Why right goes wrong

The author demolishes 13 of the most popular investment strategies and suggests ways to make them more effective. Despite the academic writing style, the book is a must for every equity investor, says Kamya Jaiswal.

Kamya Jaiswal | Print Edition: October 2, 2008

The most magnetic character in Milton’s Paradise Lost is not God, but Satan. Why is the devil portrayed as a charmer? The embodiment of sin has to be beautiful because evil must tempt before it entraps.

This psychology is not restricted to religion. Take finance. Here too, the devil is in a seductive disguise. Investment strategies promise to give you stupendous returns, but rarely live up to these on a consistent basis.

If isn’t as if one doesn’t study a strategy in detail before investing. You go through anecdotes, empirical data and historical evidence. So what goes wrong? If it’s a question you have often asked, Aswath Damodaran’s Investment Fables is a must-read. His mandate is to separate the facts from fiction and reveal the hidden evils that reduce the effectiveness of a theory.

Investment Fables
Investment Fables

Price: Rs 550

Pages: 539

By: Aswath Damodaran

Published by: Dorling Kindersley

Target audience: Equity investors

Quick read tip: You can begin reading any chapter depending on the strategy you like

Language: Easy

Style: Academic

Visuals: Graphs/Tables/Charts

Strategic flaws in sound theories

Low PE stocks: Reported earnings may be manipulated or may be high due to one-time gains.

Growth stocks: High growth may be at the cost of destroying value of the company and taking very high risks.

Momentum stocks: Valuation of stocks is often ignored. Execution costs of frequent trading cuts into returns.

One reason why Damodaran’s book is unique is because it dissects no less than 13 doctrines. These include the momentum investing theory, contrarian investment philosophy, the belief that a low PE ratio means the stock is cheap, and the theory that the stocks which give stable earnings are better investments.

Another distinguishing feature is that Damodaran does not counter one theory with another. Nor does he pitch one set of statistics against another to prove a point. Instead, he delves deeper into each strategy to dig out its faults. For instance, when he explains why growth stocks don’t always outperform the market, he does not thrust a bunch of value stocks that have managed the feat to prove his point. Instead, he introduces readers to factors such as high and poor quality growth, cost of growth, and sustainability of growth, all of which qualify the effectiveness of growth investing.

The analysis of every strategy begins with a “fable” by an investor who lost money by following it.

Like Aesop, Damodaran has a witty moral for each story. So when he talks of the fate of an optimistic Martha, who only invested in stocks that were on an upward trend, the moral is: “You live by the crowd, you will die by it.” This is followed by an examination of what makes a theory attractive. In case of the contrarian strategy, it is the belief that investors overreact to news. The theory of following the advice of experts assumes that some people have better knowledge of the markets and better access to information. Subsequently, Damodaran proves that the propagators of these theories tell you only half-truths, cleverly concealing the other side of the picture. Across all chapters, this section is the most interesting as it collates information that you want to have but don’t know where to access it. Such tidbits include how IPO s are priced and the concept of “market synergy” between two companies, among others.

The final test is the construction of a portfolio of stocks based on the strategy. Here, Damodaran compares the performance of the portfolio with indices, across sectors, time periods and other variables. Each portfolio is pruned as it passes through various screens. For example, a set of 116 American stocks with PE ratios less than 10 (in October 2002) reduces to 92 after the “risk test”. Another 41 are eliminated because along with low valuations, they have low growth prospects. At the end, only 27 stocks are left which pass all PE tests.

For an American audience, the final portfolio for each strategy (that passes all tests) is a treasure trove. But Indian readers shouldn’t be disappointed. Portfolio creation and the subsequent narrowing down of choices is as good as a step-by step manual by a valuation expert. So you actually learn all aspects of executing a strategy and eliminating its flaws. For instance, Damodaran’s explanation helps you understand that though IFCI has a low PE ratio of 3, it may not be a great investment because it has high beta—1.58 with respect to the Sensex. Similarly, you would want to stay away from Ambuja Cements , which has a high dividend yield (4.4%), but has seen its net profit growth fall in the past months.

The various tests used for evaluation are investment lessons in themselves. One of them is Damodaran’s method of analysing risk—he always uses both standard deviation and beta. For longterm analysis that spans 15- 20 years, he divides the time horizon into various “sub-periods” and assesses the performance of stocks in various permutations of each period. The returns from each strategy is adjusted to the cost of execution such as transaction costs, tax on payouts and dividends.

By now it should be clear that this book, though replete with fables, is not for beginners. Another no-no is the fear of math because calculations are integral to the process of evaluating all strategies.

If you read the book at one go, the information may overwhelm you. So try one section at a time. The structure is like a series of lectures by Damodaran, who is a highly acclaimed professor at the Stern School of Business, New York. This also explains his academic style of writing.

The book is unlikely to leave you with any unanswered questions. There are minor contradictions though. For instance, Damodaran ends up giving thumb rules at the end of each chapter even though he started by declaring that they are useless. You also wish that the explanations of graphs did not run into paragraphs, though the publishers may be more to blame for this.

Read the book as it will leave you optimistic, not confused. No strategy is written off. Instead, the devilish flaws are conquered. An opportunity for redemption that wasn’t offered to Satan by any expert.

Read our review of the book Invest Like a Shark: Breaking the rules

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