Don’t burn your fingers


Director, Banyan Tree Advisors

December 20, 2011

The stock market is a place that attracts a motley crowd–family brokers, big-time punters, companies, mutual funds, foreign institutional investors, businessmen, investment professionals, salaried individuals, housewives, students…

Diverse in character, but united in purpose: to make money from the market. And because it is a place where fortunes tend to fluctuate on almost a daily basis, it is the breeding ground for many a myth. People want simple answers to complex problems, for which they usually turn to some simplistic formulae.

The bigger players dominate the market by virtue of possessing the keys to the two most crucial resource vaults: information and capital. So, not only do they have opportunity knock at their doors frequently, they also have the wherewithal to embrace it and profit from it.

Pitted against such brute strength and tall odds, what are your chances of making money (don’t forget, it’s a zero-sum game)? Plenty, so long as you don’t try to beat them at their own game. No doubt, the market can be a minefield, but it can
also be a hotbed of opportunity, provided you know how and when to recognise it. Understanding its intricacies is not just about learning new tricks of the trade; it is as much about unlearning long-held beliefs that have somehow crept into the market’s collective consciousness. Here we debunk 10 such myths.

»The market is always right
»I am better off routing my equity investments through mutual funds
»A bonus issue creates value for shareholders
»Price is not an issue while investing in good companies
»Valuation is irrelevant in the new economy
»Price movements of Indian software stocks mirrors those on the Nasdaq
»A high-growth company that has a PEG ratio of below
»When a stock hits its 52-week low, it’s a buy
»Rupee cost averaging is always a good defensive stock strategy
»Penny stocks are great buys, as they have little downside

The market is always right. A lot of investment theorists and practitioners alike believe the market is all-knowing and perfect–that the current price of a stock reflects all material information about the company, its history and its prospects. This defies logic. We have often seen a stock double or triple in the space of a month. Often, this sharp rise is not preceded by any new information about the company being revealed to the investing populace. It’s very rare for a company’s fundamentals to change so significantly over as short a period of time as a month. Obviously, what’s changing is simply the market’s perception about the stock.

Respect the market and understand what it’s trying to say, but to conclude that it’s omnipotent would be a big mistake. Celebrated investment strategist Ben Graham advised investors to treat Mr Market like a manic-depressive partner in a
business who comes every morning with a quotation at which he is willing to buy your share of the business and another at which is he willing to sell his share of the business. Sound advice that. It will be far more useful for you to consider the
market as a manic-depressive, who is extremely prone to swinging to extremes, rather than as an all-knowing, all-powerful force that many market watchers tend to make it out to be. For only then can you use the market to your benefit, and buy low and sell high, rather than become its slave–and let its gyrations affect not only your wealth but also your health.

I am better off routing my equity investments through mutual funds

One piece of oft-repeated advice from the investing community to retail investors seems to be: don’t indulge in ‘dangerous’ activities like investing in the stock market; instead, invest your money with mutual funds, who are supposedly better money managers as they employ professionals who understand the intricacies of the market.

Incidentally, who is dispensing this advice? The same investment managers, whose profits–and hence, salaries–depend greatly on investors plonking more and more of their money with them! Would you expect them to say anything else?

Do they, for instance, tell you that in the US–one of the largest markets for mutual funds, where schemes, in fact, outnumber listed stocks–80 per cent of all active funds (as opposed to passive index funds) have trailed market indices on a consistent basis? So much for professional fund management.

Still not convinced? Think back over the past decade. The largest amount of money ever raised by an Indian mutual fund was way back in 1992, when UTI launched Mastergain 92 at the height of the Harshad Mehta-driven bull run. The next such hype was created in 1994, when Morgan Stanley lured retail investors with the idea of allotments only on a first come, first serve basis. The next big chunk raised by mutual funds was as recently as December 1999 to January 2000.

Is it mere coincidence that all three huge fund-raising activities by mutual funds took place when the market was around its peak, and that in the near term, there was only one way it could go–down. What does that make mutual funds: the retail
investor’s best friend or plain opportunists?

But why should we blame the mutual fund industry? After all, it is only natural for a businessman to try and raise money when it is easiest for him to do so. The blame for the retail investor’s predicament lies squarely with him, and his greed to
make a fast buck.

