The Hindu Business Line : `We never learn from the past completely'

Inflation is deadly. It kills all financial markets, whether it is stock or bonds. I would watch inflation more than anything else. And I think we will see more global than local business cycles.

PROF ASWATH Damodaran, Stern School of Business, New York University. — Bijoy Ghosh

Meet Aswath Damodaran, an authority on valuation and professor of finance at Stern School of Business, New York University. On his Web site and through his books, he comes across as an intelligent, logical and yet simple person. Sample the mission statement on his Web site: "I am lucky enough to be in a field where a little knowledge and some experience goes a long way, and achieving guru status seems relatively simple." He more than lived up to the billing.

When we met him in Chennai recently, we understood why Prof Damodaran is rated so highly by his students and readers of investment literature. His responses were simple and, at the same time, offered deep insights into the world of investment, drawing on his experience in tracking global markets for more than two decades. Business Line discussed a wide range of issues relating to the world of investment.

Excerpts from the interview:

Is India in a structural bull market, after a dream run that has lasted three years?

Anytime the market is up so strongly, you are always waiting for the other shoe to drop. That is something that you always worried about, because it is tough to sustain that kind of upward momentum. One of the bad things that happens is that it also draws in exactly the wrong kind of people into the market. You are sucking people into the market who have no business being there.

People get skewed visions of risk, because they think the equity market will always go up. Instead of being 20 per cent in equities, you end up being 80 per cent in equities. People who should be in large-cap stocks end up being in mid-caps and small-caps. This systematically tends to happen and, at some point in every bull market, there is a correction that occurs where those people revert to what they should be having. How painful will that be? Historically, the pain has been directly proportional to how much excess there was in this market.

Do you think there will only be corrections between the bull phases in the Indian market?

There is nothing to point that we are going to revert to 1991 levels. Maybe 7000. But there are a lot of good reasons why the market should be higher now than three or five or 10 years ago. We are in a structural bull market where, if we draw a trend line, it should be an upward trend line.

What asset allocation strategies do you follow?

I do not reallocate my portfolio every year, but make incremental choices. It is a portfolio that I have built over 15-20 years, in which I make marginal changes every year. I have nearly 70 per cent in equities, not counting my house.

Are you invested in mutual funds?

It is a mix, but still in favour of equities.

Do you have investments in technology stocks?

Not really. I bought Amazon in 2000, after the collapse. I have not touched Google yet. I have nothing against technology stocks. I do not think they are always massively over- or under-valued. I have bought them for their earnings and cash-flows, but wait till the price is right. If you are buying Google, you are buying for their positive cash-flows, but the price may not be right.

What method do you use to value stocks?

Conventional discounted cash flows (DCF) for all stocks.

How do you manage the sharp spikes and declines in growth stocks, even for companies with relatively predictable earnings?

If 90 per cent of the value in the stocks comes from perception, by definition there are going to be shifts. Small shifts in perception will cause big shifts in value. Using DCF, small changes in the growth rate will change value substantially.

When the earnings announcement comes out, it might seem like it is 2 cents below expectations, but what it states about its future is far more important than what a GE will tell you through its earnings.

In technology, the barriers to entry tend to be fairly small compared to, say, pharmaceuticals, which is more process-oriented. When something new comes out, it pretty much wipes out your existing business quickly. So, when you do these valuations, you will have to be a lot more cautious about building in long growth periods of high excess returns, because they can disappear.

All factors being constant, the same growth rate can have very different consequences for different companies because of the kinds of return on capital. If you get a 6 per cent growth rate with 12 per cent return on capital, you have to reinvest 50 per cent each year to get the 6 per cent growth. But at 6 per cent growth rate with 30 per cent return on capital, you can get away with a 20 per cent reinvestment.

Do you think global markets are now entering a period of unprecedented volatility?

If you look at global equity market volatilities now, they are extraordinarily stable. We can make an argument for mean reversion and that volatility is now going to climb back to some historical level and this is just the period.

A related aspect is that the price-earnings multiples of all asset classes are now at historical highs. Is there a risk here?

Let us face it. The interest rates today, both nominal and real, across the world are lower than what they were 20 years ago. That explains why the PE ratio is high. If risk-free rates are 5 per cent, the PE ratio is likely to be 20 rather than eight.

Has the risk premium that investors attach to different asset classes remained unchanged?

If your risk-free rate declines from 15 per cent to 5 per cent, then the risk premium will also scale down. Risk premiums are strongly linked to the level of risk-free rates. Which, again, explains why PE ratios rise disproportionately when interest rates decline. It is a double impact. That, again, is something to worry about. Single-digit rates are a thing of the recent past in economies such as India.

People have already forgotten that it was not that long ago that interest rates were 15 per cent. That is a key aspect investors should keep track of with the market at 10,000. Single-digit rates are here, but I do not know if they are here to stay.

Have investors learnt from the past and are now willing to pay the right price for assets?

I don't think we ever learn from the past completely. One thing we have learnt better is how important it is to fight inflation. Thirty years ago, we still had central bankers willing to risk double-digit inflation to boost growth. Today, no central banker around the world considers that a good trade-off. That is healthy.

Inflation is deadly. It kills all financial markets, whether it is stock or bonds. I would watch inflation more than anything else. Frankly, the Budget is just a side-story. Inflation is the main story.

From a long-term perspective, is there a case for investing 80-100 per cent in equities?

For some people, 80 per cent stocks would never be appropriate while for some 100 per cent would be appropriate. That is a choice that should be made given your risk aversion and given how old you are. The basic rule is that if you need the money in the short term, don't put it into equities.

What if you have a long-term investment horizon of 10-15 years?

How certain are you that the money will stay invested for the long term? We can all lose our job tomorrow. The flip-side of globalisation is that nobody's job is secure anymore. You may be making more money now, but it is going to come with a lot more volatility in terms of whether you will keep making that money.

So, should people build in a higher risk premium for the increased volatility that we are likely to see in our working lives?

I don't think we need to build in a higher risk premium. We need to, however, adjust our asset allocation to reflect the volatilities.

It is not that stocks have become less valuable; it is just that the amount of money you invest in stocks should reflect how secure you feel about your own long-term human capital.

The latter is a bigger part of the portfolio because we are now making more money. That is also more volatile because more money has its own upside and downside.

In terms of capital spending, margins and profits, do you think cyclicality is a thing of the past?

I think we will see more global cycles than local cycles. Twenty years ago, the US could be in recession and India could be booming. Now, everybody is locked in.

There is a line of thought that people have learnt from past cycles and are not, therefore, going to make the mistakes they made earlier.

There are a few aspects of cycles that are going to be less pronounced.

The way old cycles built up, companies took a lot of time to adjust to a slowdown. Maybe you will see shorter cycles. I am not sure if it is good or bad. It will be probably make life a little less risky from a pure economic perspective.

There is also a downside to the global economic cycle. It is going to be much more difficult to diversify because of the global link.

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