Tuesday, September 9, 2014

Book Review #13: Value Investing and Behavioral Finance: Author: Parag Parekh

Key Concepts: Law of the farm, Growth Trap, Contrarian Investing, Prospect Theory, Value in use, Value in exchange, False consensus effect, Group think, Ambiguity effect, Buyer's remorse, Confirmation Trap, Recency Effect, Base Information, Singular Information, Extrapolation Bias


As readers of my blog, especially of the Book Review Series on 50 Books on Finance, will no doubt know, I love reading and reviewing books that contain pearls of wisdom, great insights and which are conceptually compelling. This book, 'Value Investing and Behavioural Finance' offers all the three. To top it all, the book focuses on the Indian Market.

I had always wanted to review a book written by Indians and which focus on the Indian market. Such books are few and far between. Given my stated interest in reviewing books on Indian markets, it is surprising that I had allowed this book to remain unread in my library shelf for over a year.

Better late than never, as they say.

Burst a few knowledge bubbles, did this book. All through my education on Investments (Including Chapter 7 here), I have been led to believe in the superiority of Index Investing over investing through mutual funds or direct purchase of stocks. The argument was that over the long-term (there we go again !) the returns from Index Investing (also known as 'Passive Investing') offered superior returns than almost 90% of actively managed mutual funds. During the course of my investing education I bought into index investing for a brief period of time and gave up because the returns were not in sync with that of the respective indices. Two questions always bothered me about index investing. One was that if all the mutual funds were investing in the same index, why do the performance of index funds vary across the funds and with reference to the index being tracked? Value Research has given 5 Star rating to some index funds and 2 Star rating to others. This didn't make sense to me.

My other beef about index investing was that there were a number of actively managed diversified equity funds that had consistently outperformed the index and the index funds over a significant period of time. This was illogical.

I got answers to both these questions when I was reading the chapter on 'Index Investing' in this book. 

Another myth that got burst was related to IPOs (Initial Public Offerings). There is a craze in India (I suspect world wide, see the frenzy on IPO of Alibaba in NYSE) for investing in IPOs. In the chapter on IPOs, I read about how the companies and that investment managers have a motivation to inflate the price of IPO offering. 

The focus of this book is on value investing. As the author says, the objective of every equity investor should be to identify great companies with sound management that are trading at reasonable valuations, buy and hold them ("What is the best time to sell a stock? I will say never"). This approach is close to my heart. 

The division of actual returns into real returns and speculative returns is something that I learned from this book. The book also talks about the failed IPOs of Reliance Power and DLF (that cost investors crores of money) and offers key insight into the behavioral aspects of both the promoters and the investors that led to the colossal failure of these IPOs. I was one of the unfortunate victims of the Reliance Power IPO scam. Reading these insights made my blood boil. 

Behavioral aspects of Finance is an area that has gained tremendous traction over the last 20 years. This book looks at the various concepts of behavioral finance and their applicability to Indian stock market. This book was written in 2008, when the last major bull run from 2003 to 2008 was winding down. At the time of writing this book the Indian market had corrected from a high of 21000 to about 15000. As we all know, the market ended going all the way down to less than 8000 (61% Fibonacci Retracement). I am sure that we would have gained much more insights had the author waited for the entire correction to pan out (he need not have waited for long !) before publishing this book. 

It is worthwhile to note that from those lows of 8000, we are currently trading at 26000, a 300% gain in about 6 years !. And still we are talking about 'India being at the beginning of the next bull market'. Mind boggles when one thinks of the potential !.

The key objective of the book is to sensitize the readers to many decision making patterns (called 'Heuristics') that an individual investor uses when investing in equity market. Equity investing calls for the painstaking work of analyzing the current and future prospects of a company.  This involves macro economic analysis, industry analysis, company analysis, talking to the company...the works. To avoid the tedious work, investors resort to decision making shortcuts known as Heuristics. For example, I resort to heuristics like low PE /low PB /low Debt-Equity/52 Week high etc. While these are explicit heuristics, investors also resort to implicit heuristics like Availability Heuristics - 'Everyone is talking about this stock, this should be good', Herding - 'Everyone is buying this stock, I also should', Representative Heuristics - 'Logistics industry will do well, so all logistics companies will do well' and others.