We, at Intelligent Investor, believe the retail investor is capable of managing his own funds, provided he is willing to devote some time and effort towards this purpose. For a detailed treatise on this subject, read One up on Wall Street by
Peter Lynch, the most successful professional investment manager of all time.

If you don’t have the time or the inclination to manage your equity investments, consider putting your money in an index fund (a type of mutual fund scheme that mirrors a benchmark stock index), which offers you a diversified exposure to

The most-widely tracked stock index in the country, the BSE (Bombay Stock Exchange) Sensex, for instance, has returned an annualised 18 per cent since inception. That’s not bad, considering that many mutual funds haven’t even been able to return the principal to their unitholders.

The key to making money from stocks is to buy and hold shares for a very long period. Ideally, you should treat your equity investments in the same manner as your real estate investments.

Since you don’t get a daily buy quotation on your house, you are not tempted to sell it every time its value dips below some magical resistance level. Do the same with equities, and you won’t ever need to turn to mutual funds to manage your money.

A bonus issue creates value for shareholders
Theoretically, a bonus issue–or even the split of a Rs 10 par value share into 10 Re 1 shares–is akin to exchanging a 10 rupee note for 10 one rupee notes. While most people actually prefer the 10 rupee note because the one rupee notes are
likely to be soiled and torn, in the stock market, many wrongly believe that a 10 rupee note is equal to Rs 11, or even Rs 20, when split up.

Perhaps, the only thing a bonus issue does is to signal to investors that the company is doing well and is likely to hike its dividend rate in the future. However, this is not something carved in stone. Sometimes, in fact, the truth is quite the
opposite. Bajaj Auto, for instance, issued a 1:2 bonus in September 1997, when it was going through terrible times–and the subsequent price history of the stock is for all to see.

Price is not an issue while investing in good companies
A large number of investors, including erudite market observers, propound that you can’t go wrong if you buy into good companies, no matter what its share price. This philosophy is often ascribed to Warren Buffett–and his so-called followers swear by it. The truth is that, though Buffett believes in buying the best businesses, he acknowledges that if your entry price is unrealistically high, you might have to wait an eternity before you make decent returns from the stock. Usually, in such cases, your patience runs out on you–and you exit at an inappropriate time.

Take the example of Wipro, which rose to almost Rs 10,000 in February 2000. This translated into a PE (price-earnings) ratio of almost 800 on its earnings for the year ended March 2000. Yet investors continued to buy Wipro as if the sky
was the limit. Wipro is a fantastic company, no doubt, but sometimes speculators are able to generate a frenzy that leaves rationality in the dumps–and along with it, the fate of many investors. It’s unlikely those who purchased Wipro at that five-figure price will ever see those levels again. So, the price at which you buy a stock is important.

Buffett, in fact, advises investors to answer two questions while scouting for investment picks: which company and at what price. Interestingly, Buffet has never invested in a technology stock. So, it’s unlikely that his principles are applicable to technology stocks. Buffett prefers to invest in companies that have a consumer franchise, where technological change is so slow that it’s unlikely to have a major business impact. When technological upheaval takes place, even the best in the technology sector won’t be spared simply because they were the best at something.

Valuation is irrelevant in the new economy
Back in the heady days of February 2000, a section of investors–both in India and abroad–began to believe that we were entering a new era of prosperity created by technology. Further, this affluence could not be captured by simplistic old
economy parameters such as the PE ratio. How long Internet retailer could delay profitability and not have its business model seriously questioned by investors was cited by many to justify that traditional valuation parameters should be put aside while assessing new economy stocks.

Along with the Amazons and the Pricelines of the world, a large number of Indian stocks began to trade at valuations that were difficult to justify on any sane basis. I even heard someone say that on the Nasdaq, the minimum valuation of a stock is $7 billion. Hence, every stock, including our very own Sify, was trading at the same valuation!

Alan Ableson, who writes a column for Barron’s, an investment journal, coined a beautiful term for such new economy companies: price-to-hope ratio! Today, most new economy observers are convinced that the new economy is not so
different from the old one after all. It follows the same laws of economics. You can defy gravitational forces on a hot air balloon, but sooner or later, the hot air will run out–and you will fall. And, that is usually a hard landing!

Price movements of Indian software stocks mirrors those on the Nasdaq
A section of the investing community–mostly punters–has come to believe that the best way to make money in the Indian market is to simply mirror what happened to the Nasdaq the previous night. Just see how the Nasdaq moved the previous night, and go long or short on Satyam, Infosys, Wipro, Zee or Himachal, depending on your risk profile. The most appealing part of this strategy is that it requires no brains from your side. If only making money was as easy as that!

