cheaper”; or it has given “relatively better returns” over past few years.

I may prefer to invest in a company that has a sustainable business model; its stock has given 10% CAGR over past 20years, with low volatility, simply because I can plan my finances with this investment much better.

Someone else may find quality in a cyclical business that has just entered an upcycle. The stock of this company may have given 12% CAGR over past 20years , but with much higher volatility and unpredictable dividends.

The point I am trying to make here is that “quality” in relation to investments, like anything else in life, should not be considered in relative terms. The quality of a portfolio of investments should be absolute and in congruence with the underlying investment goals.

If my investment goal requires my equity portfolio to grow by 10% CAGR over next 20years, the quality for me would mean the portfolio of stocks which have high probability of growing 10% CAGR over next 20years. Performance of Nifty/Sensex; performance of competitors; performance of other sectors and markets; performance of alternative assets over this period should be mostly irrelevant to me.

Relativity may not always apply to stock analysis

There are many models to evaluate the fair value of a business, e.g., discounted cash flow method, earnings multiplier; revenue multiplier; replacement value; liquidation value etc. In practice it is seen that each business has some peculiarity and applying a standard text book valuation method may not be most appropriate way to find its fair value. Analysts accordingly modify the standard methods as per their understanding of the business.

Comparing the relative valuation of two businesses therefore may not be appropriate in most cases. Nonetheless it is common to evaluate businesses on relative valuation basis. The worst part is that analysts use different methods to find the fair value of a business, in accordance with the size, capital structure, off balance sheet items (eg., hidden assets or contingent liabilities) etc.; but often a common parameter is used to assess the relative valuation of two or more such businesses.

Imagine three pharma companies – one is a large diversified drug producer with presence in 40 countries; manufacturing branded generics and formulation; has a decent portfolio of specialty drugs and has a strong research capability for new molecules; second is a midsized CRAM service provider to foreign companies and third is a small domestic branded generic manufacturer with no export revenue. Would it be appropriate to compare these three businesses on the basis of PE Ratio; EV/EBIDTA; book value or dividend yield basis?

The businesses like depository services, stock brokerages, and asset management mostly collect the revenue upfront. The working capital requirement for these businesses may be negative or negligible. Comparing these businesses with NBFCs, which have a significantly different business model, risk profile and cash flows, may be highly inappropriate.

Notably, the global valuation guru Aswath Damodaran, calculated the fair value of the recently listed food delivery business Zomato to be Rs40.79 against the IPO price of Rs76 and listing price of Rs116. More than half the shares issued in IPO exchanged hands on the day of listing; implying that a large number of discerning investors were willing to pay 2.5x to 3x of fair value assessed by the guru. The quality and fair valuation obviously has different connotation for the guru and the market participants.

(Calculation of fair value by Aswath Damodaran as posted on Twitter)

 Gravity does not work in many cases

The mean reversion or gravitation pull & push for stock prices and valuations has not worked in a large number of cases. In past one decade, the prices of stocks like Asian paint, Pidilite, Dabur, etc., have consistently defied the gravitational pull to mean. Similarly, there is of dearth of stocks that have defied gravitational push to mean despite much desire of the market participants. Most notable examples of such stocks include ADAG stocks, JP Group stocks, Suzlon (all part of Nifty in 2008-09). In some cases however, gravitation force has worked just fine, e.g., PSU Banks.

To conclude, in my view, individual investors must focus on “quality” of their portfolio in absolute terms not in relative proportion; set investment goals as per their social, personal and financial conditions; and evaluate performance of their portfolio in terms of congruence to their investment goals. This shall make their job much simpler.