An investor who is aware of the decision making heuristics that he is using is a better investor. He will understand that during bull market there will be availability of a lot of positive news (availability heuristics) not all of which may be correct. He will be alert to the representative heuristics and will not invest in all the stocks in a sector just because the sector is going up.

This book creates that much needed awareness.

Author points out that when it comes to equity investing, investors forget history and repeats the same mistakes which were previously made by others. This is because of, one, demographic shift (new younger investors come and make the same mistakes as made by their seniors!) and two, the preponderance of recent events and news that overtakes the relevant information from the past (Availability Heuristic and Recency effect). As an example, author points out that despite the failure of Morgan Stanley Close Ended Fund which underwent 'Brute' manipulation by Gray Market Operators, Anil Ambani allowed his Reliance Power IPO to be manipulated by Gray Market, which in the end, led to significant losses for investors and loss of face for ADAG group.

This book is well structured through its 12 chapters taking the reader through the behavioral impact on various aspects Indian equity markets. Chapter 1 discusses the behavioral traits that lead to personal success and failure with emphasis on delayed gratification. Chapter two talks of human behaviors applicable to stock market and how these behaviors make the market risky for investors. This chapter also provide a peek into 'Prospect Theory' which won Nobel Prize. Chapter 3 starts off the operative part of this book with a discussion on the behavioral obstacles to value investing. This is followed by a chapter each on Contrarian Investing, Growth Trap, Commodity Investing, Investing in PSUs (Public Sector Units aka Government Controlled Companies), Sector Investing, Initial Public Offerings (IPOs) and Index Investing. Chapter 11 discusses the investor behavior that lead to bubbles int he equity market. The book winds down with a look in Chapter 12 about a new concept called 'Investor Behavior Based Finance' which discusses how a company can use the understanding of its investors while taking Corporate Finance Decisions.

Chapter Summary

If the purpose of the first chapter of a book is to arouse curiosity in the reader about the rest of the book, Chapter 1 titled 'Success and Failure' fails to do that. Were it not for my current project of reviewing 50 Books on Finance I doubt if I would have continued reading the book beyond the first chapter. The chapter is filled with generalizations, cliches and platitudes. It says that many of us are lazy, greedy, ambitions, selfish and ignorant. We strive for security, comfort, leisure, love, respect and fulfillment. I regressed to my MBA Class where professor was talking about Maslow's need hierarchy. The chapter makes two key points. Once is that the in life always the 'Law of the Farm'  works. You have to sow before you can reap. The other point is that the basic cause of failure is our penchant for 'Instant Gratification'. Key recipe for success is the ability to plan our goals and the self discipline to ignore temptations and strive relentlessly towards achieving those goals.

Chapter 2 titled 'Understanding Behavioral Trends' starts off by looking at the two components of equity returns vis. fundamental returns and speculative returns. Fundamentals deal with the returns from growth in earnings and dividends. Speculative component is due to PE expansion or contraction. The speculative components depend on investor sentiments and could fluctuate wildly.
Formula for calculating the Fundamental return is,
[ (Ending EPS - Beginning EPS) X Beginning PE + Dividends for the period ] / Price Paid
and the formula for speculative returns is,
[ (Ending PE - Beginning PE) X Ending EPS ] / Price Paid
The author advises retail investors never to get carried away by 'Noise' in the market and stick to buying fundamentally good companies at a low to reasonable price.

So what are the behavioral obstacles to value investing? This is addressed in Chapter 3 titled 'Behavioral Obstacles to Value Investing'. This chapter looks at both Value and Growth investing styles and analyses as to why people favour one style over another. There are two types of value, Value in use and Value in Exchange. Water has a lot of value in use whereas gold has a lot of value in exchange. Value Investors should know the difference between the above concepts of value and only buy those companies that has good value in exchange which appreciates over time. Behavioral obstacles to value investing include Recency effect - giving more importance to recent information at the cost of older but relevant information, Prospect theory - People give more value to loss aversion over profits and tend to sell off profitable investments soon and tend to keep ( and add to) the loss making investments in their portfolio and Instant Gratification - Not having the patience to stay invested over a significant period of time. Since the process of identifying value is complex, people resort to heuristics like PE, PB and Price / Sales Heuristics to identify value.

