Value Investing And Behavioral Finance
Lessons From The Chapter Bubble Trap
Valuations do Matter the Most
You cannot pay any price for growth or a new idea or a concept. Ultimately, it is the profits from an enterprise that matter. And for that stream of earnings, there is a price to be paid. That is the value you attach to a stock. Paying a high price for an expected future stream of earnings is a sure way to lose. This is conventional wisdom. No new economy or the advent of any technology can change that. Remember the IT boom. The new adage was “eyeballs”. How many hits a site generated made the company owning that site very valuable. People gave crazy valuations to such companies. Profits did not matter, as in the so-called new internet economy, what mattered was eyeballs.
Investing is all about earning a reasonable rate of return on one’s investment, and that cannot happen if the company does not make profits. Such fads lasted for some time until wisdom dawned and the prices of such internet stocks came crashing down. Most of the real estate, infrastructure and power stocks are highly expensive, but the India growth story is so hyped up that investors believe in paying higher prices for the growth they see in these sectors.
It is challenging to value the land bank of a real estate company. Moreover, in real estate deals, a lot of unaccounted money changes hands in the form of cash. Hence, there is a question of corporate governance. As a result, there is a lack of transparency in dealings; it becomes difficult to value the company. But, in the hope of a boom in real estate prices and the India growth story, investors are willing to buy these stocks at ridiculous valuations.
Take the case of power companies. These companies should deserve the valuations of a commodity company. Moreover, power pricing is also subject to specific government controls. There is no way that, in a developing country like India, which has a power deficit, the power companies will make significant profits to justify high valuations. But power was a hot sector, and power stocks are fancy and media-hyped.
Many capital goods companies and construction companies that will be direct beneficiaries of infrastructure growth are commanding steep valuations even on the infrastructure front. So investors ignoring the valuations are sure to get hit.
Avoid Triple Digit PEs
Another sure way to lose is chasing triple-digit PE stocks. In a bubble situation, the hype and the investor euphoria are so severe that investors pay any price to acquire certain hyped-up stocks. Undoubtedly, sometimes a company comes out with excellent performance due to a breakthrough technology or change in fortunes. However, the investors extrapolate this too far into the future. They are so excited about the salient event that they overreact. They assume that this will be repeated and will thus justify the high price they are paying.
There is no way that such performance can be sustainable. During the technology boom, we saw how even a company like Infosys was commanding a PE of over 100. It was an excellent company with an excellent track record and management. However, such a high PE was unwarranted. There were too much of investor expectations implicit in the price. Any investor who bought this great company in 2000 would lose their investment. Not that the choice of the company was wrong, but the price paid was exorbitant. Even a long-term holding period of eight years could not undo the mistake of paying triple-digit PEs. Reliance is a strong brand in the Indian capital markets. However, some stocks like Reliance Natural Resources Ltd are quoting at a PE of over 700. Reliance Infrastructure is at a PE of over 190.
Such valuations cannot be sustained in the long run, and investors are bound to get hurt. Similarly, another real estate company India Bull Real Estate Co, was at a PE of over 800 in January 2008. With the meltdown in the market in March 2008, it declined to trade at a PE of over 600. A dangerous PE at which to buy a stock. However, The Economic Times reported on 20th March that George Soros, the billionaire investor (speculator), had picked up a 2.5% stake in the company at Rs.455.80.
If one is investing, it is a dangerous thing to do. No wise investor would do this. This is speculation. Investors take the cue from such news and make investment decisions. It is on the assumption that George Soros knows all. However, he is human and prone to make mistakes as much as you are. His speculation does not make the investment instrument any better. It remains a triple-digit PE stock, and investors need to avoid it. In times of madness, anything can happen. Even a public sector company, MMTC of India, commanded a PE multiple of over 800. This soon crashed, to the dismay of greedy investors who paid such a lofty valuation.
Mid-Cap and Small-Cap Stocks
Once the highly capitalized stocks start getting expensive, the market is looking at identifying new opportunities. Thus, the focus shifts to the mid-cap and the small-cap stocks. The growth stories of the hot sectors are woven around these stocks. There is nothing wrong with mid-cap or small-cap stocks, but the problem is representative thinking in a market bubble. When the leaders become expensive, it is effortless to rig the mid-and small-cap stocks. Due to their lack of liquidity, their rise becomes fast, becoming operator favourites.
