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The beauty contest on Dalal Street
June 20, 2013

The economist Keynes compared the equity market to a beauty contest. His analogy still holds when looking at the most sought after stocks in today's market.

Author : Larissa Fernand

 Keynes beauty contest

Everyone, at least the majority of those reading this article, would have heard of the economist John Maynard Keynes. But not all would be aware of the analogy when he compared the stock market to a beauty contest.

In his 1936 book titled The General Theory of Employment, Interest, and Money he described a newspaper contest in which 100 photographs of faces were displayed. Readers were asked to choose the six prettiest. The winner would be the reader whose list of six came closest to the most popular of the combined lists of all readers.

If you want to win, the best strategy according to Keynes is not to pick your personal favourites. Go for those that you think others will think prettiest. Better still, improve your chances of winning by going one step further and pick the faces you think that others think that still others think are prettiest. In case you think I am taking you for a ride, let me quote: “…It is not a case of choosing those faces that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be…”

Two portfolio managers at Morgan Stanley Mutual Fund, Amay Hattangadi and Swanand Kelkar, have cited this in their latest newsletter where they drive home the point that the stock market resembles this Keynesian beauty contest. What one thinks is beautiful may not be the winner. Being able to guess the average opinion of prettiness is critical.

Beauty in terms of stock attributes

There are different perceptions of beauty. Both the value and the growth school of investing have a keen and, sometimes, almost diametrically opposite perception of beauty. For some stocks, high valuations have ceased to matter, while others are languishing despite being really cheap.

To drive home their point, the two fund managers look at the top performers in 5 large sectors over the last 5 years. Sun Pharma (Healthcare), L&T (Industrials), TCS (IT), HDFC Bank (Private Banks) and ITC (Consumer Staples) emerged as successful contenders.

Two things stand out when one looks at the figures (no pun intended).

  • The largest stocks have become even larger in terms of their market capitalisation relative to the sector.
  • In most cases, this outperformance has been a function of earnings multiple re-rating i.e. investors willing to pay more and more for the same claims on profits and cash flows.

It’s evident that the type of “beauty” that the market has voted in favour of is based on certain attributes: superior earnings growth (much ahead of the market) with little quarterly volatility and high profitability (measured by RoE). The verdict is that the winning combination is superior earnings growth and capital self-sufficiency.

After establishing the beauties, they look at who the beholders are.
FIIs have steadily increased their holdings of Indian equities from 16.7% (March 2002) to over 22% (March 2013). Domestic institutions and the public accounted for 28.5% of the market ownership in March 2002 to drop to 19%. Within domestic institutions, ownership of mutual funds has come down steadily over the past few years, but insurance companies have stepped in their place.

The incremental beholder of Indian equities over the last few years has definitely been the FII.


  • 15 stocks have contributed almost 76% to the rise of BSE 100 index since January 2012 till May 2013 – they are the winners of the beauty contest
  • Though the allure of the Indian market lies in its growth, diversity and opportunity to invest in high quality stocks, the attribute most sought after is valuations but quality and predictability of growth
  • Hence, despite high valuations, quality stocks with predictable earnings attract more new money, taking their PE ratio even higher
  • Analysing the composition of foreign ownership, one should not be surprised at the natural bias towards large-cap stocks with adequate liquidity

So don’t despair the exit of your favorite contestant. The composition of beholders is not permanent and neither is the concept of beauty. But do note: In investing, it’s not all about appreciating the beauty of stocks. Keep an eye on the beholders as well.

To read the report Beauty & the Beholder in detail, click here.

PE: Price-earnings ratio / IT: Information Technology / RoE: Return on Equity / FII: Foreign Institutional Investor

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