Donald Rumsfeld, US Defense Secretary during 9/11, is assured a place in history given his inscrutable wisdom on “known unknowns”. Wall Street was mesmerised by Rumsfeld’s informational taxonomy differentiating a “known known” from a “known unknown” and eventually coming to grips with the prospect of “unknown unknowns!” Put simply, the crux to making money is to understand the exotic known unknown. Enormous intellectual firepower is applied to figuring out future events whose outcome is not known but likely to have a significant impact. Such analysis is either likely to have a considerable influence on security prices or be dismissed as financial flotsam. When a known unknown loses its gloss of complexity and the outcome is a known known, stock prices adjust almost instantly. Or as brokers in London put it, “buy on mystery, sell on history.” Clearly, the last frontiers for investors akin to modern day Christopher Columbus are unknown unknowns. Nassim Taleb, the high priest of this new divinity, describes such events as those having a huge impact that are entirely unpredictable and highly amenable to glib justification, after the fact.
Long Term Capital Management (LTCM), one of the best known hedge funds ever and graced by two Nobel laureates, was savagely wrecked by the Russian debt default of 1998. Neither the incredibly sophisticated computer algorithms nor the genius of the portfolio managers could anticipate an unknown event. The US Fed and Wall Street banks acted urgently to rescue LTCM and pre-empt a global financial crisis. The primary take-away for most Wall Street CEOs appeared to be that they could pursue profits and let central banks worry about the risk should the trades explode! In a strange twist, many of the great and good on Wall Street involved in rescuing LTCM were among the great tragic actors of the 2007-08 credit crisis.
The challenge of the investors is to focus on known unknowns and prepare for unknown unknowns. Robert Rubin, erstwhile Goldman Sachs CEO and US Treasury Secretary, explores the essence of coping with these issues—probabilistic thinking—in his highly engrossing book In an Uncertain World. The vast majority of seasoned investors have an insatiable appetite for information and learning. What this does is help them to identify what they don’t know and assign odds to uncertain outcomes.
Given the apocalyptic nature of events unfolding in Europe, the listless state of the Indian economy and the buzz over imminent pro-reform, investor-friendly announcements by Manmohan Singh, what does the future hold for equity investors? Taking a cue from Rubin, the odds of economic growth continuing to disappoint must be better than the flip of a coin given the record 4.5 percent current account deficit, declining forex reserves, absence of capital spending and stubbornly high inflation. The only redeeming feature is the marked decline in crude oil prices, which is double-edged, given the underlying message of an extended global recession. The current analyst consensus is that India Inc will barely scrape home with double-digit earnings growth for the current financial year ending March 2013. Translate that into an EPS of 1220-1300 for the BSE Sensex, equivalent to an aggregate ROE (return on equity) of 16 percent for India’s most reputed blue-chips. In effect, the valuation metrics are a PE of 14.2 (at the June 29 close of 17,430) for 10-11 percent EPS growth and 16 percent ROE! Far from compelling and less attractive than many other markets such as Russia and Brazil with whom we compete for capital. The chances of truly “big bang” reform coming through in the currently frayed political environment are limited. The hostility towards international investors evident in GAAR (General Anti-Avoidance Rules) is bound to be set right. Yet it appears to be a classic example of too little, too late.