‘I’ve never found a good pick by reading a news story’

Aswath Damodaran, professor of finance at the New York University’s Stern School of Business, is one of the world’s foremost experts on equity valuation. He has written several books on the subject like Damodaran on Valuation, Investment Fables, The Dark Side of Valuation and most recently, The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit. At the business school, he teaches corporate finance and equity valuation. In this interview, he sensitises Vivek Kaul to a plethora of market-related issues — what ails the global  investment markets; why retail investors would not always gain much by blindly following legendary investors such as George Soros and Warren Buffet; where corporates such as Facebook and Apple look off-colour; how to find the right valuation of any stock; and when to enter and exit an equity.

How did you get into the field of valuation?
I started in finance as a general area and then I got interested in valuation when I started teaching. Valuation is a piece of almost everything you do and I was surprised how ill developed it was as a field of thought. It has actually very little to do with mathematics. It’s more an understanding of business and actually getting it into numbers.

Talking of valuation, much of it is not the compound interest or the discount factor. It’s really the cash flows you’ve to estimate. Much of it is in the numerator. It’s about figuring out what business you are in, how you make money, what the margins are, what the competition is going to be. So numerator is where all the action is.
 

Can you give us an example?
If you are trying to value Facebook, getting its discount rate is trivial. It’s easy. It’s about 11.5%. It’s about the 80th percentile in terms of riskiness of companies. Facebook is going to compete against Google, Apple and other social media companies. So you’ve to make judgement calls of how it’s all going to play out. It’s numbers but the numbers come from understanding business, strategy, competition and other factors.

You just mentioned that the discounting rate for expected cash flows from Facebook was at 11.5%. How did you arrive at that?
I have the cost of capital for every sector in the US.

So this is the cost of capital for dotcoms?
This is actually the cost of capital for risky technology capitals. So basically what I am saying is that I could sit there and try to finesse it and say is it 11.8% or is it 11.2%. But it doesn’t really matter. Getting the revenues and margins is more critical than getting the discount rate narrowed down.

This 11.5% would be from a combination of equity and debt?
For a young growth company, it’s almost going to be all equity. You don’t borrow money if you are that small and when you are in a high-growth phase, it’s not worth it. It’s almost all equity.

I read you sold Apple shares even though they were undervalued. Why did you do that?
There are two parts to the investment process. One is the value part to the process. And the other is the pricing part to the process. To make money, you need to be comfortable with both parts. You want to feel comfortable with value and you’ve to feel comfortable that price is going to converge on the value. In the case of Apple, for 15 years I was comfortable with my estimate of value and I was comfortable that the price would converge on value. In the last year, the Apple stockholder base has had a fairly dramatic change. There has been influx of a lot of institutional investors who have come in as herd investors and momentum investors, who go wherever the price is hottest. You’ve also got a lot of dividend investors who came in last year because they expected Apple to start paying dividends.

So you got this influx of new investors with very different ideas of what they expect Apple to do in the future. They are all in there. And right now, they are okay, for the moment, because Apple is able to keep them all reasonably happy. But I think this is a game where I have lost control of the pricing process because those investors turn on a dot -- like they did when the stock went from $640 to $530 for no reason at all. You look at any news that came out. Nothing came out.

So why is the stock worth $640 and eight weeks later $530? But that’s the nature of momentum stocks. It’s not news that drives the price anymore, it’s the herd.  And I looked at the pricing process and said I have lost control of this part of the process. I am comfortable with the value still. If these guys keep pushing it down, sooner or later they are going to push it to a point where these guys leave and then I can step in, buy the stock. So my exit is not permanent, but I think at the moment it has become a momentum stock.

You’ve talked about the dangers in relying purely on stories (news content and popular beliefs) while investing. What dangers?
Even momentum investors want a crutch, and stories give them a crutch. You’ve decided to buy the stock anyway because everyone else is doing it. You don’t want to tell people because that doesn’t sound good, so you look for a story to convince yourself that you are really doing this for a good reason. The power of the story is very strong, I am not denying it. But I am saying that if there is a story, my job is to bring it into the numbers and see if that story holds up to scrutiny. So I think you need to get past the macro story-telling because it’s easy to fall into it saying, ‘hey this company is worth a lot’.

Can smaller investors make money by piggybacking on investment decisions of big investors?
If you look at institutional investors, they do things so badly, why do you want to piggyback on them?

Someone like a Warren Buffett or Rakesh Jhunjhunwala in the Indian context?
You could, but I think by the time you get the information, It’s usually too late. It’s not like you are the only one who finds out that Warren Buffett has bought a stock. Half the world has found out. So when you line up to buy the stock, everyone else is buying the stock and price has already moved up.

George Soros once said that most money is made by entering a bubble early. What are your views on that?
Everybody is guilty of hyperbole when it comes to bubbles and Soros is no exception. Soros has never been a great micro investor. He has made his money on macro bets. He has never been a great stock picker. For him it has got to be massive macro bubbles, an asset class that gets overpriced or underpriced. You’re right -- if you can call macro bubbles, you can make a lot of money. John Paulson called the housing bubble and made a few billion dollars. So he is right and he is wrong. He is right because if you can call a macro bubble, you can make a lot of money. He is wrong because if you make calling macro bubbles your investment philosophy, you better get lucky, because everybody is calling macro bubbles and most of them are going to be wrong.

You’ve talked about buying the 35 worst stocks in the market and holding that investment and making money on it. How does that work?
It’s called the classic contrarian investment strategy where you buy the biggest holders and you hold them for a long period.  There is evidence that if you hold them for a long period, they tend to be the best investments. But it comes with caveats. One is that if you buy the 35 biggest losers, they often tend to be low-priced stocks because they have gone down so much which increases the transaction cost of your trading. The other is that, it’s very dependent on your time horizon.

It turns out that if you buy the lowest price stocks for the first 18 months, they actually underperform. It’s only after that they turn around. This means that if you buy these stocks, you are going to get about 18 months of heartburn and stomachaches. And for many people, they don’t have the patience to stay in. So they often buy the worst stocks after reading these studies. About 12 months in, they lose patience, they sell it. It’s very dependent on both those pieces of the puzzle falling in.

How much role do media play in influencing investment decisions of people?
Media and analysts are followers. None of the media told us last week that Facebook was going to collapse. Now, of course, everybody is talking about it. So basically when I see in the media news stories, I see a reflection of what has already happened. It’s a lagging indicator. It’s not a leading indicator. I have never ever found a good investment by reading a news story. But I have heard about why an investment was good in hindsight by reading a news story about it. I am not a great believer that I can find good investments in the media. That’s not their job anyway.

Interviewer Kaul is a writer and can be reached at
vivek.kaul@gmail.com