You don’t need to see the future to invest successfully in the markets

TCPL has also started focusing on semi-urban and rural markets by appointing distributors which will help in penetrating markets further

'It is difficult to make predictions, especially about the future.'
-Either Neils Bohr, Physicist; or, Yogi Berra, Baseball Player

The above quote is of uncertain origin. It cannot be established clearly which of the above two persons, or even someone else, said it. If this is true for a relatively recent event in the current information age, predicting the future is definitely a tall ask. In the stock markets, the holy grail for many is to try to predict future market levels or prices of specific stocks. However, for investing in the markets, there is another more reasonable method.

Know what you know, and know what you don’t know

While future stock price levels or index levels are difficult to predict, it is possible to have a relatively more accurate view of the future fundamentals of a company. Even within the fundamentals, the book value or net worth of a company, except financial firms, can be established with a higher level of confidence compared to its revenues. Further, it is easier to determine that the net worth of the company could likely be higher than some minimum level next year or several years in the future; we can term this the conservative future book value.

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To establish a conservative future book value, one needs to establish the Return on Equity (RoE) of the company. RoEs are quite sticky for firms that are well-entrenched in their ecosystem. These companies have significant, persistent competitive advantages and are thus able to guard their margins.
Further, the demand for their offerings is consistent and possibly, though not necessarily, growing. Such companies have predictability in their revenues and margins. This makes their RoEs predictable. These companies manage their capex in line with their expected growth rates, and most growth is within the existing markets for the existing products, new products complementary or supplementary to the existing products, or markets in new geographies for existing products. All of this makes the RoE quite predictable. Even when moving into completely new products or markets, the management of such companies is quite conscious of the need to maintain their high RoEs and thus expands only if it is possible to do so.

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With the RoE, long-term growth rates, and dividend policy in hand, one can easily predict the conservative future book value. An estimated price-to-book-value (PBV) multiple of the future book value will help one reach the possible future value of the company. Of course, if conservative growth rates and RoEs are used with liberal dividend payouts, then the estimated future value of the company should also be reasonably conservative.

Despite being conservative, there is a risk of the above estimates going wrong. The future could see the entry of many competitors into the business. Or there could be regulatory changes, internal challenges, suppliers and customers enjoying greater bargaining power, etc.

Also, the company could do M&A, buybacks, rights issues, or other corporate actions, etc, which could make the estimates differ from future reality.

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If the current multiple is lower than that justified for a company with the estimated RoE and growth rates, then one can consider adding it to the portfolio. Also, remember that an optimal equity portfolio should typically have 20-50 stocks. Aggressive individual investors can have 20-25 in a focused portfolio, and institutional investors can have up to 50 portfolios. This is likely to provide sufficient diversification if one remembers to add stocks from at least three to four different sectors/industries and not have too much allocation to a single sector.

The next question will be: how to judge a good RoE, growth rate, and PBV multiples? The RoEs and growth rates being higher than the average or median is a good starting point. For PBV too, one can look at all the companies with similar RoEs and growth rates and then start investigating the companies with PBV lower than the medians or averages of these companies. If that is difficult, then just compare it with the RoEs of the Nifty 50 or Nifty 500. Nifty publishes the PBV (sometimes written as PB), price-earnings ratio (PE ratio), and dividend yields. PBV divided by PE gives you the RoE. For growth rates, compare them with the earnings growth rates of the Nifty 50 or the nominal GDP growth rates.

Of course, if one has precise data on all the companies for the above variables and can use different valuation techniques, including DCF, etc., to estimate the conservative intrinsic value of a company, then that is the best way. But in most cases, the above should suffice to give one a significant edge.

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To summarise, don’t focus too much on macroeconomic predictions. These usually don’t pan out as expected. No one can predict the future. In fact, mathematicians have proven that non-linear dynamic systems are impossible to predict.

What can be predicted better, though not perfectly, is the fundamental evolution of a company. One can focus on that and try to see which company could be a better investment than the index itself.

Focus on the micro and not on the macro.