Author makes two observations about Growth Investing. One, growth is not the same as returns. If you buy a growth stock at a high price, you will not reap returns. Two, there is a difference between good companies and good stocks. It is not necessary that good companies are good stocks at all time. Some time there will be a divergence between the performance of the company and its potential to provide good investment returns. Another important point is that investors are reluctant to change courses and sometimes are content with sub-optimal returns.

Contrarian Investing is the focus of Chapter 4.  Contrarian investor is one who goes against the conventional wisdom when picking investment opportunities. The book discusses personal and organizational heuristics that could become an impediment to contrarian investing. Personal heuristics include Group Thinking - where you sacrifice your views to become a part of a group, False Consensus Effect - tendency to overestimate the percentage of people we think would agree with us, Buyer's remorse - tendency to regret our decisions if they go against us in the short-term, Ambiguity Effect - Depending on external inputs to reduce uncertainty of stock purchase and reduce ambiguity (looking for validation in message boards, for example), Herding, Recency effect - giving undue importance to recent negative stock and Confirmation Trap - Tendency to seek confirmation of your decision through actions of others (You may not want to buy when all others around you are selling) etc. The author talks of a study done by his firm that showed that over a 10 year time-frame, contrarian investing (at the beginning of the year buying the 10 lowest PE stocks in the index and holding them for one year) outperformed conventional investing (at the beginning of the year buying the 10 highest PE stocks in the index and holding them for one year) by a wide margin.

Chapter 5 discusses Growth Trap. This occurs when the investor pays high price for growth. Despite the stock being a growth stock, the investor do not gain any return since he paid a high price for the stock. The behavior heuristics followed by investors chasing growth stock are Availability Heuristics: Every one is talking about this stock and one invests based on readily available information, Herding (already discussed), Over confidence bias: Due to confidence in their assessment, one under-reacts to negative information relating to the stock, Bystander effect: Even when one believes counter to the market, one is hesitant to act on their belief, Information Cascade: copying the actions of the experts without doing the required analysis and Halo Effect: taking decisions based on only one prominent information. Author illustrates growth trap through multiple examples from Indian Markets. For instance, in 1979, Century Textiles was a growth company and ACC was a neglected stock. If you had invested 100000 each in both these stocks in '79, ACC would have given about 6 Percent more return (which translates to about 4 Crores in 25 years) than Century Textiles. This is because, the investor overpaid for Century Textiles which was a growth stock.

Commodity investing is the focus of Chapter 6. The book examines the difference in investor behaviour when it comes to investing in commodities. It has been observed that when the commodity cycle turns around, it is the historically underperforming companies with carried forward losses and high level of debt that provides the maximum returns. The reason is that the losses are due to high interest rates and when the cycle picks, the revenues increase but the interest costs remain the same or they decrease. In addition the carried forward losses act as an asset that can be set off against period taxes. Both the above inflates the EPS and hence the share price.

Chapter 7 of the book looks at PSUs (Public Sector Units, Government owned companies) and discusses the reasons for the perception of under-performance in those stocks. Author discusses the absence of Availability Heuristics (not much information is available about those companies unlike private sector company which is tracked by every analyst and his mother in law) and Herding - All PSUs are grouped together, as some of the reasons for this. The key point being made is that some PSU units like SBI and Oil companies are trading at very low valuations and offer significant returns over the long-term.

Each phase of a bull market is led by different sectors. Chapter 8 discusses Sector Investing. When a sector becomes fancy, investors start hearing a lot about the prospects of the sector (availability heuristic), all the stocks in the sector appreciate irrespective of fundamentals (Representative Heuristic), everyone starts investing in the sector (Herding), everyone becomes optimistic (Overconfidence), Taking wrong decisions (Winner's curse, as when TISCO purchased CORUS) etc. Sector bubble happens when many new companies spring up in the sector and the stock prices of the companies appreciates without any fundamentals. Investors should be very careful when investing in sectors. It is very important to get out at the right time. When tide turns, sector bubble can crash very fast.