Many investors tend to trade on Infosys, Satyam and Wipro based on what happens to these stocks on the Nasdaq. So if Infy falls on the Nasdaq the night before, they rush to sell Infosys on Indian bourses the next day. Is it arbitrage at work? Not quite. Infy trades at a 40-50 per cent premium to the domestic stock. So, even if Infosys dropped 5 per cent on the Nasdaq, the domestic stock need not go anywhere–it could just be that the premium is coming down. Also, while about one million shares of Infosys are traded on the BSE and NSE daily, just 100,000 Infy shares change hands on the Nasdaq. Further, if you consider that two shares make an Infy ADS (American depository share), the volume comparison becomes even more dismal.

Other than sentiment, Indian software stocks have little to do with the Nasdaq. Back in February 2000, many Indian IT stocks were trading at valuations of 500 times earnings or 50 times sales. Irrational valuations, but justifiable on account of the fact that there were a whole lot of stocks in the US market that were trading at an even higher multiple of their revenues despite having no profits–some didn’t even have a revenue model–to show.

Effectively, the US market exported its bubble to almost all countries across the world. The Japanese Nikkei, which had remained moribund since 1991, suddenly came to life in the hope that perhaps the transformation of Sony into e-Sony would mean revisiting the Go Go days of the late-eighties.

The Indian software industry is a great beneficiary of the labour arbitrage that is now possible because of the advances in telecommunications and the Internet. For many years, first-world countries kept getting richer at the expense of their
third-world counterparts because they had a monopoly over capital, a scarce resource. Moreover, by imposing strict visa restrictions, they could control labour movement to their advantage. Now, the Internet and superior telecom
infrastructure allow an Indian company to do the same work as a US company–at one-third the cost. This, coupled with the fact that the capabilities of the Indian software engineer have been recognised globally, means that Indian software and IT-enabled services companies can exploit the labour arbitrage.

The boom and bust on the Nasdaq will have little impact on the cash flows of Indian software companies, who will continue to benefit from the trend of US corporates outsourcing business that is outside their core competence. Scores of
old economy companies in the US are trying to use information technology to make their businesses more efficient. So, there is really no reason for you to get jittery every time there is a downtick in the Nasdaq.

A high-growth company that has a PEG ratio of below 1 is a good investment
The popularity of the PEG (PE ratio to earnings growth) ratio owes its origins to Peter Lynch. With earnings growth and momentum investing the order of the day, it’s no surprise that the PEG ratio is so talked about.

Many analysts propound that if you can buy a high-growth company at a PEG ratio of less than 1, it is a good investment. So, if a company made a profit of Rs 1 lakh last year and is expected to report a profit of Rs 1 crore this year, it would
become an automatic buy at almost any price because the earnings growth is 10,000 per cent. This is, of course, stretching the case to make a point.

To set the record straight, Peter Lynch suggests that if an investor can buy an outstanding growth company at a PEG ratio of 0.7 or less, where G is its long-term earnings growth, it is a good entry price for the long-term investor.

Note the emphasis on outstanding growth companies and on long-term growth. It is actually very difficult to accurately project five- or 10-years growth of a company, especially in the technology sector. So, most investors, unable to look beyond their nose, use the next year’s earnings expectation (available from most broker reports or by doubling the latest half-yearly numbers) as a proxy for long-term earnings growth.

This is an extremely risky proposition because it is very tough for most companies to follow up one year of high earnings growth with another of equal magnitude–only select Indian software companies have managed it, largely because of the strong tailwinds blowing for their business. And unless you have the capability to estimate the five- or 10-years earnings growth of a company, using this ratio could lead you down the tube because high-growth companies are high-priced. And as observed recently, when they fail to deliver on the promise, the fall is steep and quick!

When a stock hits its 52-week low, it’s a buy

The 52-week high/low is one of the most widely-used parameters by many lay investors to buy or sell a stock. The logic: all stocks have a 52-week low and 52-week high, and that range is usually at least 100 per cent. So, if you can buy a
stock near its low and sell it near its high, you should manage to earn yourselves a decent return.

