The key to investing is being incremental. If you go for the big win every single time, you are gambling and that is how people get into trouble, says Prof Aswath Damodaran, Stern School of Business, NYU, in a discussion with Ajaya Sharma of ET Now. S Naren, CIO, ICICI Prudential AMC and Chakri Lokapriya, CIO & MD, TCG AMC also debate the trade-off between numbers and narratives with Damodaran.
Edited excerpts:
I want to start by understanding your thought process on narratives versus numbers. How have you arrived at this hypothesis? How important it is for investors to understand the relationship between these two variables?
Aswath Damodaran: The key to understanding is to see how the world has shifted around us. Thirty-five years ago when I first started doing valuations, getting data was extremely difficult and working with the data was really difficult as well. So it took a lot more time in valuing companies in terms of pulling their numbers together and working on the mechanics. Today, we are surrounded by data. In fact, I promise too much data not too little data, where being inundated with data often pulls us in different directions.
We have these incredible models and in a sense we have lost control of the process. We no longer value companies, models value companies for us and thats a very dangerous place to be in because I have seen bankers enter numbers into models without any sense of how the numbers work with each other and the reason I have had to develop stories is to give some discipline to my own number crunching. I am going to enter numbers into spreadsheets to pump out valuations and I have to learn to tell a story that ties the numbers together. So, its almost self taught. I had to do it to slow myself down.
Valuation is a process in which you have to assume a lot — be it growth, profitability or the way possibly the business chain pans out. How important it is for a money manager or an investor to take both the variables hand-in-hand and not lean towards one more than the other?
Aswath Damodaran: The key is to listen to other peoples stories and try to make them your own. When I buy a company or invest in one, I am not investing in a CEO story — I am investing in my story for that company. So I have to learn to look at the story that the CEO says and have to do it with respect because that person knows more about the company, but I do recognise that they can come under biases because they want to make their companies look much better than they really are. And I have to learn to take their story and make it my own. I think its important to listen but its much more critical to think for yourself.
You have taught hundreds, thousands of fund managers in these last 25-30 years. Do you think that a lot of them who have more tilt towards the factual data, the spreadsheets — the real the way story in a company or the rationale for buying a stock or a sector — actually people lose sight on that and hence they never get the real grip on why there is a compelling case to get into a stock?
Aswath Damodaran: You start to delude yourself. Once you want to invest in a company whether you are long or short, you want your story to be true. As human beings we have an infinite capacity for self delusion, which is we find facts that back our stories. I tell people the biggest skill that I see in successful money managers is humility to the acceptances that their story might not be the right one.
Lets understand the narrative for the pharmaceutical sector. Till a couple of years back, Mr Hamied of Cipla said that India will become the pharmacy of the world and these were very high growth companies. Then the environment changed. The US drug regulator became much more stringent and the narrative completely changed. Valuations of this entire sector almost halved from top. If you could share some examples the way you avoided some accidents.
S Naren: In pharmaceuticals, the main area where these changes in narratives took place was in America and sitting in India, we got it right to only to a certain extent. What we did not see in the narrative was that there was a buyer side consolidation. The buyer side consolidation changed the power of a seller-buyer interaction from the seller to the buyer and that reduced the margins in pharmaceutical industry for people who are supplying to the US.
Second, FDA issues and other things became big because 30% to 40% of the tablets made in US were actually manufactured in Indian FDA facilities. That reflected in the kind of vigilance that FDA showed. It was at least possible to start predicting some setbacks in a few companies. But you started thinking will these setbacks happen in other companies as well? So, that has been a much more difficult narrative to follow.
Whereas if you look at something like NPLs in the public sector banks, the narrative changed from 2010 to 2018 but being a local issue, it was pretty evident that you knew that NPLs were coming and were not getting recognised at one point of time. As it was a local narrative, we were very vigilant about it because we had access to information on the listed borrowers. We knew some of them would not be able to pay their debts.
A couple of years back, you were one of the early people who got into oil marketing companies. At that time people were questioning whether deregulation would be executed the same way the way it has been promised but that narrative actually played out pretty well in numbers and the valuations of these large enterprises also quadrupled. How did you get it right?
S Naren: Oil prices fell between 1999 and 2004 and there was a big rally in some of the oil marketing companies. The interesting thing about the narrative on oil marketing companies has been that when oil goes up, the OMCs do not deliver returns. So far, the government has not imposed any subsidy on oil marketing companies but the stocks have got derated in last six months.
