Value in valuations

BEATING THE STREET

It is accepted that valuations should be the driving factor behind investment decisions. It is also true that the vast majority of market participants don't make valuation-based decisions.

This paradox is partly due to the herd mentality and partly to the numerical dominance of traders over investors.

What difference does it make to a trader whether he's buying at PEs of 5 or 50? He doesn't hold positions long enough for fundamentals to count. It is probably an unnecessary distraction for a trader to even know what he's buying and selling.

And, there are five or more traders in the market for every long-term investor. This is a healthy state of affairs "" traders create the liquidity that ensures perfect pricing.

Even the big institutions neglect valuations. This is because of the herd mentality. Fund managers are rated and compensated on a comparative basis. So everyone is acutely conscious of peer group actions.

It doesn't matter if they've lost money so long as they've done it the same way as everyone else! Very few managers have either the guts or the licence to be wildly out of whack with their peers.

It can pay to relentlessly maintain a focus on valuations precisely because most people don't. If everyone was valuation-focussed, the returns from value-investing would be no higher than from any other method.

But since few people actually do more than pay lip-service to value investing, there are extraordinary returns available from doing the simple things.

Through five decades, Warren Buffett has become one of the richest men in the world because he has ignored the herd and followed valuations through booms and busts.

Even when investors do concentrate on valuations, they can end up doing silly things because there are so many subjective ways of using numbers. The danger is that of making a buy-decision and then seeking a justification for it post-priori.

There are earnings-based valuation systems where predictability of earnings and growth prospects are emphasised. In these, there is always the necessity to move the bar up or down depending on interest rate and currency fluctuations. There are also net-worth based valuation systems where balance-sheet strength is the key.

Time frames can be crucial. If it's a long-term position, it's always prudent to smoothen out earnings fluctuations before a..pplying an earnings-based model. Graham and Dodd suggested doing using a 10-year average or moving average of earnings.

That was in the 1930s in a predominantly commodities and manufacturing economy suffering through a global depression. With the current predominance of IT/ biotech/ services plays, this is far too long. But the concept makes sense.

Another point is rate and currency fluctuations. In any given decade, interest rates will move a significant amount as will currency rates. Indian rates have dipped from near 20 per cent to just about 6.5 per cent since 1994 and the rupee in that time has moved from 37 versus the USD to 50 and back again to near 45.

US rates have moved from around 8 per cent to about 1.5 per cent and the greenback has moved through a massive range vs both Euro and Yen. Any long-term valuation model should incorporate those factors.