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…
These biases shape the lies we tell ourselves, which in turn affect how we manage our investments and savings.
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.
“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?
If interest rates are low, the discounted value of future cash flows is high. Correct. Comforting. Misleading.
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.
Long periods of drawdowns can become a trigger for bad investment behaviour.
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.
One reason why dead investors perform the best is that their bills don’t come due in bear markets.
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?
At market bottoms the end of world always seems real.
Unless your portfolio is like Buffett’s where the cash just keeps building up with time because of dividends and earning pass-through (unless he deploys it) or your earnings stream is significantly higher than the value of your portfolio – where will you get the money to buy the dip from? “I will never sell” is inconsistent with “I will buy the damn dip”. And even when you have the cash it’s not easy. In those moments the end of world always seems real. Your sense of wellbeing, your comfort with your finances and a pre-defined process – you have to muster all your forces to be patient and act (or not act) sensibly.
Again, it’s not easy. Reimagine what you felt in 2008 or 2020. It will happen again.
“You should never time the market”
This is usually a good advice. I was a staunch believer of this dictum. Over time I have moderated my view. First consider the incentives of people who propose this. Asness says “do not time the market” is same as “ignore the price of what I am selling you and buy no matter what”.
One is made to believe that timing is a binary decision. 0 or 1. It’s not. One is told stories about how if you miss the best few days in the market your returns dwindle. This is just trickery. What if you miss the worst few days?
If you sell something thinking it’s going to crash, you are just setting yourself up for heartburn and mistakes.
Are worst days correlated with best days? Do they come as a package? Short term timing is difficult. Psychology is always important. If you sell something thinking it’s going to crash, you are just setting yourself up for heartburn and mistakes (Isaac Newton selling the South Sea stock only to jump in at the peak with higher allocation). I believe timing has a role in portfolios. It has to be in moderation and it has to be gradual. Asset allocation (when you are rebalancing your portfolios) has a timing component.
What can we do
I don’t think we are in a bubble (although there are always bubbles in some corners of the markets). But I do believe sentiments and valuations are high while fundamentals are still recovering. We might have factored in possible improvements in economic prospects to some extent but we are ignoring downside risks. What should an investor do?
Pay heed to Bazerman & Watkins. If markets were to give substandard returns from this point on or even correct, it would not be a surprise. We need to:
Average long term returns are a result of higher than average returns in certain periods followed by lower than average returns. That’s just math. The time spent by markets below their all-time highs can be long and psychologically taxing. Do a pre-mortem. Imagine equity returns stagnate or markets correct from here. Will you be able to hold on to your portfolios? What will you regret more 1.) Not trimming exposure and markets crashing or 2.) Reducing risk in your portfolio as markets continue to rally?
Recognize what you want from your investments and what kind of risks are you willing to take for that.
Are you comfortable with the absolute value of your portfolio? If you are already rich (a relative term), your first priority should be to stay rich and protect the value of your assets. If you are not rich, this approach still works and is your best bet.
To generate long term returns you have to survive first and avoid mine fields along the way. This is what risk control is about.
To generate long term returns you have to survive first and avoid mine fields along the way. This is what risk control is about.
You can say you will always be fully invested in risk assets. That’s brave and impractical in my opinion. Or you can reduce exposures when the risk manifests itself. This carries the danger of acting at the worst possible moment. Lastly you can have a systematic approach to control your risk. You can prepare. I believe this is what you should focus on.
First know what you own. An investor with 30 funds in his portfolio will have no idea about his equity allocation or duration (interest rate sensitivity) of his debt funds. Most investors are not aware they might be carrying exposure to same factors even though they are diversified across funds. You can generate alpha by 1. Picking the fund/stock that goes on to deliver phenomenal returns. 2. Getting your asset allocation right 3. Avoiding risks that lead to deep cuts in your portfolio. A lot is talked about the first while the latter two are easier to implement.
Diversify across asset classes, across themes, across factors, even across countries.
Actively rebalance your portfolios or pick a product that does it for you. It’s time to follow Noah’s Rule: Predicting rain doesn’t count, building an ark does.
About the authorAbhishek Singh is AVP-Equities at DSP Investment Managers.
All Data as at Feb 17, 2021.
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