The Lies We Tell Ourselves

Life is rarely predictable. What’s worse is that we are also vulnerable to predictable surprises (recall the 2015-Ted talk by Bill Gates). Max Bazerman and Michael Watkins in a Harvard Business Review article write, predictable surprises arise out of failure of 1.) Recognition – being oblivious to risk 2.) Prioritization – underestimating a threat 3.) Mobilization – ineffective response.

Our cognitive biases often prevent us from addressing approaching calamities. We harbour illusions that things are better than they really are. We ignore evidence that conflicts with our preconceptions. We try to maintain status quo and downplay importance of the future.Your blog post content here…

This ‘undermines our motivation and courage to act now to prevent some distant disaster’. A problem that is not imminent or one that we haven’t experienced personally doesn’t seem real. These biases shape the lies we tell ourselves which in turn affect how we manage our investments and savings.

Howard Marks says the key to dealing with the future is in knowing where we are, even if we can’t know precisely where we are going.

Let’s look at where the equity markets in India are currently and assess some popular narratives about why we are here, where we are headed and finally what should an investor do.

Where we are

MSCI India, MSCI World, MSCI Emerging markets are all trading at greater than 99 percentiles of their 15-year history. That means 99 percent of the time they were cheaper than where they are today (even over a longer time horizon, the picture doesn’t get significantly better).

The expanding multiples have defied the declining ROE and earnings growth. Although capacity utilization is low in the economy and the ROEs could indeed bounce back sharply as earnings recover.

Narratives

“Valuations are justified as interest rates are low”

Most advocates of this argument assume that future cash flows remain constant as the interest rates fall. But earnings are correlated with inflation, which in turn is correlated with interest rates. Equity is a real asset. Lower inflation means lower earnings growth.

One needs to ask whether in a zero interest rate environment they will assume a terminal growth of 5%? Why are Japanese equities not trading at infinite multiples?

When interest rates are low:

1.) The valuation multiples “should” be high or

2.) The valuation multiple “are” high.

Are one or both of these statements correct? Are neither?

Clifford Asness in a paper titled Fight the Fed Model (2003, Journal of Portfolio Management) points out that when interest rates are low the prior 10 year returns are high while future 10 year returns are low.

I looked at equity returns for US from 1972 to 2010 and sorted them across interest rates (10 Year Treasury) quartiles. The prospective returns are higher in higher interest rate buckets.

One explanation is market participants are determining valuation multiples based on prevailing interest rates and incorrectly so (in India over the short period of 1990-2010 the relationship between interest rates and equity returns has indeed been along the lines of conventional wisdom).

“Equities always go up in the long run so why bother”

Equities have delivered significant real returns over long periods of time and they should be part of portfolios of most investors. But equity returns have come at the cost of long periods of stagnation and volatility. How long is long enough for you? How much drawdown can you endure?

We are nowhere close to the extremes prevailing in these market at the beginning of periods in these charts.

But a decade or more of sideways markets is common. It becomes a statistic on the chart but living through it can be an ordeal. For most of us, if our portfolio declines by 30% it does impact our sense of well-being and our lifestyles. Being reasonably confident of the recovery is not solace enough. And if this period is long it can become a trigger for bad investment behaviour. Your returns are a function of the asset class performing and your ability to participate in that performance and endure the inevitable volatility and drawdowns.

“I buy only quality stocks and they always outperform”

We have seen this before. Many times. The most prominent being Nifty 50 in 1970s. Buy and forget. These were giants (Coca Cola, Xerox, Walt Disney, McDonalds, American Express, Polaroid). The subsequent drawdown in these names were 60% to 90%. The basket eventually recovered and even delivered alpha but that took almost 5 decades. One reason why dead investors perform the best is that their bills don’t come due in bear markets.

The PE of the quality basket in India has compounded at 8% to 10%. Just the multiple not the stock. 18% for a certain Paints company. These are mature businesses with dominant market shares. There is a debate about whether technology stocks are overvalued in US.

The basket of Facebook, Apple, Google, Microsoft have an average one year forward PE of 28. This is significantly less than the dominant IT company in India. The earnings growth of this basket is 15%. I have no idea whether these stocks are over, under or fairly valued.

GE, IBM, Polaroid, Xerox, Nokia, HP, IBM were all quality. One finds out that a great company is no longer a great company usually only when it’s too late. Benjamin Graham’s security analysis starts with the following quote:

“Many shall be restored that now are fallen and many shall fall that now are in honour”.

“Corporate profit to GDP is at multiyear low and can only go up”

This one is true. The composition of earnings will matter for equity returns. Commodities for example had only 20% share in market cap but 39% share in earnings in FY19. If the earnings come in the Value bucket (quantitative Value, low PE, low PB) then it might not reflect proportionately in Indexes.

But even if we grant that this ratio is low and is bound to inch up you have to ask how much of that growth is already being factored in. Trailing multiples for Indexes were 50% of what they are today when this share was as low in 2001-2002. 3QFY21 earnings have surprised positively after a long time. This could be a fresh start and not a false dawn and we might indeed go on to see strong earnings growth ahead. One year forward Nifty EPS is currently around 680. If this were to compound at 20% for the next three years (making it one of the best earnings periods in history) and PE multiple were to contract to 1 standard deviation above mean, then the Index return will still be close to 12.5% return. The debate is not whether this is possible but what probability to ascribe to this scenario.

“I would never have made money had I worried about valuations”

Think of the most extreme bubbles in history. You will find the same sentiments echoed in each one of them.

Looking at valuations and by that I mean just trying to value businesses instead of stocks has been an underperforming strategy during the last decade. Businesses are dynamic and value of these businesses change. But downright discarding valuations always has its consequences. They are dire at times. Value of a business is discounted value of all future cash flows it will generate. This is axiomatic. There is no debate here. Just because it is tough to estimate these cash flows (it has to be) one can’t reject the approach.

Ask yourself this: If you are holding a stock trading at 100X PE would you sell it if the multiple goes to 200X or 500X. Assuming there is a point where you will sell – how do you decide this number? What process gives you a sell at 200X that is not giving a sell at 100X?

“I will buy more if market falls”

How will you do this if your risk allocation is already high?