reflections of the market

Short term or long term: Price and Value

We have discussed in the past about historical values of markets and made some analysis on key pointers. Well, it's about a year since and I see it apt to reflect on where it stands now. 

The factors that drive markets are the same as those drive individual firms, i.e. cash flows, growth and risk. Since risk has direct impact on cash flows and growth it becomes all the more important how we see risk both in terms of intuition and reason. In the long term markets catch up with the fundamentals of the firms. 

However, in the short term that is not the case. Markets move up and down based on the expectations of short-term price seekers. Often, there is irrationality embedded in these expectations. The game of short-term players and long-term investors always renders moot. In the battle of price and value as I see it, eventually value will have the triumph. This is based on the premise that price has to catch up with the fundamentals despite odds and delays.

The year so far

Let's come back to the market and its moods during the year. It started with 5937.65 and closed at 6299.15 yesterday; that is about 7.3% annualized, not very exciting. 

The Nifty was at 5285 by end of August 2013, though; that is about 19% in just two months. You can try the annualized yield, but, the point is such things happen in the short term. The expectations drive moods and consequently, the stock prices.

In the past ten months, the PE has moved from about 15 to 19. The fact that current values are far different from the all time high-low values lets us an opportunity to make decisions. Clearly, the buy time was end-August / beginning-Sept. 

The dividend yield has never been great for the index. This should be because either the firms are in high-growth phase, hence low payout ratios, or there is over-estimation of growth in price. In a growing economy like India, the tendency is to assume the former; however, this should be done with caution. We see firms investing in mediocre projects when they have a lot of cash. This happens primarily when their core business is generating excess cash, and the managers try to extend their smartness to the area they are not good at, just to fill their ego. Instead of increasing dividend payouts they go about empire building. This is not smart corporate finance. When firms reach their stable growth period it is far better to accept that reality and behave like mature firms.

The PB ratio has moved between 2.62 to 3.26. How far one can pay over the book value depends upon the type of business one is looking at. For a capital-intensive business the PB can vary significantly based on the expected earning power of operating assets. For a financial firm the PB is more closer to the book, though. Collectively for the index, it is better to visit history to check the prices it has traded at, albeit keeping in mind the level of interest rates . In Sept-2001 it was 1.92 and in Jan-2008 it was 6.55. A grand display of the vicious moods of Mr. Market.

The Diwali bonanza

Now, the Nifty is trading at 18.18 PE, 2.99 PB and 1.46% dividend yield. In the coming days, there will be a lot of coverage on hot stocks for the season, for the next year and for the next few years. All I can say is, be wary of these talks for these are often loose. Think about this default reasoning: If anyone is good at picking stocks that person would not appear on media and talk about it, rather would concentrate all resources on those stocks and get rich. As a corollary to this, because that person is appearing all over and trying to sell ideas there is reason for us to ignore it. One should try to recognize the bias involved in every proposition.

The basics

The suggestion is to stick to the basics. If you have time and are interested in business, finance and investing, set this activity as your business (full-time or part-time) and make all the efforts in understanding the business and its valuation. Try to understand the difference between price and value. Pick stocks on a selective basis whenever there is price-value mismatches. 

If you don't have time because you enjoy a different activity, there is plenty to cheer than fear. It is best to stick to long-term investing on a systematic basis in a diversified index, let's say, S&P-500 or S&P CNX Nifty. Such a program should be continued despite low or high index values, or adverse economic conditions, and should be carried out for a fairly long period of time. With this strategy you would have beaten a large number of so-called professionals managing money. The rest of the time you can concentrate on your favorite subject.

For both the strategies to work, one aspect is far more important. That is the ability to control emotions, not to get carried away by markets, media, week-end parties, relatives or friends. The fancy word is behavioral finance, but, one need not get there if one has discipline and right behavior.

We all need to cultivate such habits, and thus create our own good luck. 

Finally, the decision to buy an index or a stock should come from the expectations of cash flows, growth and risk. Bear in mind that expected inflation and interest rates influence value at any point in time. Therefore, none of the market ratios should be looked at in isolation.

Let's go back to work, rather than hear the media on hot stocks. Flap!