The narrative is when oil goes up, there is a risk of subsidy which is built because it happened in the last cycle from 2004 to 2007 by the then government. That cycle thinking does happen again because you are still worried that if oil went up, subsidies would come in. So, you have a 2004 to 2007 narrative playing out in 2018. Is it still valid today? The answer is no. But if there were to be subsidies, then the narrative of history of 2004 to 2008 would be played out again.
Chakri, you have been operating currently last couple of years in India but have been wearing a hat of an emerging market fund manager for some time now. Haved you faced this tug of war in other markets as well? Give us some example when you are managing money in London and New York?
Chakri Lokapriya: Narratives and numbers do matter across geographies, across markets and as Naren was pointing out there is probably lesser in one country versus the other. But again in todays world where data, information everything moves much faster than it did before a business model that happened in the US, it would take many years for it to be replicated in India if you rewind back let us say 20-30 years ago. But today that knowledge transfer happens much more faster and therefore it is sometimes become easier where you just look back at the other markets that you invest in, made a mistake where or eventually that the narrative went wrong or the numbers did not keep up with the narrative and try to avoid those in the local market that you are operating in.
The other thing is that being a fund manager or even an individual investor who analyses the narrative for a sector or stock and then takes bet or sometimes waits patiently for the numbers to start trickling in before building a position. Does it have more relevance for a particular size of a company? Is it more large cap oriented issue or more midcap or you think it is agnostic of a size of the company?
Chakri Lokapriya: It is a good question. To think about it. every large company today was small at some point in time. Let us take Reliance IndustriesNSE 1.61 %, one of the largest companies in India and so long the narrative and the numbers behind the company was its refining business and its E&P business.
Today the company is growing big in telecom where it is killing the competition and now it is going into ecommerce. It is also one of the biggest retailers. So here you have one of the largest companies in India which has grown over time with the narrative of all oil analysts.
You must be getting a lot of sell side guys coming and talking to you about individual stock ideas where there is a promise and there is a case to look at that company or invest in that company but the numbers are not visible right now. By the time you actually look at that company or dip your toe in the valuations, the situation would have completely changed. Would it be inappropriate chasing a story or taking risk when numbers are not visible?
Chakri Lokapriya: As the country evolves, new businesses evolve. A new business — social needs, consumer needs — creates other new businesses with new business models. Indians love going to the movies and love eating popcorn at the movie theatres. They did not have good facilities and companies like PVR which were born about 10, 15 years ago and had single digit PEs, were expanding across the country from one multiplex to another.
Over time, as that promise became a reality they started delivering on numbers and expanding throughout the country. From a single digit PE companies today they are trading at about 35, 40 times and the earnings are still keeping up. Now, it is a different question how fast they can grow, will regulations change so from that perspective yes, as new needs emerge or if an entrepreneur is able to identify and then capitalise on it, it can create value. How are you analysing the narrative of global stock markets right now? Market capitalisation globally is at an all-time high. Of course, companies in US mainly FAANG are leading that and making the investors across the world jittery about where is it heading. So how are you analysing the numbers and the story for the US markets?
When you talk about the markets, there is always a macro component in the story to meet the big shift over the last decade, which is the recognition that interest rates were low not just because central banks wished them to be so, but because the global economy has changed in the long term becoming a lower inflation-lower growth economy, which is going to translate into lower interest rates. It also translates into higher PE ratios for any given level of growth because your opportunity costs have changed.
Aswath Damodaran : When people talk about mean reversion in PE ratios, look at PE ratio 20-30 years ago, they are almost asking markets to do the impossible as to price stock as if it was 1986 when T-bonds were at 2018 levels. And its not just T- bonds but the bond rates across the world — interest rates were at historic lows and they would stay there.
That is a reality we have to recognise now and thats one of the reasons I am always cautious about mean reversion for people expecting things to revert back to the way they used to be.
And I think you can have a stock where the story for the stock shifts enough that the mean reversion doesnt work anymore. Its not like the stock is overvalued — its a new story driving the stock and it also depends on where in the lifecycle you are looking at companies. I think Indian companies historically have been more mature because you did not go to the market until you were a more mature company. So when you are looking at a more mature company, you are in chapter 33 of a book — you cant rewrite the story, you cant make up new stories, but look at an Ola you are in chapter 2 of the story. You do not know where the story is going to evolve. The younger the company, more critical the story becomes. The older the company becomes, the more the story gets established and the numbers start to matter.