The simplicity of this theory is its biggest positive–and, yes, many people actually make money practising it. After all, it is exactly what experts say: buy low and sell high. However, it’s a theory that’s also fraught with risk. For, usually, there are
good reasons why a stock hits a low. Moreover, a rebound does not always take place. On the contrary, the stock might just keep sinking to new lows, till it reaches a point where nobody wants to buy it at all. There are reams of share certificates held by investors whose worth is nothing but that of kabadi.

To repeat a cliche, there are no free lunches on the stock market. You need to research your stocks very well. Zeroing in on the blue chips is not easy, as there are only a handful of companies that merit such pedigree–so, before you jump to
any conclusions, think really hard.

Apply the 52-week low rule only to companies that make this cut. If one of them hits a new low and you feel it has what it takes to come out of this trouble (even if it takes three to five years to do so), you will have found a good opportunity to buy the stock at bargain basement prices. There is little point in trying to figure out if the company can fix its current problems in a jiffy–if you knew the answer to that question, the company should be hiring you as a consultant and its stock would not be at that low!

A very good example of this is Hindustan Lever–acknowledged in corporate and investor circles as a great company with strong brands, good management, a formidable distribution network and dominance of the marketplace. A few months
ago, Lever hits its 52-week low of Rs 163, but there were few brave people willing to buy the stock. The news was that Lever was facing a problem with sales growth, and would find it difficult to log growth rates of the past. Many on Dalal
Street, in fact, felt the stock would go even lower. If you were a long-term conservative investor (incidentally, there is no better kind!), this was a great opportunity to buy the stock.

Nevertheless, using the 52-week low as a buy signal is an extremely risky strategy, as it can so easily lead you up the wrong alley. For instance, attempting this strategy with technology stocks would call for a lot of courage to face up the
consequences. Most technology investors tend to follow ‘momentum investing’ (buy a stock when it starts to gain momentum and sell it when it begins to lose steam). When momentum takes a stock to a new low, there’s no telling where it will eventually end up.

Rupee cost averaging is always a good defensive stock strategy
Rupee cost averaging advocates buying more of a stock if its price falls in order to average out your purchase price. Say, you bought 100 shares of a company at Rs 100 (total consideration: Rs 10,000), after which it falls to Rs 50. At this price,
you should buy 200 more shares (total amount invested remains Rs 10,000) so as to bring down your purchase price.

Sure, you bring down your purchase price, but is it worth it? If you buy something whose intrinsic value is only Rs 10, first at Rs 100 and then at Rs 50, no matter how much you average down, you will still be buying onions at the price of
orchids! And, sooner or later, either your money will run out or you may be the only investor left in the company!

So, the more important thing to look at is the true worth of your investment. Once you have figured that out, it is much easier to apply theories like rupee cost averaging or buying a stock when it hits its 52-week low.

Penny stocks are great buys, as they have little downside

Is a stock priced at Rs 10 cheaper than another priced at Rs 1,000? Well, some people will tell you it is. Their reasoning: how much lower can the stock priced at Rs 10 go? By extension, all the upside is already factored in the Rs 1,000 stock–
the story is already recognised and there is no more to be gained from buying this stock.

The truth is that the absolute price of a stock has absolutely nothing to do with its future prospects–and hence, its valuation. If anything, a stock floated at Rs 10 (maybe 10 years ago) and now quoting at Rs 1,000 suggests that the company has done well over these last 10 years in terms of earnings and profitability. By contrast, stocks trading at or below par smack of something drastically wrong with the company and/or its management.

Another argument extended in favour of retail investors buying penny stocks was that they have little choice as marketable lots of 50 or 100 shares put high-value stocks out of their league. History indicates that a majority of penny stocks stop trading after some time, putting to waste your entire investment. But why look at penny stocks when you have better options–on an identical investment outlay?

Demat trading has pruned the minimum market lot to one share. So, high-value stocks like Infosys or Lever are no longer out of the reach of the small investor. Before the advent of demat trading, an exposure in Lever would entail a minimum
investment of Rs 2 lakh (share price: Rs 2,000; minimum market lot: 50 shares). Today, you can invest in Lever with as little as Rs 200.

Lever or a penny stock, don’t take either company for granted–put their annual reports under the lens every year before taking any investment decision. The price of a stock must be viewed in relation to its earnings, its book value,the  dividend per share and revenues per share, rather than on an absolute basis. More importantly, you must also analyse qualitative factors relating to the company’s business–its longevity, profitability and sustainability of those profits.