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Investing & the theory of inversion - Views on News from Equitymaster
 
 
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  • Apr 16, 2008

    Investing & the theory of inversion

    "66", muttered the grocer to himself as he reached out to his cash counter at one of the corner grocery stores and pulled out few notes and coins totaling Rs 66. He settled the transaction by promptly handing over the money to the customer who had bought goods worth Rs 34 but had paid Rs 100 for lack of change.

    While the grocer moved onto other activity with nonchalant ease, we were impressed by how quickly he managed to mentally calculate the difference between 100 and 34. After watching him settle few more of such transactions, it finally dawned that rather than subtraction, he relied upon a quicker and a less error prone technique of starting with the base amount and then continuing adding to it until he reached the amount that the customer actually paid him. Like in the case of the customer who gave him Rs 100, he started with 34 and kept on adding until he reached 100. '66', the number struck to us at lightening speed and we had just discovered a technique that is sure to save us few hours over the course of our lifetimes.

    Little did the grocer realize that he was relying upon a mental exercise that the famous mathematician Carl Jacobi had made immortal with his words, "Invert, always invert". Jacobi had reasoned that it is probably in the nature of things that a lot of problems in the world can be solved by thinking backwards. This phrase has been made more famous in recent times by Charles Munger, the lesser known but an equally erudite partner of Warren Buffett and who is believed to have had one of the greatest influences on him.

    Let us try and find answers to few simple questions like 'What does it take to be successful?' or 'What should I eat to remain healthy?' While the answers to these questions can definitely be worked out, exactly opposite queries to the above set of questions will most likely lead to new insights and make our job that much more easier. Thus, if we now try answering questions like 'What qualities makes a man unsuccessful and how should I avoid them?' or 'What food will make me fat and unhealthy?' These questions are exactly opposite in nature to the ones posted above and rely upon the theory of inversion. To test the efficacy of the method, additional sets of questions, one proper and one inverted should be framed and indeed analysed. After going through the results, we don't think that there would be doubt in anyone's mind that this technique is indeed a very important tool to solve many of the life's problems.

    Now, how do we use this theory of inversion in the field of investing? We believe that inversion works just as fine in investing as any other field and if properly adhered to, is likely to result into much better investment results. Say for example, after an investor has carefully analysed all the reasons for investing in a stock, he should resort to inversion and ask himself, "What are the reasons that will make me not invest in the stock?" More often than not he is likely to stumble upon something he had not known previously and hence, would help him take a more informed decision.

    Another way in which the technique can be used effectively is by questioning the price that a stock commands in the market place. Normally, while analyzing the investment worthiness of a stock, an investor makes some assumptions about future cash flows and discount rates and then arrives at a fair value. This fair value is in turn compared with the stock price and depending upon the premium or discount, one chooses to invest or not to invest in the stock. How about inverting the analysis and starting with the market price and then questioning ' What kind of future cash flows does the current market price imply?' The results that such kind of analysis throws will be no less than startling.

    Let us consider a company ABB, which as per our database is currently the most expensive stock on the NSE-Nifty with a trailing twelve-month price to earnings ratio of 50 times. Now if you are the one looking to invest in 5 baggers with an investment horizon of five years then is the stock a right bet for you? Let us assume that in five years time, the stock will come down to a more realistic and the broader market like P/E (Price to Earning) of 20 times. Thus, for the stock to become a five bagger in five years, it will have to grow its earnings at a CAGR of around 66% (explanation given below), a feat that is really difficult if not impossible to achieve for most of the well-established companies like ABB.

    This wonderful insight was made possible because of inversion. We started with the price and the P/E ratio and then went on to check whether it is really possible for the stock to become a five bagger, realising that the probability of such an event happening is indeed low. Hence, the next time you come across a good stock to consider for investment, do not forget to pass it under the screen of the inversion theory and as mentioned before, the results might surprise you.

    Explanation - Assume that ABB's current EPS is Re 1. So, at 50 times P/E, the company's current stock price will be Rs 50. If the stock were to become a five bagger in five years, the price has to touch Rs 250. Now, assuming that after 5 years, the stock's P/E were to come down to a more realistic and the broader market like P/E of 20 times, the EPS thus calculated will be Rs 12.5 (Rs 250 divided by 20). Compared to the current assumed EPS of Re 1, for the same to grow to Rs 12.5 in five years times would require it to grow by 66% CAGR.

     

     

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