Indias weight in the MSCI EM index was say less than 2% earlier, now we are 8.5%. What stage of the cycle are Indian markets right now as compared to the developed markets? Are we catching up? How do you see the next 3-4 years?
The way I see Indian markets, as I see big emerging markets, is always three steps forward and two steps back. You are never going to have this linear rise where you go from being successful. In fact, when you see markets year after year, you are setting yourself up for disappointment. I am not forecasting anything drastic but there will be disappointment down the road — that is the nature of the markets. I think in the long term, the trend line has to be up because Indias share of the global markets is not as large as it should be given how big it could be as a percentage of the global economy. So I think there is plenty of room to run but there will be disappointments along the way.
The best example right now on narrative versus numbers is the way earnings in India have been over last three-four years — the earnings cycle. One section of the market believed that earnings have been disappointing but if you take private banks, at least the broader market companies have started showing some improvement in earnings last two-three quarters. We are again sitting here looking at a new quarter ahead. How you analyse the earnings cycle so far versus what the narrative was couple of years back and versus the numbers which have been delivered so far?
S Naren: See some of the narratives becomes very interesting. Suppose oil were to come down and commodity prices came down and inflation comes down, then at that point of time what becomes interesting is that earnings come down. If inflation comes down, does it help earnings? It does not. In India inflation came down from 10% to less than 5%, did it help earnings? It actually reduced earnings.
So, do you actually give a higher valuation to the earnings which come when inflation is much lower and oil is much lower and therefore all your macro indicators are much better? The answer is yes. Did it help the small and mid-cap sector, certainly. If you look at the period when oil came down and interest rates came down, small and mid-caps got rerated much more significantly.
The market has its own way of looking at things and that is why the market did not obey earnings and that is why now putting a linear progression and saying now earnings is coming so market is to go up to the extent that earnings goes up is again not logical because now you are in a higher oil world, in a higher interest rate world and a higher current account deficit one from an Indian context. Earnings may come when the markets can get derated compared to where it was two years back because the macro conditions also play a role.
You cautioned investors pretty early on the midcap end of the market. Do you think a reasonable amount of correction has happened there or is there scope for further correction? The rally in midcaps started in 2013 end. By 2018, the data which I was looking at was at least three, four times over 50% of BSE 500. Now we are down to say 30, 40 times broader markets. What are your thoughts?
S Naren: As fund managers, we all want cycles to last for six months to a year and then you can turn bearish and bullish alternately. But markets need not obey and have short cycles. So, we look at other indicators. Last year, there was a huge inflow into smallcaps and midcaps. Now, we have to see whether the froth of inflows into small and midcaps have got reversed. I had two examples; one was metals and the second was pharma. In metals, in 2008 metal prices peaked and it bottomed in 2015. It looked like in one year pharma has corrected but there was one more year of correction. It is only in the last few months they have rallied. So, somewhere we want market peak to market bottom to be just a short period of time and that need not be.
Right now in India there is a cult of trying to find multi bagger stocks. People are value investing. The word is very actively used on most forums. How do you think prudent investors should try to understand the narrative from their point individually, as Professor Damodaran said not from the management side and still not lose sight of numbers, so that they can both walk hand in hand?
Chakri Lokapriya: As Professor Damodaran says and I am trying to recall what I learned, you start off your valuation with a simple narrative of how you see your company unfolding over time and then you keep your assumptions simple and see how it progresses and you tag on as the company delivers. I do not think that it is possible for you to discover a multi bagger. Yahoo did not see its end coming. They got offers multiple times over and finally got sold for a pittance.
From that perspective, as managements deliver on numbers and they have the vision and expand their horizons, the narrative builds on and tags on to you and the numbers also show up. That is the way I would approach. I do not think I have the capability to find multi baggers on day one.
Aswath Damodaran: I agree entirely. The key in investing is to be incremental. If you go for the big win every single time, you are gambling and that is how people get into trouble. I think the notion that you can invest to get rich is the most dangerous notion in investing. You invest to preserve wealth and to grow wealth, you do not invest to get rich. If you get rich think of it as icing on the cake, you got lucky but if you go out and say I want to make a small amount of money into a large amount of money you can end up with no money at all. So, I think that is the reality investors have to face is be patient, be incremental and the multi baggers will fall in over time.
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