Tuesday, May 5, 2009

Keep it simple!!

While I took issue with a great deal of what Mr. Buffett said in the last post, there is one point on which I completely agree. Keep it simple! In my valuation classes, I begin my class by promoting the principle of parsimony. In the physical sciences, this principle (also known as Occam's razor) specifies that when trying to explain any phenomenon, you start with the simplest possible explanation before moving on to more complicated theories.

In valuation, the principle of parsimony calls on us to use the simplest possible model to value any asset. However, there is a catch. The definiton of simplest will vary, depending upon the asset you are valuing. When valuing cash, for instance, you can just count the cash on hand; you don't need a model or elaborate assumption. When valuing a mature company, with stable and predictable, profits, knowing what the firm generated in cash flows last year may be sufficient to value the firm. When valuing a young, growth company, the simplest model may require you to forecast earnings and cash flows for an extended period. You may not like to do it (I don't think anyone does) but there is no real choice..

So, here is the bottom line. I oppose detail for the sake of detail and complexity designed to show the world how smart and sophisticated an analyst is. I think you risk mangling the valuations of simple assets by doing so. However, I think to argue that detail is always bad and that forecasting is dangerous works only if you decide that your investment space is going to be populated only by mature companies. If you, as an investor, are interested in buying growth companies (and there is no law that says you have to be) or valuing them, you have to face up to the truth. There is no way to value these companies without peeking into the future and making forecasts, and then adjusting your value for the uncertainty you feel about these forecasts.

9 comments:

Uiucfinance said...

I think you nailed it.

Its a matter of using the correct tool for the job at hand.

If I have learned anything in finance, it is the answer to almost all questions is "it depends".

Aswath Damodaran said...

I like the way you put it. We have an extensive tool kit in finance, but half the job is picking the right tool. Too often, I think we reach for the tool that worked so well on the last job we had and expect it to work on the next one.

bhavin said...

Three Lessons:

1. Keep it simple

2. "it depends"

3. Pick the right tool.

I think thats a great conclusion to end up this fantastic debate.

Bravo to you, Sir!!!

dharma said...

Yes professor..thats a perfect conclusion on valuation models.There is never a one size fits all approach as regards valuing companies. Accurate forecasting requires remarkable clairvoyance which very few people in this world possess. Analysts can take a lot of cues from sun tzu's "art of war" to simplify the valuation process

Puneet said...

The bottom line is - do not use a hammer to swat a fly.

dharma said...

Sensex witnesses its biggest single day gain in market history. I hope investors remember the theory of reflexivity before investing at these levels. Irratinal exhuberance ( on the congress forming a majority government) can lead to market disequilibrium. Its just fascinating to understand herd mentality and investor behaviour. What wasnt cheap at 8000 levels of sensex, with a turn of sentiment becomes cheap at 14000.

Gaurav Mehta said...

what was very undervalued at 8000 can still be very undervalued at 14000 and the point is 8000 almost everything was undervalued it was just that fear was in control and investor appitite was almost zero for stocks. Sentiments have changed .. people are looking at growth and fear is no where in sight... if you dont invest now... markets will move higher as there is a rush to buy... Also i thinks have changed structurally in India as moving to 9-10% growth now looks easier than it ever has... this is a once in a 25 year thing and i think the markets reacted perfectly.... I dont think markets will go back to 8000 levels in the near to medium term... for that to happen you would need another crisis ...which looks very unlikely having had one major crisis just recently.... You are looking at a potential multi year bull run from here on for India...Decoupling theories might finally find place... as US and large part of developed nations would obviously not be in the kind of bull run that markets like India is likely to see. Professor your thoughts on this would very appreciable infact i was looking for an article from you on this topic....

dharma said...

Yes i do agree that with congress securing a strong mandate, this has really turned out to be a gamechanger of sorts for the indian economy. But the velocity with which the markets have moved up has taken everyone by surprise. With no change in the present fundamentals of the economy and with global environment still struggling to get out of the woods, it was just euphoria and pure sentiment that brought about this "golden monday" rally. Given what has happened, markets are pricing in huge expectations of reforms and if the government is seen as going slow in the days ahead, we might start pulling back but the probability of getting back to the lows of 8000 seem pretty distant from here on. Every sizeable 10-15% dip should be a buying opportunity as far as india is concerned.

Gaurav Mehta said...

I think it was kind of expected the market to break the circuits once the election results had been announced ...as for a 10-20% dip is concerned ..obviously there are stocks that have run up too fast especially the large caps and are looking for a correction ...and thats the reason you are seeing the sensex and nifty underperforming the midcap index... due primarily to the valuation gap between large caps and small caps...also what i am not saying is that Indian story will run on 4 wheels from here on .. the markets will countinue to react on what is happening on the global front ... its just that on the long term global funds, FII and FDI will allocate a larger allocation to India which will mean that as the market makes a large correction there will be renewed buying ...also about the bull run .. that would be seen only if indian corporates are able to perform as expected going forward... the goverment will just help their case!