Unscrupulous management, operators and brokers take advantage of a bubble phase in specific stocks and sectors by rigging the mid-cap and the small-cap in these representative sectors. Since IT stocks were doing very well during the IT boom, we found that many small and less-known companies attracted investor attention due to representative bias. When the tide turned, these stocks became worthless paper. Examples of smaller companies affixing the words ‘dot com’ to their names became sought-after companies, and investors paid a heavy price for chasing them.
Moreover, the mid-cap and small-cap stocks become highly illiquid when the bull market ends. In such a situation, they lose their value very fast without any buyers. After the Harshad Mehta boom in the early-1990s, when the financial sector liberalization started, we had a boom in the financial services industry. Any company having a financial services business was sought after.
When the party ended in 1995, investors were left with worthless paper and the entrants in the industry without jobs. Revisiting the real estate sector, we had new entrants in the mid-cap category entering the markets to take advantage of the boom. Akruti City was one such stock, commanding a lofty multiple of over 90. Similarly, Mahindra Life Space Developer became an investor craze with over 160.
Avoid Large Little-known Companies
In a bubble phase, little-known companies tend to become large due to the market capitalization going up because of the price increase. Such companies attract media and investor attention.
Analysts always want new ideas and thus are born such growth ideas around little-known companies. These companies being in the limelight, become famous and their recall value in the minds of the investor increases. Visual Soft during the IT boom is a fine example of a little-known.
The Hyderabad-based company became large because its stock price went up to ₹Rs.10,000 for an ₹Rs.10 face value. It was the talk of the town, recommended heavily by reputed investment bankers, brokers and analysts. Unfortunately, investors lost a fortune when the tide turned. Financial Technology is another little-known company that came into the limelight due to its fast-growing financial sector and its knowledge base of stock exchanges. It promoted the Multi Commodity Exchange of India. It is an excellent company, with able promoters and a good business model. However, the triple-digit valuation of over 120 PE in the mid-cap category makes it an unattractive investment idea. There are many such examples in the hot sectors like real estate and infrastructure.
Beware of information asymmetry. Information travels in a channel, right from the people surrounding or involved to the ultimate recipients, the investor. The medium encapsulates various mediums and forms. From management updates to stock exchanges to business news channels to sources close to the company to your next-door neighbour who knows somebody in the company.
When you are bombarded with information from various directions, always consider what part of the news reflects the ground reality and what part is somebody else's interpretation of that event. Be critical in your reaction to such news items; otherwise, one might have to face seemingly reliable news turning out to be a hoax, resulting in losses and distress. Moreover, one has to be aware of what step of the information ladder one is.
If one is not at the second or third step of the information ladder, one is likely to be a loser. Availability heuristics create such information ladders. These are made through websites, blogs, newspapers, business magazines and rumours. They also have geographical variants. For example, information in Mumbai city could be old and tenth on the information ladder. Still, in Ahmedabad, the same could be brand new information and first or second on the ladder. The initial investors become salesmen and spread the information more widely. It is only when such inside information becomes public news, and many investors chase it that the stock price goes up and the initial investor's exit. To avoid being an investor who would help the initial investors to exit.
Always check how fast the stock has appreciated in the near past.
This Time it is Different
Every bubble phase has a new theme; however, the excesses are the same. The institutional memory of investors, though decisive regarding the past mistakes in bubbles, fails to help them as they believe that “this time it is different”.
Every bubble signifies excesses and irrational crowd behaviour. This leads investors to buy expensive stocks, buy what others are buying, buy what is fancy in the markets and buy dreams.
However, every new bubble has a unique story, justifying how this is very different from the past bubble. These are just new ideas and fads to act upon the new mania.
During the technology boom, did we not hear “this is the new economy emerging”, “the old rules do not apply”, and “bricks and mortar is dead”? The Indian growth story is leading to excesses in sectors like infrastructure, real estate, and power in the recent past. Stocks in these sectors have been investor favourites and available at expensive multiples. But over a more extended period, the excesses will be corrected. Certain universal principles do not change, irrespective of other changes: A company has to make a profit to reward its To earn returns, one has to buy at the right price; valuations matter the most, there are no short-cuts, and you cannot sow today and reap tomorrow. Irrespective of different times and circumstances prevailing, the universal principles do not change. The euphoria of markets makes one forget the conventional wisdom.
