The World Of PC Sorcar

Why businesses and financial markets have become a hotbed of illusion.

Illusion is the gap between what is supposed to be and what appears to be. Illusions galore in all walks of life, including our own body. When a body part doesn’t play its role, another body part takes over and in the process dupes our mind into believing that all is well. It is only over the years that diagnosis reveals that both body parts have deteriorated, sometimes irreversibly. Similarly, when an ostrich perceives a threat, it digs its head into the sand, giving it a false sense of comfort that the danger has been averted. Boiling-frog syndrome is another example of how an illusion can be fatal. A mirage, a rainbow and Aurora Borealis are all illusions of nature. The movies we watch are an illusion. All facial creams create the illusion of becoming a timeless wonder, more like a mannequin. Most advertisements for consumer products are as such (Maggi is, sorry was, supposedly healthy!). Come to think of it, even money is also an illusion since on its own, it doesn’t have any utility. Its utility is derived from its ability to buy other things which satisfy a want. But that, too, is restricted to the things money can buy. Some money in the bank acts as insurance which also satisfies a security need. But beyond a point, it is an illusion – because it derives no worthwhile benefit – which makes the world go round. So an inherent dichotomy about illusion is that even though it is not reality, it still makes people happy, at least momentarily.

Illusions in capitalism

Businesses and financial markets are the hotbed of illusions. Policymakers in the US have been trying to talk up a V-shaped recovery in their economy for the past five-six years. Many promoters have this illusion of building empires/creating assets though essentially they are the ultimate examples of massive capital destruction. Some other promoters live in the illusion of creating value/wealth without looking to make worthwhile profits well into the foreseeable future (Eg. Amazon). We also have top companies which churn out loads of cash, only to deploy it in some form of grandeur such as an acquisition which is written-off in subsequent years. Many financial market participants have the weirdest of strategies which don’t add even an iota to the economy or to humanity, and is also not connected to any fundamentals of demand and supply of any good or service. Herding is rampant, and the desire to make a quick buck is strong enough reason for illusions to sustain and thrive, though not necessarily for the same set of participants at all times. It’s hilarious to believe that you can get some stock tips on TV and consistently make money out of it. Its only illusions, or misplaced assumptions/expectations, that lull the market into its ‘irrationally exuberant’ or ‘manic depressive’ moods, which in turn throw up price quotes far away from the range of their rational intrinsic value.

Illusions in financial theory

Let’s take a hypothetical company which has a 100% payout (simplistically assuming no dividend distribution tax), but no growth in earnings. Such a company should, at any point in time, quote at a price that generates a dividend yield equal to the YTM on a G-Sec. Given the 10-year G-Sec YTM of approximately 8% currently in India, the P/E for such a company should be 12.5X. It should not matter what the return on equity (RoE) of such a business is. In terms of P/B however, it shall be 12.5X for a 100% RoE business and 1.25X for a 10% RoE business. But this is the inception of illusion. Most market participants get excited about higher RoE businesses because its hip to own shares of a big known company than a little local company in some random industry (akin to the excitement one gets shopping for an ostentatious good as compared to a Giffen good). The illusions in this case could be two. First, they assume they are getting such a business at book value. Second illusion is the overestimation of future growth rates. The only other criteria which may determine P/E is, well illusion itself.

Let us examine the first illusion: Investor fondness for high RoE businesses and the act of becoming part-owners by buying shares in those very businesses. If we were to extend this logic to buying out the whole company, then the economics for the acquirer at a fancy price is quite damaging. In the above example, if the acquirer buys out the company at 12.5X P/B, its own RoE shall instantly fall to 10%. So the buyer of a share (or company as a whole) should be indifferent to buying a 100% RoE business at 12.5X P/B and a 10% RoE business at 1.25X P/B. But, factually, investors in India pay a far higher differential for the former. So, presumably this must be justified on the basis of future growth expectations. This gets us to our second illusion.

