Goddess Lakshmi And The Path to Fortune in Equities

Resplendent at the entrance of the Bombay Stock Exchange building is a stunning picture of Goddess Lakshmi. In India and some Asian countries, Goddess Lakshmi is revered as the provider of abundance and divine power that transforms dreams into reality. However, the stock exchange is a place of speculation where many a fortune has been built or wrecked. So, is the placement of this picture invoking the right imagery? Let's dwell on this question in some detail.

The stock markets are a mechanism of distilling future economic conditions into today's prices. The future, however, being inherently uncertain produces contrasting beliefs regarding efficiency of the markets:

1. "Proponents of the Efficient Market Hypothesis believe stock prices reflect all available information about companies and investors can't beat the market indices by stock picking. They say investors trying to find a secret formula are wasting their time because stock prices follow a random walk."

On the other hand, The Sage of Omaha that Warren Buffett is referred to has this view about the markets:

2. "I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors (Buffett gives the e.g., of 9 Value Investors who have long term record of outperformance) have successfully exploited gaps between price and value. When the price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical."
Where does the truth lie? Is investing in equities akin to being on a roulette table ~ where (mis) fortune is determined by chance or is there skill involved?
For instance, in Roulette - a game of chance, there are 38 spaces on the wheel and if a player picks the right space, he gets paid off 35:1 i.e., for each Rupee invested the Casino will pay the winner Rs 35. Since the probability of victory is 1:38, the balance sum is retained by the Casino. Meanwhile, the price for victory is stacked against the player - the longer he plays, the greater will be his losses and greater will be the Casino's revenues. The prices are pre-determined, hence probabilistically the player would win only by chance, and on concerted play, he will lose without doubt.

If, on the other hand, the game involves betting against other players (and not the house), then occasionally the public makes incorrect prices. Poker and Horse Racing are examples of such "Games of SKILL". For example, given the past data of various Horses in a race, one could identify which horse is the most likely winner. However, the analysis that would be of value is which most likely winner is not priced right by the other bettors. Hence to bet on that Horse would yield the right value.

In this context, Steven Crist, a successful Horse bettor, says:

"If a horse has a 33 percent chance of winning a race, and if you can get odds of 2-to-1 on him (which means tripling your money), there is no value - the horse is priced correctly. If you get a 4-to-1 (quintupling your money, or more) on a 33 percent chance winner, then the bet is great."

In parallel, let us consider equity markets; here the counterparties are the buyer and the seller. Price of the security is determined by the eagerness of the seller to sell and the buyer to buy, under the set regulatory guidelines. The stock exchange is a facilitator of these transactions, wherein it brings the counterparties together. Hence there is no house which is setting prices, unlike a casino. Macro factors like rising or falling interest rates, urgent need of capital, mis-assessment of fundamentals, entry-to or exit-from an index, illiquidity of securities, etc. are some reasons why market participants trade. Many times, assessment of the situation is coloured by biases of participants and pricing of securities is inefficient. This inefficiency offers opportunity, in the form of bargains, to the discerning investor.

Nearly 60% to 70% of a stock's value in a Discounted Cash Flow model is a function of its Terminal growth estimate. Frequently, the street extrapolates low growth scenarios into the future, due to temporary prevailing conditions, as elucidated above. This may have an adverse impact on stock prices in the short term. However, correct estimation of future business prospects & growth can offer an opportunity at such times. As growth comes in stronger than expected, stock prices tend to reverse. The Skill in Investing is to identify this differential in expectations and capitalize on it. We firmly agree with Buffet and believe markets frequently price stocks inefficiently. At Kotak PMS it is our constant endeavour to identify such inefficiencies. Goddess Lakshmi blesses those who toil ~ after all she also emerged from Samudra Manthan!

The author is Portfolio Manager & Head- PMS at Kotak Mahindra Asset Management Company. The views and opinion expressed in the column are personal and do not necessarily reflect the opinion of the organisation or the Kotak Group.