Markets: Myth and reality

The stock market is all about stories. Some people sell stories and others buy them.

The efforts of investment bankers, brokers, and analysts are directed at spotting new ideas for stories, stories that can then be packaged well and sold easily. This book is about these stories.

The book's title is a bit misleading, because it seems to suggest that these stories are not really true, and this impression is reinforced by the sub-title that talks about exposing investment myths.

But debunking myths is not really the author's intention. Rather, this book goes beyond that, examining each of the main themes around which stock market stories are wrapped, identifying the kernel of truth at the heart of each of these themes or "myths", and advising the investor how he can use that insight.

Damodaran identifies several of these stories. "Buy good companies, and you're sure to get good returns" is one of them. A related one is the growth story""stories with good growth will deliver great returns.

Another theme is that of value""identify low-priced stocks, either by their low price-earnings (PE) ratios, or by their low book values, and sit back and wait for them to appreciate.

A similar strategy asks investors to pick losers""stocks that have been beaten down out of all proportion to their "fair" values. Other stories focus on market timing, or on riding the momentum.

Sometimes the stock salesmen will talk of high dividend payers or companies with stable earnings. At other times they claim superior insight into identifying the next multi-bagger""companies not yet tracked by analysts.

Others will talk about the big money that can be made by subscribing to IPOs. Investors who have been at the receiving end of advice from so-called experts, whether they be newspaper columnists or stock analysts or brokers, will have no difficulty recognising these stories.

They cover the entire spectrum of the market and can be used to sell practically any kind of stock, from blue chips to mid-caps to momentum plays.

So which of these strategies work? None of them and all of them, depending on how you use them. That's not just a clever way of saying nothing""Damodaran's point is that you need to take the essential truth of each of these strategies and combine them with others.

For instance, the advice to buy low PE stocks will obviously land you in trouble if you buy these stocks indiscriminately. Often, stocks have low PEs for sound reasons""their growth prospects may be zilch, or their managements may be dubious, or their earnings may fluctuate wildly.

That's why Damodaran suggests combining the low PE criterion with that of reasonable earnings growth, low risk""either by screening out high beta stocks or those with low debt ratings, and good quality of earnings.

Even after adjusting for these factors, the rewards for following a low PE strategy may be reaped only in the long term.

Like the value story, there are several risks to the "Follow the growth" strategy.

Damodaran points out that you will need to screen the growth strategy "to make sure that you're not overpaying for the growth, that growth can be sustained, that the risk exposure is not excessive and that it is high-quality growth."

He also suggests what screens to use. For instance, the price screen can be based on the principle that only companies with PE ratios less than earnings growth, i.e. a PEG ratio of less than 1, could qualify for the portfolio.

The thing to keep in mind is that you benefit only if the higher growth translates into higher value.

How about a strategy based on momentum? You'll have to be a short-term investor and trade frequently, so keep an eye on transaction costs.

Damodaran says that while there is evidence of stock price momentum, it's very sensitive to the time horizon. So keep testing the data to find the right timing.

Also, since momentum stocks are subject to sharp reversals, you should have a strategy for eliminating the most overpriced of these stocks from your portfolio.

Yet another strategy suggested is of buying when the market overreacts to bad news""one example is of Brazilian companies which lost 40 to 50 per cent of their value because of the country's perceived instability.

A parallel would be May 2004, when the Indian stock market plummeted on political concerns. Buying when there's blood on the streets is investment advice that's as old as the hills.

And finally, what about the well-known fact that stock market investments do better than other asset classes over the long term? Damodaran says that while there's a high probability of that happening, there's no guarantee it will.

He points out that an investor who invested his money in the Nikkei in 1989, when the index reached 40,000, would have lost 80 per cent of his investment by 2003 and is unlikely to recover his losses during his lifetime.

So what are the lessons that investors will learn from this book? Damodaran lists several of them.

Here they are: Be wary of complex, fancifully named investment strategies that claim to be new; if you want guarantees, don't invest in stocks; if you cannot see the risk in a high-return strategy, you haven't looked hard enough; ignore the fundamentals at your own peril; cheap companies are not always good bargains; good companies may not be good investments""it depends on their price; numbers may provide an illusion of objectivity; have a healthy respect for the market; and last but not least, remember the Socratic injunction,"Know Thyself"""that means there's no one best investment strategy that fits all investors.

In short, this is a book that will not only tell you, in a very readable way, about investment strategies, but will examine each of them in the light of the available evidence and advise you how to tailor them for maximum benefit.

INVESTMENT FABLES

Aswath Damodaran
Pearson Education
Price: Rs 499
Pages: 539