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Predicting the winner of a reality show is tricky. What one feels is a beautiful voice often gets eliminated in the initial rounds of a singing contest just because the person is not able to garner enough public votes. The blame is then inevitably laid at the doorstep of biased judges, lack of a support base or in an extreme reaction to even fixing. John Maynard Keynes nailed this phenomenon in his 1936 book The General Theory of Employment, Interest and Money when he said, “It is not a case of choosing those faces that, to the best of one’s judgement, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be." The stock market resembles this Keynesian beauty contest: what one thinks is beautiful may not be the winner but being able to guess the average opinion of prettiness is critical.

If beauty is thought of in terms of stock attributes, there are many perceptions of beauty. Both the value school and the growth school of investing have a keen and sometimes almost diametrically opposite perception of beauty. One hears a persistent complaint amongst market participants that for some stocks, high valuations have ceased to matter while others are languishing despite being really cheap. If one were to look at the relative performance of the current market darlings over the past five years, across sectors ranging from healthcare to information technology, two things stand out. One, the largest stocks have become even larger in terms of their market capitalization relative to the sector and second, most of this outperformance has been a function of earnings multiple re-rating, that is, investors willing to pay more and more for the same claims on profits and cash flows. If over the last five years, this has been the beauty that markets have voted for, it is important to analyse the attributes that investors have rewarded. The defining characteristics of this group would be steady quarterly earnings (evidenced by low standard deviation), superior earnings growth (much ahead of the market) and high profitability (measured by return on equity).

While this may be well known, what is possibly less known, but is more important for understanding the perception of beauty, is that the composition of foreign ownership itself has undergone a change over past few years. Data sourced from EPFR Global, which conducts a monthly survey based collation of FII flows, shows interesting trends. The 2003-06 period saw India-dedicated funds dominate FII flows. After the financial crisis, the mantle has shifted to global emerging markets (GEM) and Asia funds, with India allocations. This is an important shift of beholders with the median FII investor now changing from being an India specialist to an emerging market or Asia generalist. The foremost implication is for the number of stocks in the portfolio and the size of each position. While India-dedicated investors had the appetite to own larger number of stocks and, hence, seek out ideas lower down the market capitalization curve, the multi-country investor is more likely to have lower number of stocks in each country but with a bulkier individual weight. This creates a natural bias towards large capitalization stocks with adequate liquidity. Also, at just over 16% since 2009, index funds’ contribution to the overall foreign flows hasn’t been as big as is popularly believed. It is not a surprising statistic then that only 15 stocks have contributed almost 76% to the rise of BSE 100 since January 2012. While the allure of Indian market definitely lies in its growth, diversity and opportunity to invest in high quality stocks, the attribute most sought after in these uncertain times is not valuation but quality and predictability of growth. So despite high valuations, quality stocks with predictable earnings attract more new money, taking their price-earnings ratio even higher.

While despairing the exit of your favourite contestant in the early rounds of the reality show is understandable, the reason may have more to do with public perception. The current composition of beholders is not permanent and soon there will be a new set that will be enamoured by a different concept of beauty but till then calls for automatic mean reversion in stock performances will be in vain. Of course, investing is all about appreciating the beauty of stocks, but keep one eye on the beholding crowd as well.

Amay Hattangadi and Swanand Kelkar are portfolio managers with Morgan Stanley Investment Management. These are their personal views.

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