‘Social media companies are over-valued’

If you thought only pop stars attracted 3 million page-views to their blog and occupied cult status, meet Aswath Damodaran, Professor of Finance at Stern School, New York University.

He teaches equity valuation and corporate finance, not exactly simple subjects. But his lucid commentary on the workings of the market and stock valuations has a global fan-following. In recent times, he has argued for doing away with merchant bankers in IPOs and valued electric car maker Tesla at less than half its market price.

The professor was recently in Chennai at the invitation of TVS Capital, to interact with young people on his pet subjects. The hall was packed to the rafters, but Business Line stole half an hour with him over lunch for an interview.

“I wanted to talk to the people in the trenches”, said the professor when we asked him why the seminar wasn’t targeted at the CEOs and finance chiefs of India Inc. “I was keen to interact with students of finance and young analysts starting out on their career. They are the ones who actually do the valuations.” He insisted that the seminar be open to all. “When you have a seminar for students, you can’t charge them steeply for it. TVS Capital agreed to sponsor such an event. So here I am. I’m flying back tonight”.

Excerpts:

With tech stocks such as Twitter and Facebook trading at such steep valuations, are we seeing version 2.0 of the dotcom bubble?

I am always reluctant to use the term ‘bubble’. It requires incredible hubris on the part of a person to say, “I knew there was a bubble.” It is always easy to talk of a bubble in hindsight. Just because stocks are up 80 per cent or down 60 per cent, there isn’t necessarily a bubble. I have a rigid definition of a bubble.

If the stories around individual stocks in a sector don’t add up the macro story, in my view, that’s a bubble. For instance, if you take what people are projecting for individual social media companies and aggregate it, the number today is far greater than the market potential for online advertising. From that definition, I think social media companies are getting close to a bubble. That’s what happened with dotcom companies too. People said online retailing is a big business and then valued companies on the assumption they would all be successful and capture that market.

They were wrong. So I would say that collectively, social media companies are over-valued. But there are going to be winners in this game − it could be Twitter, it could be Facebook, it could be Google. But there are going to be losers in this game too. The market is making the mistake of allowing far too many potential winners.

You’ve said that you are not a fan of value investing, because they have this blind spot. Do you lean towards growth investing?

I am an investor who believes in value. But I am not a value investor because value investing the way it is practised today is incredibly rigid and rule-driven. I wouldn’t blame anybody, but I think it is coming from the Ben Graham, Warren Buffett school of thought. The essence of ‘value’ seems to be that you need to buy a dollar for fifty cents. If you can do it, all the more power to you. But it isn’t easy to find that kind of value in today’s market. So true value investors seem to think that the best investments are to be found in mature, boring companies. But I see it as buying a company at a price that is lower than the value. I don’t see why that can’t be a young company. I don’t want to constrain myself to the 10 per cent of mature companies in the market. I want to look at every company. So, Facebook at $18 may actually be a much better deal than Coca-Cola at $43. I think we’ve done people a disservice by drawing this line between growth and value investing, where each camp thinks the other has nothing to offer them.

How much does the composition of the market affect stock valuations? In India, a third of the outstanding shares are held by foreign institutions.

It’s a pricing game. The problem for foreign institutional investors is that they’re sheep. They come in and go out at the same time. They’re going to create big swings in prices. To me, that is opportunity. When there’s a selloff, if you’re buying stocks for the cash flows and the value, you have a list of stocks you want to buy; you jump in and buy them. If you’re a domestic investor, yes, it does add another dimension.

You’re in a classic Keynesian beauty contest – which is not about which stocks are cheap but what stocks foreign investors are going to like. Whatever causes money to move is going to drive you.

Today, investors fancy many non-equity assets and would like to value them. How would you value gold, for instance, which doesn’t generate any cash flows?

Gold can’t be valued. You can price it. I think of gold as an alternative currency driven by pure demand and supply. The demand for gold is driven by how much people mistrust conventional currencies.

You can use the same logic to decide the price of Bitcoins too. Bitcoins are an alternative currency for a different group of people – the paranoid and the illegal. If you are worried about your transactions being tracked, you’d prefer Bitcoins.

That’s why the Bitcoin’s value is so volatile. It goes through wild swings depending on whether it is gaining acceptance in transactions or not. So if the Chinese government says it won’t accept it, it crashes. That doesn’t make gold a bad investment or a good one, but just a currency.

There is this big distinction made between defensive stocks and cyclical stocks. Today, the so-called defensives trade at 35-40 times earnings, while cyclicals struggle at 6-7 times. Is it right to make this distinction?

I think the problem is that people define cycles in domestic economy terms. But increasingly, there is disconnect between what’s happening at companies and what’s happening in the domestic economy. In the US, in the last five years, though the economy has been doing badly, companies have seen pretty healthy profit growth. About 60 per cent of the earnings for S&P 500 companies now comes from outside the US. It’s happening at a slower pace in emerging markets, but it's happening there as well.

So, that means weaker links between the stock markets and economic growth, right?

Yes. That’s why country stories don’t move me any more. I see that increasingly, the sector stories are what help investors make the right calls. If you’re a social media company, no matter where you’re listed, you command a high valuation. If you’re a steel company, you trade at a low valuation. So, if governments are thinking about what they can do to attract capital, they need to make the right sector bets.

I think the problem with being an Indian investor is that because of restrictions on investing overseas, you are forced to over-invest in domestic sectors. You are stuck with the sector bets the economy has made. Beyond a point, if the preferred sectors are over-valued, the money may go into real estate and other assets. You create recipes for bubbles.

Several Indian companies are sitting on large cash balances and analysts keep telling them to deploy the cash in acquisitions. Is that strategy right?

That’s a bad idea. If you have a lot of cash chasing acquisitions, there are going to be a lot of very bad deals in the market. The only people who are going to be happy about that will be (investment) bankers. If you have a lot of cash and have no use for it, you should return it. That allows the cash to work in some segment of the economy which really needs it. But wait, doesn’t India tax dividend payouts to investors?

Yes, there is a dividend distribution tax. But capital gains are tax-free if you hold stocks for more than one year.

Sometimes, what companies do is simply a fall-out of stupid rules. If you have differential taxation between dividends and retained earnings, I am surprised anybody ever pays any dividend! In fact, this is unhealthy because you may have start-ups in India which need that capital.

They may not be in sexy businesses that private equity investors like, but where are they going to get that capital if it is locked up in mature companies?

That’s not good for the economy.

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