Thursday, April 17, 2014

Is value only found in small caps? (And why markets are inefficient)

A company analysis is due from me and I will get to doing those next week. This week I don't have access to my research data as I am travelling. Hope you enjoy the articles on value investing concepts.


Many readers write to me saying why do you even bother covering large cap stocks? Look outside the top 300 companies for value as the large cap stocks have too many eyes on them. I agree that from first principles value is likely to be found outside the top 300 companies, but the concept of Mr. Market needs to be understood in great detail before we declare the market for the top 300 companies to be fully efficient.

Value investing as taught by Ben Graham and practiced by Buffet is an activity where we first figure out what the intrinsic value of a company is and the compare that number to what the market is offering to buy or sell it at. Another Buffet addition is that if the company has a moat that enables it to consistently grow earnings then you may never need to sell the company. First up if the top 300 companies are always efficiently priced then Buffet would never have succeeded in beating the market by buying large cap stocks.

Secondly and most importantly no market is efficient. Let me illustrate this point by a recent turn of events. Since August 2013 till Apr 2014 the NIFTY has risen by over 21%. Has the intrinsic value of the underlying companies changed by 21% over this short period of 8 months? I think not. Before that between May 2013 and Aug 2013 the NIFTY fell by over 10%. Again in 3 months can the earnings potential of all NIFTY companies change such that the value is 10% lower? It simply is not the case that the markets are rational. This is the basis for the creation of the Mr. Market concept.

Let me try to address some of the reasons why markets are irrational:

1. Sectorial allocations

A large section of the markets is institutional money. When individuals buy mutual funds they do not pick weightages perfectly. In fact this process of capital allocation to a real estate mutual fund or an infrastructure mutual fund or a small cap mutual fund is almost always a fairly arbitrary decision based on little data. Even when people try to make an informed call on this the data required to perfectly allocate capital on a macro basis is simply too large for people to analyze and thus macro strategies rarely beat the markets. So when a particular sector gets too much or too little allocation relative to the available earnings and potential future earnings underlying the sector systematic mispricing takes place.

2. Fear and Greed

This is the holy grail of the value investing literature. Human beings find it very difficult to be rational and disconnected from the emotion of the market prices of investments. When the markets start falling there is typically a flight to quality by everyone into government bonds or fixed deposits or the likes creating an overreaction in one direction. On the contrary during a market rally a trading desk is a very interesting place to be - the primary concern of every portfolio manager is that the competition will make more money and this fear leads an overreaction in the direction of the market being overbought.

3. Fads

Stocks and companies can become fads much like fashion. These fads can continue for years and even decades. Examples include the powergrid IPO in India which was trading at a ridiculous P/E ratio but everyone bought it. Solar power companies in the US have seen this. A very famous stock Amazon in the US has consistently traded above 100 times earnings which implies earnings growth that is unprecedented by Amazon itself! We have all heard of the tulip mania stories from 100s of years ago.

4. The old boys club

Influential investment banks back companies who are their clients and market some stocks far better than others. This sometimes changes the capital allocation to some stocks more than others.

5. Use of Leverage by equity investors

Yes believe it or not when large highly leveraged funds decide to change their positions drastically it leads to market inefficiency. As the FII activity in India has picked up this factor has picked up importance as a source of inefficiency. Imagine a fund that is levered 1:10 times equity to debt where the market moves 5% against the fund. The fund will probably loose around 50% of its equity and the prime broker will force the fund to reduce leverage by liquidating their portfolio rapidly. This situation typically leads to market inefficiency.

There are several more reasons for markets be inefficient but this hopefully gives you a flavor of the reasons why markets are not efficient.

Another reason for analyzing large cap or highly watched stocks is for me to add these to the moat list - a wish list to keep around when the markets take a nose dive to go shopping for deals. That way one is able to react rapidly when the prices are low enough for you to buy.

Hopefully you are now convinced that value can be found in all kinds of sectors and capital classes, and even if value is not found there today analyzing over valued companies enables us to create a wish list to keep handy for shopping in times of pandemonium.

Please do write to me if you have a different perspective on whether markets for highly watched stocks are efficient.