The beauty contest on dalal street


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The economist Keynes compared the equity market to a beauty contest. His analogy still holds when looking at the most sought after stocks in today's market.

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The beauty contest on dalal street

  1. 1. The beauty contest on Dalal StreetThe economist Keynes compared the equity market to a beauty contest. His analogy still holdswhen looking at the most sought after stocks in todays market.Author : iFast Content TeamEveryone, at least the majority of those reading this article, would have heard of the economistJohn Maynard Keynes. But not all would be aware of the analogy when he compared the stockmarket to a beauty contest.In his 1936 book titled The General Theory of Employment, Interest, and Money he described anewspaper contest in which 100 photographs of faces were displayed. Readers were asked tochoose the six prettiest. The winner would be the reader whose list of six came closest to themost popular of the combined lists of all readers.If you want to win, the best strategy according to Keynes is not to pick your personal favourites.Go for those that you think others will think prettiest. Better still, improve your chances ofwinning by going one step further and pick the faces you think that others think that still othersthink are prettiest. In case you think I am taking you for a ride, let me quote: “…It is not a case ofchoosing those faces that, to the best of one’s judgment, are really the prettiest, nor even thosethat average opinion genuinely thinks the prettiest. We have reached the third degree where wedevote our intelligences to anticipating what average opinion expects the average opinion tobe…”Two portfolio managers at Morgan Stanley Mutual Fund, Amay Hattangadi and Swanand Kelkar,have cited this in their latest newsletter where they drive home the point that the stock marketresembles this Keynesian beauty contest. What one thinks is beautiful may not be the winner.Being able to guess the average opinion of prettiness is critical.Beauty in terms of stock attributesThere are different perceptions of beauty. Both the value and the growth school of investinghave a keen and, sometimes, almost diametrically opposite perception of beauty. For somestocks, high valuations have ceased to matter, while others are languishing despite being reallycheap.To drive home their point, the two fund managers look at the top performers in 5 large sectorsover the last 5 years. Sun Pharma (Healthcare), L&T (Industrials), TCS (IT), HDFC Bank (PrivateBanks) and ITC (Consumer Staples) emerged as successful contenders.Two things stand out when one looks at the figures (no pun intended). The largest stocks have become even larger in terms of their market capitalisationrelative to the sector. In most cases, this outperformance has been a function of earnings multiple re-rating i.e.investors willing to pay more and more for the same claims on profits and cash flows.It’s evident that the type of “beauty” that the market has voted in favour of is based on certainattributes: superior earnings growth (much ahead of the market) with little quarterly volatilityand high profitability (measured by RoE). The verdict is that the winning combination issuperior earnings growth and capital self-sufficiency.
  2. 2. After establishing the beauties, they look at who the beholders are.FIIs have steadily increased their holdings of Indian equities from 16.7% (March 2002) to over22% (March 2013). Domestic institutions and the public accounted for 28.5% of the marketownership in March 2002 to drop to 19%. Within domestic institutions, ownership of mutualfunds has come down steadily over the past few years, but insurance companies have stepped intheir place.The incremental beholder of Indian equities over the last few years has definitely been the FII.Conclusion 15 stocks have contributed almost 76% to the rise of BSE 100 index since January 2012till May 2013 – they are the winners of the beauty contest Though the allure of the Indian market lies in its growth, diversity and opportunity toinvest in high quality stocks, the attribute most sought after is valuations but quality andpredictability of growth Hence, despite high valuations, quality stocks with predictable earnings attract morenew money, taking their PE ratio even higher Analysing the composition of foreign ownership, one should not be surprised at thenatural bias towards large-cap stocks with adequate liquiditySo don’t despair the exit of your favourite contestant. The composition of beholders is notpermanent and neither is the concept of beauty. But do note: In investing, it’s not all aboutappreciating the beauty of stocks. Keep an eye on the beholders as well.To read the report Beauty & the Beholder in detail, click here.PE: Price-earnings ratio / IT: Information Technology / RoE: Return on Equity / FII: ForeignInstitutional InvestorHeres why you should consider investing in mutual funds.To buy and sell mutual funds online, click here.Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual fundsof any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or bematerially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or saleof any mutual fund. No investment decision should be taken without first viewing a mutual funds scheme information documentincluding statement of additional information. Any advice herein is made on a general basis and does not take into account thespecific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, andlegal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative ofthe future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise.Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website. Please read ourdisclaimer in the website. Risk Factors: Mutual funds, like securities investments, are subject to market risks and there is noguarantee against loss in the Scheme or that the Scheme’s objectives will be achieved. As with any investment in securities, the NAVof the Units issued under the Scheme can go up or down depending on various factors and forces affecting capital markets. Pastperformance of the Sponsor/the AMC/the Mutual Fund does not indicate the future performance of the Scheme. The name of theScheme does not in any manner indicate the quality of the Scheme, its future prospects or returns. Please read the Statement ofAdditional Information and Scheme Information Document carefully before investing.