If the expected foreseeable future growth in profit is 15%, the P/E on a very rough basis could be double of that in the earlier example. And if the expected foreseeable future growth in profit is 25%, the P/E on a very rough basis could be triple of that in the previous example. It is such assumptions that make some of the current stock quotes a little more justifiable. However, the question is if these assumptions are realistic or illusory. It’s surely hard to forecast accurately, but to assume that any company shall continue to grow at 25% compounded for five-six years or even 15% indefinitely is the equivalent of believing in Jack and the Beanstalk.

Create, then justify

The catalysts adding fuel to the fire are the intermediaries and the media. The former make money when gullible lay speculators (it’s a travesty to call them investors) ‘buy and sell’ shares. They bring out reports which exaggerate the reality or create the illusion of an exaggerated future, which makes the shares gyrate wildly. Their business would be severely affected if people just ‘buy and hold’; even though there is enough empirical evidence to suggest that a fortune can be made if you ‘buy and hold’ the right stocks while trading is a zero-sum-game. Yes, some traders have made fortunes, but then it’s an illusion (overconfidence bias) to assume that you are as nimble and unemotional as them. The illusion of high growth companies is tailored to fit only the next few quarters/years by analysts and TV talking heads, even though any company worth investing in has a life far greater than that. During this high achievement phase, another round of high octane is infused by the media which loses no chance to trumpet new found heroes and then heaps awards on these high flyers and their companies.

Illusions are also created sometimes owing to the inability of Mr Market to distinguish between high quality companies (let’s call them ‘Great’) and the also-rans. And once people miss out on great companies, they shoot in the dark with the hope of getting lucky with the ‘next’ great company. Then there are certain others who want to own existing great companies at any price because while they can’t find anything else, they are still mandated to stay invested in something/anything. Finally, many people mistake expansion for growth.

A fool & his money…

In any company’s lifecycle, there are periods of par growth and supernormal growth. But over long periods (more than seven-eight years), the average growth of most companies tend to mean-revert. But it’s the period of change in growth from par to super-normal when the intermediaries and media cook up stories to pull in the crowd. I remember before the turn of the century, many of the IT companies, though top-notch, made it to this list. Then it was FMCG and pharma companies, then steel. Thereafter there was a phase when PSU banks graced this list. Then it was the turn of textiles, and sugar and then real estate, followed by infrastructure. And we have come full circle now with FMCG and pharma dominating the list again, though private sector banks have replaced IT on the list. The illusion in each case was that the two-three-year period of supernormal growth was extrapolated as if it would continue for many years, and, hence, over-exuberant valuation was accorded to those companies by Mr Market.

The illusion is so lifelike that even the most experienced and levelheaded sometimes lose their heads. The first-movers in such an upmove surely make money, undoubtedly a lot of it. But the majority isn’t as lucky, and end up getting sucked-in. The lure of illusion is too strong to resist and they eventually end up in a suckers rally. And this happens not only in stocks of companies who don’t have meaningful operations or are run by fly-by-night operators, but also companies which are the best in class and scale. The people who bought Infosys at 200 P/E took nine years to barely recover their opportunity cost even though its average RoE in the interim period was 39% and its PAT grew at 26% compounded annually. People who bought HUL at 64 P/E took even longer – 16 years even though its average RoE in the interim period was 76% and it’s PAT grew at 12% compounded annually. In an extreme case, people who bought Zee at 500 P/E are still way under water even after 15 years. There are enough horror stories across sectors. This is illustrated in Insomnia guaranteed. Although peak prices have been taken as entry points, even if we moderate it, the main point still holds that ‘great companies’ create an illusion of safety for an investor who has paid a premium price.

Insomnia guaranteed

Wrong entry price ensures a prolonged period of agony even in great companies...

...while in mediocre companies, this mistake ensures a lifetime of agony

Note: 1) In table 1, entry date is the date when the stocks were most pricey (in terms of valuation) since 1991, and thereafter how many years it took for them to recover their opportunity cost, including dividends. For both table 1 and table 2, June 30, 2015 is taken as the exit date. 

