Chasing returns in a market where opportunities are fewer is not unusual. Every investor likes to believe in their ability to find opportunities in the toughest markets. Investors constantly seek new opportunities in every market context.
Expensive markets with trending higher valuations only increase the challenge of finding opportunities. More investors chase fewer opportunities in such a market scenario. This only leads to even higher valuations in a market where finding better opportunities only becomes tougher.
The problem is not the availability of investment opportunities or the investor's ability to spot them. Investors' soaring anxiety becomes the primary problem. This anxiety manifests in investor behaviour in ways that distinctly affect their compounding journey. The first symptom is the willingness to overpay for growth.
Investors believe that with elusive growth opportunities, the companies offering growth deserve a higher valuation. The first set of investors who overpay is generally seen as thought leaders and trendsetters. They go to town highlighting the theme, talking up stock prices, and making the theme fully discovered. Then, more investors follow the theme, bid up stock prices and buy at elevated valuations.
With more interest chasing the available liquidity, we see stock valuations soaring, leading to eye-popping charts, mind-boggling technical setups, and an algo explosion. The stock's liquidity rises, but still fails to meet the interest in the stock.
At that stage, anxious institutional buyers want more liquidity without incurring further impact costs buying stocks from the market. They don't want to be left out of further upside and are happy to simply participate in the story.
Here, the company steps in to provide the liquidity by raising the capital it needs. The valuations at that juncture are usually still elevated and the company typically uses the recent high as the reference point, readily selling shares at a discount to those highs.
The excitement around the stock continues, and everyone experiences different kinds of highs depending on when they bought shares. Early buyers experience notional gains, late buyers experience participation in the highs and those who bought in between experience the hope of further upside.This is almost a textbook case of the scarcity investing we just described.
When the scarcity story changes
What follows is the real story. Once the company raises the capital it needs to fund its growth for the foreseeable future, it goes back to business and focuses on operations while letting the market wait for the results. The market, which has raised its expectations for the company, given it more capital at elevated valuations and priced the business to near perfection, is now still in a state of anxiety.
It expects more from the company in the near term now that the company has the capital it needs. At this stage, everybody has different perspectives and differing expectations of the immediate future begin to surface. Most importantly, the demand for the company's shares has been fully satiated and the liquidity in the stock starts exceeding the demand.
Imagine this happening across numerous companies in an entire sector or theme, with the majority of growth stocks at this stage. Extend this to all the growth sectors and you realise that a new market setting is developing. This new market setting has now become the real risk.
The danger of pricing perfection
Every company has more than adequate capital needed for future growth. Their valuations are priced to near perfection, accounting for high growth. Future profits are taken for granted, and the company is already fully rewarded for its future success. Now, we have a binary setting in place. The first scenario is a good place to be. If the company still delivers beyond even the elevated expectations of investors, it will sustain valuations at even higher levels, as large investors will simply not sell under the influence of the fear of missing out.
On the other hand, the second scenario can be scary and is more frequently the case. If there are slippages in execution or a lag in meeting the set investor expectations, the hypothesis itself will turn shaky and edgy downside momentum will start playing out.
The valuations will see a sharp cut from where the bigger investors entered the stock, and investor anxiety will remain elevated. Confidence of one set of investors will be shaken and the other set of believers in the company will be forced to show more conviction.
This can be a tough decision with no room for error. It is here that more investment mistakes can occur. The problem with the current market setting is that we are assuming this scenario will not happen. Our current capital allocation in Indian equities prices the outcome to perfection and we are investing most incremental, institutional capital on this assumption.
The flows are at their highest exactly where everything is priced to perfection. The small-cap and mid-cap space is receiving very high flows and deploying capital exactly how we described investing here.
The hope is that more companies exceed our expectations, deliver sustained performance that justify the valuations we paid and compensate for the companies that struggle, delay delivery or fail. However, the risk clearly is not in how the companies perform. The risk comes from how we invest our capital. “Risk clearly comes from not knowing what we are doing.” Time to return to the eternal words of Warren Buffett.
Shyam Sekhar is chief ideator and founder of ithought Financial Consulting LLP