A Study in Stocks: The Science of Investing


Beating the markets or generating investment alpha requires an “edge” and unconventional analytical methods can provide a powerful edge when applied to investment opportunities in the IT industry.

The next day at the dinner table, I wanted to ask Vikram about his stock and equity investing philosophy. I had been hearing about it and had several brief discussions with him for a long time but never got around to a detailed discussion about his investment philosophy and methods.

“Vikram, tell me this about stocks and equity investing. The academicians say that everything that is known about a stock is already priced in. There is no advantage to studying individual stocks and one is better-off investing in the whole market. Why do you waste time in, as you put it, bottom-up stock picking?”

www.newsbarons.com“Whittle, while I agree that today all the information is available, it is not necessarily known to everyone who buys, sells or holds the stock. Analysis of the information to reach the appropriate conclusions from the same is still more difficult. To make it even more difficult, investing is about future cash flows of the companies. That requires, not only an analytical mind, but also a synthesizing mind. Imagining what could be, the probabilities of various scenarios and the impact on cash flows and then judging whether Mr. Market is pricing it too conservatively or too optimistically is what lies at the heart of investing with a margin of safety. Deduction, Abduction and Induction, all are required.”

“Vikram, you remind me of Sherlock Holmes. He used to practice the art of deduction.”

“No doubt you think you are complimenting me Whittle when you compare me to Holmes. But while in his fiction he was able to solve numerous crimes with the help of the art of deduction, you understand that the author was helping him out. While not trying to belittle him as he tried to belittle Poe’s Dupin and Gaboriau’s Lecoq, I think there are many more skills required to really make good inference, conclusions and decisions in real life.”

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“Vikram, I think you are being quite unfair. Sherlock is one of my favourite detectives. I think that this intellectual arrogance of yours is quite unbecoming.”

“Whittle, sorry to make you think that I am being arrogant. Far from it. The equity specialist is quite a humble fellow. He knows that he operates in an environment where one has to be confident but not overconfident. He is guided by the maxim: Strong ideas weakly held. He knows that no information about the future can be certain. He works with a Bayesian mindset. Different possible future scenarios are given certain probabilities, objectively if data is available, subjectively if not. As more data becomes available the probabilities of various scenarios are updated.”

“Holmes’s art of deduction has a long history, Whittle. Poe’s detective C. Auguste Dupin called it the art of ratiocination. He had probably picked it up from Voltaire’s Zadig. The line of evolution of such thinking processes can be traced back eventually to the story of the Three Princes of Serendip which is actually based on a story from ancient India about 3 Princes from Swarnadip, i.e. modern day Sri Lanka. By the way, Serendip is the origin of the word serendipity with a completely wrong meaning ascribed to it by Horace Walpole. In any case the correct word for such thinking processes is abduction.”

“That is all very well, Vikram. But how does this help in equity investing?”

“Let me give you an example. In 2017-2018 if you were tracking US companies, you would notice that company after company across sectors was talking about digital transformation, digital marketing, online sales/ecommerce, supply chain management, customer-facing apps and so on. They were upping the budget for IT significantly. They were hiring and appointing Chief Digital Officers. If the top 500 companies represented by either the S&P 500 or Fortune 500 were going to spend so much on digital, where were the dollars going to go? A lot of them would go to the digital products and platform companies, such as, Amazon AWS, Microsoft Azure, Google adwords, Google Cloud, Salesforce, and the like. However, a lot of the services required for that migration to digital would have to come to IT services companies. In fact, this could be confirmed from the extraordinary growth that Accenture was already enjoying from such projects.”

“A good abductive reasoner along the lines of detective fiction and a Bayesian mindset would have inferred that if such a massive IT budget was being spent, a significant chunk would come to IT services companies. The migration to cloud, digital marketing and digital supply chain projects would not happen on their own. While automation would take away some manpower, the sheer massive demand for going digital would require massive manpower.”

“Now, Whittle, where was this massive, well-trained, and quickly trainable manpower to be found? Which companies had access to such large amount of manpower and the expertise to hire and quickly train them on the new digital technologies? One could think and come to only one conclusion. One had to look at India. The Indian IT services companies would be supplying these digital transformation services.”

“This reasoning led to looking at the financial statements and activities of Indian IT services firms. Sure enough, they were making a large number of acquisitions of mostly small companies specializing in various aspects of digital technologies. By 2017 itself they had collectively acquired more than 50 such companies.”

“To the untrained eye of Mr. Market, it looked like the Indian IT services companies were struggling to grow at mid-single digit growth rates. Analysts declared that the cost arbitrage model of Indian IT companies was over. Automation would wipe out the Indian IT industry. Fund managers hated these companies. Even Ashwath Damodaran said that a 50 year old should not behave like a 15 year old in reference to TCS and the Indian IT industry.”

“Whittle, a closer look at the statements from the companies would clearly show that while the legacy IT services business was struggling a small niche contributing around 15%-20% of revenues was growing at 35%+ annually. The legacy business was shrinking or flattish. Overall growth was around mid-single digits. This was further supported by the narrative of the management in conjunction with actions of acquiring digital-native companies and retraining thousands and lakhs of employees on the new technologies.”

“Calculations could clearly show that 20% of revenues growing at 35% p.a. could become nearly 50% of revenue within 3 years. A company with nearly 40%-50% digital revenue growing at 30% p.a. would show a double digit growth rate for the full company even if the legacy business was actually shrinking. It could be predicted that the analyst and fund manager community, i.e. Mr. Market would then suddenly wake up and re-rate these companies.”

“This is the reasoning that led to the Digital Transformation or DX portfolio launch in early 2018. You can learn more about the Omni DX strategy to understand this reasoning.”

“Vikram, now I understand a little bit more about the Science of Investing. Look forward to deeper discussion on this topic with you.”

Disclaimer: Equity investments are subject to market risks. Global investments entail currency and country risks. The above is not a recommendation to buy, sell or hold any of the stocks or sectors mentioned. We and our clients might have exposure to the above-mentioned stocks or sectors. Please consult your investment advisor and assess the suitability of investment products for your circumstances before investing. Please read the detailed disclaimer on omnisciencecapital.com/disclaimer.

[This is an authored article by Dr. Vikas V Gupta, CEO & Chief Investment Strategist at OmniScience Capital. All views, opinions and expressions are personal and limited to the author.]