2) Entry and exit prices have been taken on a monthly average basis (to weed out intra-day abnormalities, as also ease of exiting). 

3) PAT and ROE (average) calculated for each stock from year of entry until exit year. 

4) Average ROE = five-year PAT (FY11-FY15)/average net worth (Op FY10 + Cl FY15)/two)/five-year. 

5) Adjusted for dividend, bonus, rights issue, split, merger and demerger.

 Now showing

At present, we have illusions being personified in three spaces. One, in certain pockets in the public market; here there are a bunch of great companies with excellent return ratios accompanied by sustained super-normal growth. They perhaps deservedly quote at a rich valuation. But even here, it is being implicitly assumed that these companies will repeat their chequered history well into the future; and the probability of this happening maybe lower than in the past (see: Great expectations).

Great expectations

The following companies are richly priced and investors are expecting an growth encore

 

There is another pocket, where the quality of the businesses is not exactly commensurate with their growth rates. It’s in this case that it becomes a little harder to justify the valuation at which they are currently quoting. This category may turn out to be a graveyard for investors (see: Much ado about nothing).  Then there is a bunch of businesses that are not extraordinary, nor are they growing at any scorching pace, but still quote at price that seem absurd. The stocks in this category are an accident waiting to happen. This is depicted inMirage of glory. It can be inferred that neither a high RoE nor growth in profit justify such a valuation, but still the halo around such companies showered by Mr Market is nothing but an illusion.

Much ado about nothing

Keynes' beauty contest winner who have a halo around them for seemingly no good reason

 

 Mirage of glory

These are the pinnacle of illusion; mediocre businesses, low growth or both still richly priced 

*Compounded annual profit growth from FY11 to FY15 

Note: Price used for calculation is as on July 15, 2015. 

1) Cut-off market cap > Rs.100 crore to weed out micro-caps prone to manipulation. 

2) D/E > 2.5X (except banking and finance companies) removed from the list to weed out companies with serious balance sheet issues. 

3) Average RoE = five-year PAT (FY11-FY15)/average net worth (Op FY10+ Cl FY15)/two)/five-year. 

4) Adjusted for bonus, rights issue, split, merger and demerger. 

5) Limitations include: using P/E for cyclical businesses, an abnormally small or high base distorting the inferences, not accounting/adjusting for fluctuating PAT across years and assuming them to be linear and an assumption that the audited figures give a true and fair view. 

Source for all data: Capitaline

Second, in certain specific businesses, many promoters or CEOs of big companies are continuing with their zeal to build grandiose empires. It is only years later that many wake up to the reality of a write-off, (see: Acquire now, repent later). 

Acquire now, repent later

Destroying capital is a global phenomena and not just in commodity companies  

The third frenzy is in the startup space. Here, I don’t have a lot of insight, but anecdotal evidence suggests we might be going back to the ‘eyeballs’ days. A few Google clicks should tell anyone interested how it all ended. But right now, everybody is in cruise mode (see:Unicorn club).

Unicorn club

That is the exalted title for startups that have a

valuation upwards of a billion dollars 

Source: CB Insights, figures in $ billion

Watch this space

The illusions are such that people can’t resist hiding their discomfort in them, and this is never going to change. Most people don’t learn from mistakes, neither others’, or their own. This is the cardinal sin which most market players commit, which creates opportunities for players who can resist the lure, and stay focused on hard facts even if it means standing alone in a corner while the rest of the world is going nuts. That’s what it takes to be a winner over long periods in this world of PC Sorcar. But even if one turns a winner in this game of illusion, he is still a rat. As the mighty John Maynard Keynes famously proclaimed, “In the long run, we are all dead”. To play the bigger game, one needs to step out from the world of capitalism and into the world of philosophy and spiritualism. But that is for another day.