India Should Avoid Financial Over-Confidence

Just a year ago (March 9, 2009), stock markets round the world closed at their post-crisis low in what appeared to be a stunning display of synchronized swimming. The strength of the subsequent rally was unprecedented in the history of financial markets. By March 12, 2010 and the Nifty has gained 101 percent, the BSE Sensex is one step better at 112 percent.

What is truly impressive is the change in sentiment. The current buzz of optimism appears to be driven by a pragmatic Union Budget, impressive growth in earnings for most companies and the belief that a second sub-par monsoon is highly unlikely, suggesting therefore, that the demon of inflation will be vanquished by mid-2010. By all accounts, what investors have experienced in the last 12 months is a gigantic “relief rally” that must surely be on its last legs given the slim pickings since December 2009. The crux of the issue is not to celebrate yesterday’s victory but rather to discern what comes next.

Domestic industrial production is on a roll. The mandarins in North Block would have us believe that growth in agricultural output is slated for new highs. Renowned economists are near unanimous in praising RBI for ensuring that the Indian banking system is among the most resilient in the developing world. Finally, and perhaps most significantly, the market seems to be reasonably priced at 15-16 times consensus earnings for financial year 2011. Given these circumstances, is it fair to chide investors for being upbeat about the future? Not really. But it is worth remembering that the world we live in is “probabilistic” and quite often the relationship between cause and effect is not transparent.

In 1947, B.F. Skinner, the founding father of “behaviouralism”, chose to explore the habits of pigeons. He placed a series of hungry pigeons in a cage attached to an automatic mechanism that delivered food to the bird at regular intervals with no reference whatsoever to the pigeon’s behaviour. What he found was fascinating – the pigeons associated the delivery of food with whatever chance actions they had been performing as it was delivered, and they continued to repeat that behaviour! As human beings we love to be in control. The feeling of not being able to influence the outcome of an event is unacceptable. Perhaps, this is what leads investors to mimic Skinner’s pigeons.

We also know how to reach the conclusions we want to find. If the data does not confirm our hypothesis, we cast it aside and look for “facts” that do. As a result, we hate to admit that “I don’t know.” Funnily the more we know, the more we think we know even more than we do. These troubling inadequacies in our mental hardwiring lead us to become complacent and even worse, put too little effort in planning ahead and thinking about the future. I was certainly guilty of having succumbed to these traps in recommending a couple of sugar companies in February! Genuine apologies for the damage done to your hard earned savings.

So, are there attractive opportunities at the present moment which offer a high margin of safety? With some trepidation, I would recommend looking carefully at Clariant Chemicals (Rs. 500). Clariant is an undisputed leader — in terms of technology, quality and price — in selling chemicals used by the leather, textiles and paper industries apart from having considerable strengths in niches such as master batches, pigments, additives and specialty fine chemicals. Despite a tough operating environment for its major customers in calendar 2009, the company earned a shade under Rs. 47 per share of which it paid Rs. 25 as dividend to shareholders! The company also proposes to sell some surplus land which is worth between Rs. 150-175 per share on a highly conservative reckoning.

Iconoclast philosopher George Santayana remarked that “when experience is not retained, infancy is perpetual. Those who cannot remember the past are condemned to repeat it.” Perhaps this sobering thought will help to temper any over-confidence pervading our collective minds!

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.