THE DUBIOUS EFFICACY OF DOCTORS, CONSULTANTS AND PSYCHOTHERAPISTS -Regression to Mean

Everything in a world moves toward an extreme direction from average and come back to average. This is known as a regression to mean. Sometimes we get more happy or sad and as time passes, we start coming back to our normal feelings. We tend to be nice to other people when they please us and nasty when they do not, we are statistically punished for being nice and rewarded for being nasty.

Poor performance was typically followed by improvement and good performance by deterioration, without any help from either praise or punishment. Our performance has an average point, sometimes we perform very better than average and sometimes perform below average and sometimes reach back to mean performance. So that when performance is above or below average, then it has a higher probability to meet the average which is known as a regression to the mean.

Investment – The price of the companies sometimes go either extreme to fundamental points but as time passes stock prices start moving towards fundamental performance and at some point fundamental performance and stock prices marched. The stock price cannot be sustained at either extreme. We have seen various cyclical events, business cycle and many more are responsible for the regression to the mean. We have experienced that market always walk away from averages for a period but it comes near to mean by its self-correcting nature. So that when anything moves at the extreme side of the mean then we must have to be ready for self-correction of it. Value investing mainly focus on reversion to mean theory. It believes that if the stock price is well below its fundamental value then now or later it will catch up with its fundamental value.

We have seen that the best performance in equities has come after the worst performance and vice-versa. So that we should not focus on a smaller period of outcome to make any conclusion. Rather should focus on a decently long period to understand mean reversion. But when fundamental performance is improving then we should compare market price with improving fundamental performance rather should wait to fall in price as it has risen in past. Also, we need to study thoroughly about fundamental of any business, its prospects, challenges faced by the business. Rather believing that if the business has performed well in past then it will repeat it in future. It may or may not repeat the same performance but that we have to conclude from a detail study of business.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

NEVER PAY YOUR LAWYER BY THE HOUR – Incentive Super-Response Tendency

People respond to incentives by doing what is in their best interests. What is noteworthy is, first, how quickly and radically people’s behaviour changes when incentives come into play or are altered and, second, the fact that people respond to the incentives themselves and not the grander intentions behind them.

We all seek self-interest; our efforts get changed with incentives. We act for getting back something. Proper incentives can improve performance but improper incentives can spoil the performance. We assess the risks and the associated rewards and respond in a way that seems to best serve us.

Business – For example, incentives for selling every single loan will spoil credit quality but if we keep negatives incentives on every NPAs then performance will get improves with safety in nature. The sub-prime housing crisis in the US is one example of incentive bias. 

Investment – There will be incentives on different products to marketing personnel and due to that incentives, they sell products where they get higher incentives. The same happens with the stock market products. We have experienced Franklin mutual fund debt scheme example where distributors have decent commission available. And distributors have aggressively sold scheme to the investors.

Many a time, management focus on their performance incentive over an above of long-term benefits of shareholders. That is the reason to provide ESOP to top management (aggressive ESOP has its disadvantage, which we will discuss later on).

When we study pieces of advice given to us by others than 90% of cases having incentive effects hidden into it. We need to study the given pieces of advice thoroughly before accepting it. If we work on anyone’s advised without putting our efforts then that will become our fault.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

WHAT CAN BE A PROBABLE BOTTOM OF INDIAN STOCK MARKET?

We have seen a sharp fall in the market these days. Now, everyone has a question that what can be a probable bottom? where we should start buying? Bottom of the market already made? Should we buy or will we have missed out this opportunity? Yes, Nifty has reached to the fair value zone but pendulum never stayed at the middle zone it will go extreme to both the direction. So, we have seen upside extreme and now have to see downside extreme move.

Before starting answering the above questions, here, I am requesting you to read my old article which I had posted on 4th August 2019. In that article, I mentioned regarding market fall. Please first go through that article because the current article is a continuation of that article.

THE INTELLIGENT INVESTOR – 3 – A CENTURY OF STOCK-MARKET HISTORY

Now, if we analyze current fall then we can say that Indian corporate and GDP has witnessed a limited growth in the past. Also, Covid-19 virus has disrupted the entire world economy. Majority of the economy has started giving a revival package but if we look at the speed of the spreading of Covid-19 and death of the people then it is very painful for us as well as the economy.

Our PM has announced with the 21 days lockdown to fight against the Covid-19. We have taken this step well in advance so that we can able to control the situation, because if the situation will go out of control then we do not have a proper infrastructure for citizens to cure.

I have taken a few data from HDFC Bank India growth outlook 2020, cost of lockdown.

Health exp

By looking at the above data and havoc of Covid-19 in the world, it is essential to go for the not only lockdown but to declare an emergency in India. Now, let’s go to the economic impact of this mayhem. People can oppose that government of the majority of the economy has started announcing a revival package. But We have to think that it’s not a financial crisis where you pump liquidity into the system and things will start recovering. It’s taking the lives of people so what will change after the liquidity get infused. People try to save life rather use those liquidities. So, disruption can take time to revive. If this problem can worsen it will be led to a financial crisis which is still pending to come. It’s just my thoughts, don’t know what can happen but this thing looking worse than any financial crisis.

If the normal situation has come where growth remains subdued then the market can remain in range but here this difficult situation can hamper the earning badly.  we have to understand that our states of India are equivalent of the many of the country where corona has done huge damage. Here, the world economy gets hamper, trade around the world hamper, supply chain get disturbs, corporates have to fund fixed cost, they only can manage variable cost through the lockdown.

