Break away from the herd; find pockets of inefficiency
The interesting thing is that such companies are still available, and in abundance - Vikas Gupta
Two roads diverged in a wood, and I—
I took the one less travelled by,
—Robert Frost, The Road Not Taken
Success in investing—whether in the stock market or in other asset classes—requires one to move away from the herd. While in the jungle the herd instinct saves one from getting slaughtered, in the investment jungle, it is the perfect way of getting slaughtered.
Contrary to the efficient market theory, value investors believe that the market is mostly wrong. Of course, just as a broken clock is right two times in a day, the markets are correctly valued twice during a cycle, i.e. once on the way up and once on the way down. For the rest of the time, it is either overvalued or undervalued. That should not be understood to mean that it is easy to make money from the markets. But one can safely infer that there are some portions of the market that are mispriced practically all the time—these are pockets of inefficiency. Finding those portions of the market is an entirely different challenge.
So how does one find these pockets? There is an easy way to do that, by taking the road less travelled.
First, avoid that part of the market which is grabbing favourable headlines. While what is mentioned in the headlines is likely to be good for the society, it is probably not good for the investor. Remember the first ‘dot com’ boom? (The second one is in full swing now.) While the Internet was a great boon for the society, ‘dot com’ investors lost their shirts.
Where the excitement is soaring and the market is roaring, it is likely to be fully valued, nay, overvalued. Search in the downtrodden, the disappointing and the boring. Within these are some hidden treasures, though not all. This is where the ‘herd’ does not like to search and that is why it is available at a huge discount to intrinsic value. Majority of the companies in this section of the market are probably not at a discount even though they look ‘cheap’ on many valuation parameters. But a few are. And these are likely to be significantly undervalued giving multi-bagger returns.
Finding such companies is a challenge. But value investors with a sound understanding of financial analysis, business strategy and industry ecosystems can find these hidden gems. Many of the picks are still likely to be wrong; most will give market-like returns, few will be disasters and a few will be multi-baggers, growing the portfolio value at above-market returns. But all of this is likely to happen over a couple of years, and not in the immediate few months after the investment.
One more pocket of inefficiency lies in another part of the market, which is less frequented and highly profitable: the fallen angels. These are excellent companies facing temporary trouble. The headlines are full of what is wrong with the company. Imagine Infosys Ltd about a year back. It could do nothing right. Or Hero Motocorp Ltd right after the break up with Honda Motor Co. Ltd. Or currently, Coal India Ltd, or Bajaj Auto Ltd. What kind of trouble were/are they in? Definitely not financial distress, since all of these were and are sitting on billions of dollars each. It’s just that the business outlook for growth in the near term is unclear. For that the market has discarded them: the herd loves certainty and clarity.
Where there is certainty and ease of forecasting there is likely to be overvaluation. Where there is uncertainty and difficulty there is likely to be significant undervaluation. This is one of the ‘roads less travelled’, where one searches for companies with uncertain growth outlook but rock-solid balance sheets and probably even income statements and cash flows.
Originality of thought, skill in valuation and strength of character are essential pillars on which value investing stands. Without original thought, it is unlikely that an investor will discover a new path. Even if it is discovered, navigation will be difficult. An arbitrary contrarian stance, i.e. arbitrarily buying stocks with a low price-to-book ratio could lead to losses. (Although, it has been proven by the doyen of Efficient Market Theory and a Nobel prize winner, Eugene Fama, that even this simple strategy on an average makes money across all major world markets.) But skill in valuation, of which financial and business analysis are but a part, can help in selecting the right portion of the market.
Finally, strength of character is required to take the plunge and buy what your original thought had uncovered, and valuation skills have proven to be an undervalued business. The last is where many good fund managers and investors fail. Even more strength of character is required to hold and probably buy more when the inevitable further drop in prices of your holdings happens. And to defend ones holdings to others—which fund managers have to do but fortunately, not individual investors—requires even more conviction.
At present, most individual Indian investors are still selling what they had bought several years ago and until recently was in losses. They are planning to first take those profits out and then take it easy for a few months. Many have no intention of getting into the markets immediately. They want to wait for “something” from the Reserve Bank of India, or the US Federal Reserve or the budget, which will tell them that it is the right time to enter the market.
Meanwhile, the foreign institutional investors are increasing their positions and own nearly half of the free-float of Indian markets. The Indian ‘herd’ is exiting and not willing to enter since the market is “too high” and the “time is not right”. It will enter sometime next year when it will seem that the market has no plans to stop and has given huge returns in the past 18-24 months. The ‘herd’ loves chasing past returns. Value investors had already invested in the past few years and are increasing their positions.
Valuations show huge swathes of inefficiency. However, they are not chasing the typical headline stocks or theme stocks. They are chasing rock-solid balance sheets and businesses at rock-bottom prices in ignored sectors or stocks in headline sectors. The interesting thing is that such companies are still available, and in abundance. These will be available even at the peak of a bubble, probably 3-5 years from now, albeit in fewer numbers.
Vikas Gupta, executive vice-president, traded markets and investment research, ArthVeda Fund Management Pvt. Ltd