Those investors who lost money in IPOs (yours truly, for instance) will no doubt identify with the points made in Chapter 9 on IPOs. Investors use 'Singular Information', which are available recently and not the 'Base Information', which are the historical information relevant to the current investment decision. Since IPOs appear in bull market, singular information is normally very positive and hyped up. Investors extrapolate the singular information (extrapolation bias) and make decisions which they regret later. Another point discussed is 'winner's curse', where uninformed investors tend to get full allocation of bad IPOs, (I remember receiving full allocation of Orient Green IPO and lost money heavily. It listed lower than IPO price and has avoided the IPO Price since then) since informed investors avoid these IPOs. The Chapter points out that ever since 1990, investors have lost money in more IPOs than they have made. Despite this well known fact, author finds it puzzling that those investors who did not get the allotment in IPO tend to buy it on listing, normally at a higher price, as if the stock is some hot target or something. (Current craze of Snowman IPO is an example). The chapter analyses the behavior of various stakeholders in IPO market and come to the conclusion that the idea that IPOs are normally under-priced is incorrect. The motivation for the company coming to IPOs is to get as much money from the market as possible, so they have a motive to steeply price the IPO. The bankers to the issue get their bonuses depending on how much money the IPO can accumulate from the market. Hence they have a motive to over price the IPO.  

Chapter 10 covers Index Investing. To understand this one must know the difference between the philosophies driving a corporation and index. Corporations focus on continuity. If they do not inject fresh blood at regular intervals, they could decay. Indexes on the other hand focus on discontinuity. They are always scanning the markets and injecting new potential stock and removing the weaker ones. This way Index is never resting on the past laurels and is always focused on future potential. This is the fundamental principle behind Index Investing.

The problem comes in execution. Market Capitalization is considered to be the benchmark for a stock to be in the index. Sometimes weak companies enter the index by playing the market capitalization game. This is the reason why different index funds perform differently. Due this manipulation of the index, especially in emerging markets (I presume), an efficiently monitored active investing strategy can pay rich dividends (and stock appreciation !).

Author sites a study done by his team. Starting from the 90's, each time a stock is replaced in the index by a new one, he invested equal amounts of money in both of them on the day the transition occurred. In this way, he built up two portfolios, one of rejects and others of entrants. To their surprise, the team found that the portfolio or rejects consistently outperformed the portfolio of new entrants by a statistically significant margin !

When markets go through bubbles, investors tend to lose heavily. Investors want answers to four questions. How are bubbles formed, What are the types of bubbles, How can one identify if bubbles are forming / formed and How should an investor handle bubbles. Chapter 11 on Bubble Trap answers these questions. Bubbles start to form based on real information. For example, the cue for the bubble of 2008 was the real GDP Growth from 6 to 9 percent. As initial investors start making money, the news spreads and others waiting in the wings enter and the prices go up. There is overconfidence and optimism all around and this leads to bubbles. Bubbles can be either market bubbles, sector bubbles or stock bubbles. There are two characteristics of Bubbles. One, rapid PE expansion to abnormal levels and two, entry of new and small companies into market through IPO. Investors should keep the valuations always in mind when investing in market. As soon as they see PE expanding beyond reasonable limits, they should sell and exit. Do not wait for the stock to touch the last 5% to exit. As Livermore mentions in the book Reminiscences of a stock operator, 'If all the people who lost money waiting for the first 5 percent or last 5 percent and laid end to end, they will cover the entire coast of England'.

The final chapter of the book, Chapter 12 discusses Investor Behavior Based Finance. Just as an investor will benefit by researching on the company before investing, the company's can also benefit by understanding their investor profile before taking any major corporate finance decisions. Some investors may be long-term, some medium-term and some short-term. Some investors may be focused on the Organization, for some others focus may be on the management, for some it will be strategic direction of the company and some others may be only focused on the financials. Through this knowledge, company can predict impact of their decisions (lets say Restructuring) on the share prices of the company and decide if that kind of movement is acceptable.

This completes the review of this book.

As I mentioned in the beginning, the field of equity investing is heavily influenced by the emotions and behavior of the investors. Investors are driven by two primary emotions, greed and fear. An understanding of these emotions is primary to become a successful investor. While taking investing decisions an investor relies on many heuristics. Some of them may be explicit and some implicit. Some may be beneficial, some may be detrimental. He/She becomes a better investor if they know the heuristics that they use. And that is where this book comes useful.

The glossary of this book provides an exhaustive list of heuristics that people (not necessarily investors) use in decision making. That is one heck of a list worth reading !!!

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