The Myth of Fair Value

Mean reversion is a defining characteristic of stock market returns over the long haul. More often than not, the excesses of fear and greed are brought in line by the pendulum like effect of valuation. This is not to suggest that its impact is either timely or evenly distributed across categories. Yet, mean reversion is the only antidote to a breakdown in market behaviour driven by animal instincts. However, the faithful are often done in when trying to figure out the “right” mean!

Valuation metrics are significantly dependent on macro-economic context. For example, Asian emerging market stocks look expensive relative to the US and Europe keeping in mind the trends of the last three years. Typically, most Asian markets have simply been more volatile versions of their Western counterparts. The Indian market since end-2007 bears this out perfectly — it fell a lot harder and since early 2009 the strength of the rally has been breath-taking. This is to be expected given the far greater mismatch in capacities and the need for higher inventories in manufacturing compared to the West.

But we may be on the cusp of fundamental and far reaching change. There is no argument about Asian economies being less leveraged and better poised for economic recovery. The banking system is far more resilient and better capitalised. Seven of the top 10 stimulus packages worldwide, in relation to GDP, are Asian. Perhaps, we are headed for a “new normal” now that investors are certain that the worst of the recession is behind us.

If that be the case, the financial crisis may be receding in the rear-view mirror — at least for India. The optimism of the bulls is supported by quarterly earnings that were far better than expected. The numbers suggest industrial production is on the mend. Government seems to be making the right noises with the NHPC IPO a harbinger of further positives on the divestment front. Yet mean reversion often confuses the mathematically gifted! That is because the mean moves. The consequences of our newly ordained political masters seeking to fund inclusive growth through a lax fiscal policy should make us pause for thought. A deficit that spins out of control can do enough damage to reshape our investment choices.

Though most bears are in hiding at the moment, they put forward an interesting argument: Investors don’t have the knowledge and analytical skills to make sense of what’s going on, and are even more hamstrung when it comes to predicting the future. Whenever they are besieged by unexpected events, they respond in an exaggerated manner for fear of being left out. Given this uncertainty, it may well be that the old rules hold and the pendulum is about to swing back by the end of the year.

For the experienced karmayogi, this is a genuine test of character. To invest aggressively based on the prospect of imminent global economic recovery and extended decoupling for Asian emerging markets, would endanger survival. Conversely, to sit on the sidelines oblivious to the remarkable performance of a number of companies in coping with adversity would be to miss an opportunity. Two companies that deserve mention are Shree Cements (Rs. 1,450) and Phoenix Mills (Rs. 112).

The first is benefiting hugely from fresh capacity addition, firm prices and commendable operating efficiency. At under 5 times FY2010 earnings, Shree Cements offers room for upside even in a tricky economic environment. Phoenix Mills is a captivating work in progress leveraged to rising consumer spending. The current valuation provides significant downside protection while holding out the prospect of dramatic gains for the patient investor.

Beware the wisdom of crowds and the madness of mobs — or are they the same?

The words of the late Amos Tversky, statistician par excellence and founding father of behavioural finance, resonate: “It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.”