Devangshu Datta: Stock takers

BEATING THE STREET

Just before the dot com bubble burst in mid-2000, Andrew Smithers and Stephen Wright (S&W) collaborated in a seminal book called "Valuing Wall Street".

S&W set themselves the task of studying James Tobin's replacement ratio "q", and the accompanying hypothesis. The q-ratio is the ratio of value of the entire stock market to the net worth of all the listed companies. If q is lower than 1, it costs less to buy existing assets than to create new ones. If q is higher than 1, it costs less to create new assets.

Like most economic ratios, this one cycles within tight limits as the economy cycles through boom and bust. In general, in a healthy economy, it is likely to be above 1. It takes big depressions to push q lower. In countries with different rates of growth and inflation, the limits of q will vary.

By implication, investors should always buy at low q to benefit as, and when, investment pours in and q rises. This strategy of investing at low q will at the least, protect the value of the investment and should yield super-normal returns in the long run.

As a surrogate for q, S&W used the price-book value (PBV) ratio, which equates the price of a company's share with the net worth per share. The average PBV of major market indices has been calculated for decades and they used this data across several markets with a special focus on the US.

S&W discovered the performance for investors who used PBV as a buy and sell trigger was indeed better to that of investors who used other tools. The "sell" part is important "" under their rules, investors must exit stocks to protect capital whenever the q is over-valued.

The book had impressive timing. It was published in April, 2000 and unequivocally recommended investors should exit US stocks (the Nasdaq was then trading at 5000 points) and not re-enter until there was a minimum 60 per cent fall in price. The roof fell in two months after the book was released and the Nasdaq bottomed at 1100 points (down 78 per cent) in October 2002.

The book offers convincing explanations why q works. BV changes slowly with small fluctuations. This makes the ratio stable and it reverts to mean. The changes in q are mainly due to price changes.

In contrast, a ratio like the popular PE sees wild swings in both price and earnings. The PE doesn't revert to mean for very long periods.

India has seen bigger variations of PBV than most. At the height of the Harshad Mehta boom, in April 1992, the Sensex PBV was 9.5. At the 2000 market-peak, it hit a ceiling of 4.6. At the lows of September 2001, the Sensex PBV was down to 2. In January 2002, it was 3.65. Now, it's around 2.9.

It seems conservative investors who bought below 2.25 and sold above 3.5 have always done well. That 55 per cent change in PBV has usually reflected 75 per cent plus change in price. But the returns have often come over very long periods.

Unfortunately S&W's analysis didn't unearth rules for predicting timeframes.