How it helps.
Derivative in simple terms means deriving value from an underlying asset. There are derivatives in financial markets where people with 2 opposite views about an underlying asset would enter into a contract both expecting to benefit and, in the end, only one of them would. The one that benefits at the expiration of the contract is the one who was
able to “value” the underlying asset better than the opposite party. In that sense, derivative thinking would mean deriving value from the underlying facts, implied and explicit and using it for our benefit.
Let me look at the current market, what is explicit, what is implied, what financial history has to say about it, and derive some conclusions. Remember, I am trying to gauge the direction of the market not to predict whether Sensex will be 83,451 or 85,775 on 31st December 2024. My experience in the markets has taught me there is a lot of value in differentiating between good and bad and very little in differentiating between good and very good. Sounds counter intuitive at first. But it’s true.
Market levels are derived by two things. 1) Earnings of the companies and 2) PE multiple assigned by the market. Hence market capitalization is EPS X PE. This is true for individual companies as well as markets (indices like Nifty, Sensex, BSE 100, etc.).
FisPlease find below a table depicting factors that affect EPS and PE multiples.cal Math:
| Factors affecting Earnings of Companies | Factors affecting PE given by the Market |
| Gross and Pre-tax Margins | Expansion / Contraction of Margins |
| Invested Capital | Return on Invested Capital |
| Past Growth | Expected Future Growth C Longevity |
| Economy and Industry Growth | Liquidity and Sentiments in the Economy |
Here is what I shall derive from the above table. Factors affecting earnings of the company are ex-post i.e. either in the past or in the present. We know what the margins are, how much capital is invested, what is the growth compared to last year and what is the current state of the economy and the industry in which the company operates. What makes things interesting (and tricky) is the PE multiple assigned by the market to aparticular company or an industry or an index as a whole. Factors that affect PE are in general ex-ante. It’s the change in gross or pre-tax margins or the change in expected future growth rate of the company that expands or contracts the PE multiple. High liquidity injected by central banks or massive spending by the governments will expand the PE and vice versa.
Hence, in most cases earnings follow a reasonable cycle of contraction and expansion of margins, requirement of additional capital, etc. But when it comes to PE multiple assigned by the market, the patterns are very short term (1-2 years) and they reverse very quickly. Markets are a discounting machine. They aggressively try to discount the future. They do so by increasing or decreasing the PE multiples. Moreover, because most investors do not delve into the financials of the companies, there is a need for a narrative. This is where derivative thinking helps. We can reasonably gauge what is implied under the high PE of a particular company or a sector.
For example, take Railways. Look back at Railway stocks and see what PE multiple market was assigning them say 5 years back. It was in the single digit. Like 9 times earnings. They were going through a rough cycle since 2011 in terms of their margins and growth. Things started changing (due to cyclicality and not divine intervention) and the narrative was built. Today the same stocks are trading at several times more PE multiples than their last 10 years average. The narrative is government is going to spend money on railways like a drunken sailor. Narrative is past growth, expansion of margins and most importantly the continuity of the same “rate of growth” and “margins” into the foreseeable future. When growth rates slow or margins contract, all hell breaks loose. This happens all the time. Large companies which require less capital to grow their businesses and maintain their competitive positions go through time corrections (Asian Paints), whereas small companies operating in capital intensive industries go through price and time corrections.
But narratives are strong. They are built on emotions. Envy being the most dominant. Let me reminisce about a dialogue from the movie 3 idiots. “Dost agar fail o jaaye to dukh hota hai, lekin dost agar 1st rank le aaye to usse bhi zyada dukh hota hai”. It is hard to see people making money (at least that’s what the majority of them think). We don’t ask how much they made. A person with a net worth of Rs. 100 putting Rs. 25 to Rs. 30 and making Rs. 100, 200, 500 is good. In most cases people put Rs. 1 and make Rs. 5 once every few years. There is ample data to show that people are unable to create long lasting wealth from the markets because investments are made on the basis of narratives.
Narratives have facts to support. There is no question. But the problem is twofold. One, narratives can last longer than they should and two, people don’t derive what growth rates or margins are built-in the narratives. While I may never understand how long the narratives can last, I can derive that the current growth rates built-in some of the sectors are not sustainable. One day markets will become skeptical of the high future growth rates and ditch the companies or the whole sector altogether. We as responsible investors who are looking forward to creating long term sustainable wealth from the markets should be aware and skeptical while investing in these hot sectors.
In conclusion:
Markets are frothy in some parts like Defense, Railways, and most PSU. Most of the growth for the next 3 to 5 years has been priced in for many of these companies. When the announced expansion begins, margins will shrink, and the market will start to get nervous. Staying on the side of caution, looking for companies that are large and cash generating with dominant positions in their respective sectors is a prudent approach. All growth is cyclical, even for the best of the best companies across the globe. During expanding margins and high past growth, the PE multiple looks cheap but when you take into consideration the median margins and PE assigned after the margins shrink and growth falters, many companies are trading at very high multiples. There will be a fraction of companies that will grow fast and consistently for a long period of time but I am positive they wont be from the current hot sectors or WhatsApp list.
