Two friends catching up in a coffee shop got into an interesting conversation as one of their favourite musical pieces — ‘One Man’s Dream’ by Yanni — started playing in the background.
Ram: Wow! This new-age genre of music is mind-blowing. Although new-age sounds like more of a painful word these days with the series of flop shows of such companies that listed last year.
Portfolio podcast | Are you a ‘Ketchup Economist’ when it comes to investing?
Veena: Haha…these new-age companies remind me of ketchup economists, though.
Ram: What is that?
Veena: It’s a term coined by economist and former US Treasury Secretary Larry Summers. It was his sarcastic take on some of the highly paid economists and finance professionals who are concerned only with inter-relationships between prices of different financial assets. Based on this approach, they conclude whether the price of an asset independently is efficient or not. If two bottles of ketchup sell for twice as much as one bottle (except for minor differences traceable to transaction costs), the market is efficient.
Ram: This sounds like relative valuation. What is wrong in that?
Veena: It ignores the aspect of whether one bottle of ketchup is priced rationally. In Summers’ view, contrary to ketchup economists, a general economist would attempt to test valuation of an asset based on fundamental factors as well and not just believe in market efficiency. Is one bottle of ketchup priced rationally based on factors affecting demand and supply for ketchup — like cost of tomato, wages, substitutes, etc?
Ram: Are you saying relative valuation is flawed?
Veena: Not at all. I am only saying relative valuation that does not do some sanity checks on pricing of the original asset you are comparing with, is flawed. You could say IPOs of new-age companies since the listing of Zomato have turned out to be a disaster due to lack of these sanity checks. High prices of bonds (low yields/interest rates) was used as justification for high valuation of high-growth but unprofitable companies. But were bonds properly priced? The rout in global bond markets this year clearly indicates they were not. Similarly, comparisons with other high-valued new-age companies in other markets were made to justify these valuations, without analysing whether those companies were properly priced.
Ram: Interesting.
Veena: Nobel Laureate Paul Krugman once explained how the US housing bubble that precipitated the global financial crisis reminded him of ketchup economists. Before purchasing a house during the bubble, buyers carefully compared prices with ‘prices of other houses’, but ignored whether the overall level of a home price made sense.