Many of the articles and reports indicating towards global recession and as intense as the recession of 1929. I don’t know that will happen or not but I only can pray that such will not happen because it will take many further issues with many of the lives. Let’s not getting into the debate and do some number crunching which is always my favourite.

Current, Nifty EPS is ~Rs.444 so proceed with the calculation based on that. I am assuming current EPS will remain same for FY20 and all degrowth will account in FY21 and FY22 (if the situation will not come to the control then FY22 will also go for a toss).

I have taken the bank rate as an SBI FD rate after the rate cut.

EYield by Bond rate01

Now, if we look at the earnings yield to bond yield ratio then it has reached at the 1.03x in the current period. If we take same EPS and take that ratio to the worst happen during the 2008 – financial crisis then it was 1.11x so nifty level come to the 8000 but Covid-19 will going to hamper earning growth and might be a new level of earning yield to bond yield ratio can come, which I have taken a range of 1.25 to 1.50 with a different scenario.

If things will be in control in coming few days then might be 5% degrowth can be possible and then market also maybe get stable at the old worst level of earning yield to bond yield ratio – 1.11x to 1.25x. But if things will get more worst then now and continue with coming 1-2 months then 10% degrowth in earning can be expected. I have made a study in S&P500 of USA and in that market earning yield to bond yield ratio has reached around 3x in worst level which I am not considering as of now. If we see that then past falls in the market have accounted for ~50% fall from the top so that that will also come to ~6215 level.

Now, another point is that earnings growth always essential for generating returns in the market. So that market can be remaining in the range till no sign comes for earning growth revival because, on the hope of earnings growth, the market has already run a lot.

I have posted an article on WHAT CAN BE A PROBABLE RETURN FROM SENSEX IN COMING 10 YEARS? a way back and where I have taken SENSEX level after 10 years on worst earning growth of 3.50% came at 43547 on P/E and 57678 on P/BV based. So, if earning growth cannot revive then the market can remain in range for a longer period. But from the current base, we can have a good chance of making a return in the range of 4-7% CAGR in the index overcoming 10 years. Tax cut reform will also aid in earning growth coming forward. We only have to pray that situation will not worsen from here and for that we have to stay at home, stay safe and fight against Corona.

#Stayhomestaysafe #Stayhomesavelives #Fightagainstcorona

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

What can be a probable return from SENSEX in coming 10 years?

I have written on this topic is due to current market fall and fear into the mind of an investor. We are seeing many uncertainties hindering the growth of the economy, rising crude oil prices, commodity prices, fiscal deficit, banks NPA, government expenditure, rising interest rate, the success of GST, structural changes into the economy. All such events will impact the growth of business positively or negatively. If we try to put all such events into different scenarios then we can come to know what can be a probable return from SENSEX in coming 10 years.

For the calculation of probable return, I have taken a formula which is given by John P. Hussman. John P. Hussman is the U.S.A stock market analyst and owner of the hedge fund.

Formula

Annualized Return (%) = (1+g)(future PE or P/BV / current PE or P/BV)^(1/T) – 1 + dividend yield (current PE or P/BV / future PE or P/BV + 1) / 2

G = Business earning growth,       P/E = Price to Earnings ratio,          P/BV = Price to Book Value ratio

Return of our investment is based on

Business Earning Growth – Our investment return will grow if particular business earning will grow. Investment return is directly related with the earning of a business. If business survives for the longer period of time with generating the higher return on invested capital with earnings growth then we will able to earn a decent return from particular business.

Dividends – Dividends comes from the earning of the company. If a company distributes dividends to shareholders with growing earnings, the dividend is an additional return for the shareholders with the appreciation of business value. As per Mr.Buffett, if the company does not have a reinvesting opportunity available or business does not able to generate a higher return than the cost of capital then management should distribute earnings in form of dividends.

Changes in the valuation – the Stock price of the particular business is also affected by the changes in the valuation such as changes into the P/E, P/BV, P/S (Price to Sales) or Market Cap to Sales, etc.

Assumptions

  • Dividend yield (%) is assumed to be 0.50% to 1.00%.
  • Business Earning Growth (%) is assumed 3.50% (a rate, which is half of the current GDP growth), 7% (current GDP growth rate) and 14% (twice of current GDP growth rate). Assuming average earnings growth of various businesses comprises SENSEX.
  • Future P/E taken as 19x (Historical average of last 20 years since the year 1998), 21x (10% premium on historical average P/E) and 23x (20% premium on historical average P/E).
  • Future P/BV taken as 3.29x (Historical average of last 20 years since the year 1998), 3.62x (10% premium on historical average P/BV) and 3.95x (20% premium on historical average P/BV).

SENSEX

We can use a similar kind of valuation matrix for the particular business itself. Here, I have also shown valuation calculation of an air cooler manufacturing company of India, I have calculated as I was at the year 2012 and what can be a probable return from particular business till the year 2022.

Stock 1

If we consider actual business performance then sales of the company have been grown by 17% CAGR since the year 2012 to the year 2018. But the stock price has been increased to Rs.2209 (high price and the current price is Rs.967) from Rs.130. This entire return is come to the stock only because of valuation multiple expansion such as P/E, P/BV, EV/EBITDA etc. Similar period has P/E increased to 85x (high P/E and current P/E is 46x) from 23.63x and P/BV increased to 33x (high P/BV and current P/BV is 11x) from 5.84x.

Disclosure – I am not using this valuation matrix in my investment journey till now. This is only one of the valuation matrix and we need to use a different appropriate valuation matrix for reaching to a value range.

Learn matrix from

http://hussmanfunds.com/wmc/wmc050222.htm

https://www.gurufocus.com/stock-market-valuations.php