A lot of retail investors, and some institutional investors too, assume that they invest in equities or other asset classes but in reality, it is a mix of analysis and judgement call. Had it been pure science everybody would have made money but that doesn’t happen in fact most investors lose money in a short period of time. Let us dive into the functions of analysis.
Whenever we are looking to put our money into an asset we tend to look for descriptive data. This descriptive data gives us some standard measures to understand the functioning of the operations of the assets. For eg., if you invest in stocks, you would usually get basic information available on stock exchanges or broker websites like income statements, balance sheets, cash flow statements, liquidity ratios, efficiency ratios etc.
To be able to understand these rations and then arrive at a conclusion on the investment activity is not feasible as the investors don’t get the entire picture from this data.
- Intrinsic Value vs Price - When investing in a company one should understand that the intrinsic value and market prices give different signals. The intrinsic value does not have a definite formula and uses the descriptive data to tell about the health of the company from various perspectives. Whereas the market prices, a definite number, tell us about the perception of investors in the market about the security. So whenever you get the descriptive data from any source, keep in mind what exactly you want to conclude from that data instead, is it that intrinsic value or market price.
- Intrinsic Value vs Earning Power - Whenever you see the track record of a certain security, by general human nature, we tend to believe that the security is bound to perform the same way as it did in the past, which is really a wrong notion. Security giving an average return of 10% in the last years should not be expected to give a return of 10% in the next year. It is very rare that the past is reflective of what is going to happen in the future. The ability of the security to provide a good return can be assessed through the evaluation of intrinsic value more than the earning power or average historical performance.
- Purpose of Intrinsic Value - As mentioned previously there’s no definite number that can be achieved for intrinsic value but a range can be achieved for the same. For eg., if the intrinsic value of TCS is between INR 5000-6000 per share but it is priced at, let’s say, INR 2000 per share that means it is a signal that the market price of TCS should be much higher. The purpose of the intrinsic value is to signal if the security is over or underpriced. But if there’s no definition of intrinsic value how do we know that it is high or low?
- Continuing the TCS example, let’s say, the net asset value per share is INR 3000 and the cash value per share is INR 2000, hence we can easily conclude that the intrinsic value is more than the market price of TCS.
- Flexibility and Range - The flexibility of the range of intrinsic value can be high or low depending on the nature of the business. A business which is inherently stable and has low volatility will have a narrow range and the one with more instability will have a broader range. The securities with definite output will also have a narrow range of intrinsic value like bonds issued will give a more definite output of intrinsic value.
- Analysis Obstacles - There are 3 obstacles that an investor faces while doing the analysis of the security
- Incorrect Data - Other than the descriptive data, for analysis one needs to look at the industry or country-level data from different sources. There are very few standard sources for this data. On the company side, a company may falsely represent its data or won’t tell the whole truth. In such cases, the analyst must dig down to extract such information.
- Uncertainty of the future - The future is highly unpredictable and knowing that is really important. No one can predict the future nor the past performance of the company is a suitable guide to the future unless the past has a high correlation with the future for that particular security.
- Market Behaviour - The market behaviour is highly unpredictable for an investor. The market usually excesses itself on the emotion of investing i.e. if certain security is doing it will get overvalued pretty frequently and if it is not, it will be highly undervalued. Even if certain security is undervalued, it can stay so for a pretty long period due to bias in the market and the same is true for overvalued security.
- Relationship between Market price and Analysis - The relationship between the analysis and market price is partial and indirect. No matter what analysis we do, that analysis will have to go through the perception bias of the investor so the analysis can’t have a direct effect on the market price. The relationship is partial because the analysis is not the only part which is looked at by the investor but it is also the speculation of the market which dilutes the analysis of the security.
- Uncertainty dilutes Analysis - If the security that you are analysing is subject to very high uncertainty in the future then the value of analysis will give us certainly lesser value. A less certain environment gives a better direction to the analyst or investor.
Once you have the information on the selective function and description function, an investor or analyst is in a suitable position to provide a critical judgement on the possibility of investment.
Hope you enjoyed today's read. Cheers!