A theory for every bull market

One should study a theory well before believing in it

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist,” John Maynard Keynes, twentieth century’s greatest economist, had once said. Most individuals who invest in the stock markets consider themselves to be largely free of an academic orientation. They believe in “practical” stuff.

But every bull market has a theory behind it. The theory puts across the “reasons for investing in the stockmarket” to the investors. As Debashis Basu points out in his book, Face Value, Creation and Destruction of Shareholder Value in India: “When things look rosy, the market finds new sophisticated theories to stretch valuations”. At other times, theories explain why the market is rightly valued when evidence suggests otherwise. And, at still other times, when a person or a group of persons are rigging the stock market, it helps convince the investors to come and join the party so that the markets can go to even greater levels and the scamsters can rake in a quick buck.

As Basu points out: “In 1991, as Harshad Metha rigged up stocks like ACC, the price was justified by the replacement cost theory. Under this, it was argued that ACC’s value should be at least the same as the cost, time and effort needed to create another ACC”. After Mehta’s game got over this theory has been confined to the dustbins of history, at least as far as Indian stock markets are concerned.

After Mehta, the next big bull was Ketan Parekh. Parekh was not as media friendly as Mehta. But stock market experts picked up on his investment style and justified it by saying that the companies he invested in have been selected for investment with help from his research team. The research team, they said, had listed out stocks with a low capital base and low liquidity. This convinced not only the ordinary investor but also foreign institutional investors and mutual funds, who bought the stocks Parekh had invested in even after Parekh was believed to have more-or-less exited from them.

Another theory that gets bandied around a lot is the theory of undervaluation. A company is said to be undervalued if the market value (i.e. the share price of the company) is less than its book value per share (the difference between the assets and liabilities of the company, its net worth).

“Under this theory, if Steel Authority or Essar Steel’s market price is Rs 6 and book value is Rs 15, they would be grossly undervalued. The obvious flaw in this theory is that assets are as useful as the returns they generate. Just because SAIL has paid Rs 15 per share to acquire its assets, why should shareholders pay as much for it? They buy stocks, not steel plants,” writes Basu.

A lot of these theories gain popularity when very little or sketchy information is available about a sector or a company. Shareholders need a reason to invest and, if a theory is available, they are convinced about investing. As Basu points out, “Shareholders are far removed from the company they have invested in and they know little about its day-to-day working. Yet, they are forced to take a view on it and act because the market price — a supposed reflection of that value - is quoted daily.

Under the pressure of this dichotomy - compulsion to have a view and the inadequate means to arrive at it - value gets distorted. It is only natural that anything based on no information or scanty information will be deeply influenced by irrational factors like fear, hope and greed and, therefore will swing wildly from one end to another as each nugget of positive or negative information hits the market”.

Given this, the latest theory to have hit the market is the “land bank” theory. This theory is being used to justify the huge valuations of real estate companies as well as a lot of other companies which own a huge amount of land. The logic being that the price of land and real estate has been rising at a rapid rate and so these companeis are sitting on a potential goldmine. The stock market is just trying to price in the market value of their land holdings into the stock price.

Under the garb of this theory, the stock valuations of a lot of real estate companies and companies heavy on real estate have reached astonishing highs.

Taken in by this theory, investors have forgotten to ask a few basic questions like: a) What are the actual values of the land bank with companies? b) How have these valuations been arrived at? Who has arrived at these values? c) Given the extremely low amount of transparency in the real estate sector, do companies actually have these land banks? d) Will there be a huge oversupply in the market once this land is developed and starts hitting the market? 
A mutual fund like Fidelity has stayed away from real estate stocks because they have not been able to develop a valuation methodology for it. And mutual funds who are investing as doing it because everyone else is. Given this, those who have been investing in real estate stocks either haven’t got the point or believe in the greater fool theory.

A believer in the greater fool theory essentially makes a questionable investment on the assumption that when he is ready to get out of the investment there will be a greater fool in the market ready to buy it off from him.

For other companies that are land bank heavy, the right question to ask is whether the company has stated an intention to develop the land they have. Infosys owns around 800 acres of land. But does that mean that the company will go ahead and sell it? State Bank of India (SBI) owns a large amount of property, and so does ITC. In fact the land bank theory has been applied by analysts on SBI in the past to justify that the stock of SBI was underpriced and hence should be bought. It was felt that SBI has a lot of assets like property and flats in the posh areas of metropolitan India, whose market value had not been factored into the stock price.

As Basu points out “Now, this sounds fine in theory but is unrealistic because nobody even remotely believes that SBI will put on the market properties that its employees enjoy, such as the huge chairman’s bungalow in the most expensive part of the country. Hidden asset value and branch network of SBI are useless for the market now”.

So the next time someone bandies a new theory to justify buying a stock, ask a few basic questions regarding the stock before investing your hard earned money.