Never Get Married to your Stocks
One common mistake investors make falling in love with their stocks so much that they are not willing to part with them. Yes, one could be lucky to make a fortune in a particular stock, as one was lucky enough to buy it at the right price. But, what must one do when the stock has risen and becomes expensive? There are chances of one getting into a decision paralysis mode.
One must undertake this small exercise:
1. Ascertain the profit you are making on the stock.
How many times have you been lucky enough to make much money? Do these opportunities come often? What can you do with this money? This will set the clarity for your decision-making process.
2. Thereafter, assume that you have money and need to invest.
Ask yourself if you would buy the stock at this rate? If the answer is yes, don’t sell. If the answer is no, sell your stocks and keep the cash handy to buy when the markets offer good buying opportunities. Remember, bull and bear markets follow each other. Cash is the king. Opportunities always come, but you need to have the cash when they arrive. This cash can come when you follow the basic tenets of investing: buy low and sell high. There are many foolish people around who will give you such opportunities. So never get married to your stocks.
After understanding the signs of a bubble, one may become confident and think of short selling, the act of borrowing shares and selling them to repurchase them when the price drops. This temptation needs to be avoided, as a bubble can last longer than one imagines. A stock at a triple-digit PE of 100 may be overvalued, but the market's euphoria can take it up to even 600. No one can judge how long the madness will last. There is another danger in short-selling. If one buys a stock at a price, one knows the maximum loss one can make. However, one does not know how much the stock will go up when one short sells.
If one buys a stock at ₹50, the maximum damage is ₹50 if the stock goes down to zero. However, if one sells a stock at ₹50, the loss is unlimited. The stock can go up to ₹100, 500, 1,000. Or even ₹10,000. When buying a stock, one can borrow money from various sources to pay for the stock. However, when one short-sells the stock, one needs to go to the stock owners to borrow. And these owners can demand any price. One's universe of borrowing is very small. The stock market contract is thus heavily biased towards the buyer.
Moreover, every government would like the markets to be moving up, as that signifies a healthy economy and sound economic policies of the government. The world over, stock markets are the barometer of the financial health of a country. Whenever there is a crisis in the stock markets, the government comes to the rescue. Large government institutions step in to buy to support stock prices, the Finance Minister soothes the sentiment by announcing stimuli, the Reserve Bank brings down interest rates, etc. In such a situation, a short-seller is never respected and is seen as unpatriotic. He cannot have any government sympathy, although he only defies the market stupidity. So it is best to watch the "fun" end and then buy your stocks at reasonable valuations.
Investors would do better in investing and in all walks of life if they kept in mind the behavioural biases that affect clarity in thinking. Money is good as long it is in the pocket. It becomes dangerous when it goes in the head. That is when we become irrational and start making blunders. ‘House money effect’ is used to denote the tendency common amongst gamblers playing in casinos, where they are ready to take more risk with money earned quickly or unexpectedly, which is eventually what success in gambling means.
This tendency is not limited to gamblers in the casinos; it is prevalent in the stock market, particularly during bull runs. As the bull run moves from stage to stage, the money made during one phase is put at risk much more quickly as the thrill and ease associated with making money in the market increases. Thus, just as an investor avoids taking a risk before the onset of the bull run because he values his money more highly, he eventually becomes much more vulnerable to parting with his money, which has grown somewhat during the initial stages of the bull run. This, in part, explains what makes market valuation lose touch with economic reality. Human beings tend to credit their successes to themselves, whereas their failures are attributed to external variables. This bias is termed as ‘attribution bias’.
Money is made mainly backed by the overall increase in stock market levels because of increased demand for stocks. People start attributing their successes to themselves and become more and more confident about their abilities and methods. But any event is a confluence of internal and external factors, and the same is the case in investing. Thus, when an investor makes money, he should reason his success by appreciating any unforeseen event, which led him to make money out of a trade and, accordingly, weighs his strengths against his weaknesses, rather than blindly attributing all the success to himself. If he fails to do so, he will cease to see the linkage between cause and effect, and the result will not be favourable in the long run. Imagine the confidence you will have if you can spot a bubble. Waiting for it to burst can open up a host of opportunities to make a fortune. But it requires courage and patience—rare attributes amongst humans accustomed to quick fixes and instant gratification.