Insights – Equity Asset Class

Insights into the Equity World

Price & Value

At its core, equity investment is nothing but buying an appropriate share at an appropriate price. The determinant of both selection & pricing is the value resident in the asset.

Value is what the product pays to the customer. It is the worth of a good/service for a customer. Such utility or worth could be embedded in the asset (e.g., Gold) or be on account of its cash flow generation (e.g., dividend & capital gains from share, rent from property, etc.). Valuation of a business is mostly about its’ ability to generate free cash flows but would also take into account quality of cash flows, ability to scale up, corporate governance standards, brand recognition etc. 

Price is nothing but amount paid for acquiring the perceived value. Greater the value, greater should be the price. If price paid is less than intrinsic value of asset, then difference between the two becomes margin of safety for the investor.

Determination of value of a business entity is a combination of science & art. There is often difference of opinion among market participants regarding the valuation because of the dynamic nature of economy, business, fund flows etc. When value demonstrated by business is more than the general consensus, share price moves up. The reverse happens when price overshoots the intrinsic value.

The P/E multiple assigned to every rupee earned by the business, is taken as indicator of value. Market rewards value creation by assigning a higher P/E multiple to business & thereby pushing up the share price. On the other hand, P/E multiples get pushed downwards signifying value destruction when fundamentals of business weaken.

Risk-Reward Ratio

Risk-Reward ratio gauges the level of risk in investment as compared to expected returns. Successful investing demands that, over long term, potential for reward should significantly outweigh the risk of loss given the probability of future not panning out as expected.

Before an investment is initiated, the targets on the upside as well as downside are drawn based on the investment framework. It is important that the targets are based on realistic assumptions & risk assumed to capture reward is within investor’s risk tolerance level. In case of mismatch, either the downward target is pushed upwards to reduce potential for loss or an investment with better upside at same risk, is searched for. 

Regression to Mean

Regression to mean is a mathematical tendency of extreme events being followed by those closer to average – whenever variables are not perfectly correlated. Randomness & luck are key features of stock market & investing. So, whenever markets move too far away from the long-term averages, regression to mean can reasonably be expected to happen.

Behavioral tendencies of investors make sure that regression to mean happens. It all starts with stealth phase, when smart money accumulates quantity of shares in small price range. It is followed by awareness phase, when institutional money jumps in a big way to push up valuation multiples. Thereafter, media spotlight feeds the greed of retail investor participation for quick profits, to provide momentum to rising valuations during this mania phase. Valuation shoots up to the extremes & fundamentals no longer remain in sync. It is at these levels that statistic kicks in to make market realize that thesis justifying extreme valuations is, in fact weak. Capitulation marks the blow-off phase that follows, when fear of huge loss makes everybody rush to the exit gate at the same time. Valuations get destroyed & dip far below the long-term average. This extreme low valuation sets the stage for value buying. Regression to mean happens & prices again come up to long term trend line. 

Indisputable truth of Equity Investment

  • Higher priced asset will produce a lower return than a lower-priced one. The price to be paid for chasing gravity defying valuations is ‘lower 10-year return’ from the peak.
  • Strongest investment opportunities emerge in periods where favorable market internals combine with significant retreat in valuations.
  • Hostile investment environment is when ‘extreme valuations over extended period’ combine with deterioration in market fundamentals.

Circa 2021 – food for thought

  • In major economies of the world, interest rates have trekked down to zero in last 40-years.
  • Investors are being forced to chase risk assets in search of yield.
  • Longevity & depth of credit market bubble in major economies have pushed all asset classes to price extremes.
  • Sensitivity levels of the market are significantly up. Even a small rise in interest rates would be a high % on such low base & reaction to that will not be linear.
  • Risk is totally mis-priced.

Mean Reversion Levels seem to be at all-time high. In movie lingo, let’s just say, something’s gotta give!

Circa 2022 – food for thought

  • Inflation genie is finally out of the bottle. Every major economy is experiencing decadal high inflation.
  • Central Banks are being pushed into a corner. Pushing inflation down to acceptable levels has become greater policy imperative than growth. Primary lending interest rate has been raised by almost every central bank & is expected to be raised 2-3 times over the next year.
  • US & Euro economies may be pushed into recession, in the bid to curb inflation expectation from getting entrenched.
  • Value contraction (or destruction) may be pre-dominant post-effect of the new interest regime. Management quality & stability of earnings may once again return as the primary investing touchpoint.
  • Mean Reversion is all set to happen. Even an outlier economy cannot be expected to remain unaffected by the turmoil.
  • With many long-term trends inflation, interest (& hence, valuation of equity & real-estate financing), index investing, dollar as reserve currency, globalization etc. all set to change, the coming Epochal Change would demand a reset to long held assumptions of investment strategy. As Buffett observed, the tide is now turning & all those swimming naked (& the crypto guys) better be prepared.  

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