This time it’s different right?

Legendary investor Warren Buffett once said, “We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

Having spent more than twenty-five years in the listed equity space, one thing I have absolute certainty on is the inability to have absolute certainty on what the market may be up to in the next week or month.

The idea that fund managers have a magic wand which may help them better predict how the market may operate in the next month, is a dangerous illusion.  What’s worse is the faulty confidence that an investor may operate with, when they get lucky but mistake it for skill.

The market has the ability to swing from bouts of optimism to stints of pessimism in the blink of an eye. Being able to separate this “moody price” from the “true value” of a business is the challenge which all investors face. In our constant endeavor to better understand valuations, one input which has helped us map out risk-rewards at aggregate market levels is the price to book ratio.


The Price to Book multiple

Imagine a friend who has started a business with Rs 100. That is the net worth or book value for that business. Now let’s assume that she is earning 15% on that Rs 100. If you were to buy her business how much would you pay?

While that is very little information to go on, one thing you would almost intrinsically do is look at the return the business is earning over a risk free investment. If a business was earning 6% you would probably not pay any premium at all. After all you can earn that return by keeping money in the bank. The value of the business would be its book value which is 100.

However, our friend is earning 15% and so her business will be more valuable than Rs 100.  The premium one ascribes to the net worth of a business (price to book value) often comes from the excess return above the hurdle rate (in this case 6%) and the ability of the business to maintain that excess return over time. Simply put, the higher the return on net worth a company generates, the higher the price to book multiple that is given to that business.

As earnings can be very volatile, we have found price to book to be more stable than the price to earnings ratio. When looking at aggregate market valuations, we often rely on a simple framework which revolves around the price to book ratio. The chart below shows us the Sensex Price to book from 2000 to 2022.


Price to book Band
Source: Bloomberg

In that period, Sensex had an average price to book of 3.10.

Price to book range
Source: Bloomberg. *Median 5-year CAGR. Data from Jan 2, 2000 to Nov 30, 2022. Past performance may or may not be sustained in future.

The table above shows rolling returns segregated by the time the market spends in a particular price to book range. Interestingly, Sensex spends close to 85% of the time between 2x and 4x. Close to normal returns can be expected when investing in this range. However, the returns dramatically change when we move to either extreme.

The five year return expectations after investing in the Sensex when the price to book is above 4x is a mere 4%. On the other hand, the five year return jumps to an incredible 40% (annualized) when investing in periods when the price to book was below 2x.

Looking at this may make it seem that investing when the market is at valuations close to or lesser than 2x price to book is a no brainer. While it has been so for the last 20 years, it only becomes evident in hindsight. Think back to March-April 2020. The market was languishing at valuations close to 2x price to book. The prevailing market sentiment though was anything but positive.

Google Trend for Recession
Source: Google Trends for India

Rising Covid cases, country wide lockdowns, oil price volatility, supply chain disruptions, etc. all led to recession concerns. This is what makes contrarian investing difficult. It’s a constant battle between “This time it’s different” and “The risk reward makes it a no brainer”.

While our price to book risk-reward framework simplifies our thinking we are always cognizant of the fact that the Indian market is still very young. Twenty years of a study may unfortunately not be enough to cover every potential market dynamic.

All this brings us to the simple realization that fundamental investing is not a perfect science. Random speculation aside, even historical risk rewards are not the answer to everything. However, in times of uncertainty, they come in handy as they help build conviction to be more confident or cautious to take a contrarian bet.

This article was initially published in Business Line on December 14th and is co-authored by Anup Maheshwari and Dhruv Maniyar. As of February 2023, Anup Maheshwari is the Co-Founder and Chief Investment Officer at IIFL Asset Management. Dhruv Maniyar is Assistant Manager (Research) at IIFL Asset Management.



Securities investments are subject to market risks and there is no assurance or guarantee that the objectives of the Scheme/Strategy will be achieved. This document is confidential.

The views and opinions expressed herein are solely of the author(s) and do not reflect the views, opinions and beliefs of IIFL Asset Management Limited (“IIFLAMC”) and/or its affiliates. As with any securities investment, the value of a portfolio can go up or down depending on the factors and forces affecting the capital markets. Past performance of IIFLAMC may not be indicative of its performance in the future.

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