Don’t let volatility get you down


Director, Banyan Tree Advisors

December 20, 2011

If you’re a long-term investor, count the market’s extreme volatility as ablessing. There are always great bargains when the chips are down, andgreat profit-booking opportunities when they perk up again.

Predicting short-term movements of stock prices is about as difficult as predicting rain. This, of course, does not stop governments the world over from setting up full-fledged meteorological departments. Nor does it stop scores of people from investing hard-earned money on the advice of technical analysts employed principally to predict short-term moves of the stock market. And just like the meteorological department, technical analysts have elegant ways of defending
themselves when their predictions do not come true. Despite this fundamental fact, an inordinately large amount of time is wasted, in the media as well as in the drawing rooms of retail investors, trying to predict what will happen tomorrow or
the next week and so on.

Why is it inherently difficult to predict short-term prices? Imagine your colleagues were asked to vote for the most charming person in office, and then imagine the exercise were extended across every office in the country. The stock market is also essentially a voting machine where investors and speculators cast their votes. At any point in time, there are a whole lot of investors and speculators with widely differing time horizons casting their collective vote on a real time basis.

Would you expect the result of such a voting exercise to be anything other than chaotic? You have to merely look at the voting exercise that we conduct to elect our leaders every five years!

Of late, one observes a marked increase in stock volatility all over the world. This can be attributed to the advent of the ‘New Economy’ which, by the sheer virtue of being new, is constantly changing. One of the key features of the new economy is the fast rate of change in all facets of life. Time is being collapsed, geographies are becoming irrelevant and business models die untimely deaths everyday. It is, therefore, not surprising that this results in a lot of uncertainty not only in the operating environment of these companies but also in people’s perception of their value.

Online trading. The other major factor driving the increased instability in stock prices internationally is the day trading phenomenon. Due to increased access to stock markets through the Internet, a whole new breed of investors has cropped
up. Trading is now possible at the click of a button and one does not need to connect to a broker via a phone to execute a trade. This, coupled with huge price rises seen in 1998 and 1999 in a largely upward trending market, meant that the
temptation to day trade to make pocket money or even millions, was huge. A lot of the new entrants belong to the category of the uninitiated – people who have never seen a full stock market cycle. And when the number of participants
(especially novices) in a voting phenomenon increases, high volatility is a natural result.

In India, Internet trading is still at a nascent stage – the first few online trading sites are just coming up. So, what explains the high volatility in our markets? Consider that a number of Indian IT stocks are down to 25 per cent of the highs they
touched in February 2000. The stock market here is characterised by very thin delivery-based volumes and is dominated by speculators, who are grossly over-leveraged. Even the retail interest is largely speculative. I have often met investors
who follow a peculiar investment strategy: they invest a large proportion of savings in fixed income instruments such as bank deposits and invest the balance in equity. However, this equity investment, presumed to be risk money, is put into the most risky stocks in the hope of garnering returns of at least 100 per cent per annum. These investors treat equity markets like a satta bazaar, letting their speculative spirits run riot. This is characteristic of a large number of emerging markets and India is a leader here.

The logic for short-term trading is very clear to its proponents. On average, all stocks have a high-low range of at least 100 per cent – meaning that the high is usually at least double the low. So, if I can buy the stock near its low and sell it
near its high, I should be able to make a tidy profit. So, why can’t I repeat this strategy with different stocks, exiting on making a profit and re-entering when it recedes.

Elegant as this logic may seem, the fact of the matter is that even Peter Lynch or George Soros would not bet on making the right moves all the time. When the stock actually goes from 100 to 200, there is a lot of good news emanating from the market. For instance, that the half-yearly results are likely to show a 40 per cent growth instead of the regular 15 per cent reported every year. Or that some FII has taken a large stake in the company or that the company is set to get into the extremely lucrative Internet service provision business. Or even just that the stock market is now in an extremely bullish phase because it has crossed some magical resistance mark and the only way is up. So, at this point of time, instead of selling, most retail investors are likely to increase their exposure in the hope of making even more spectacular gains.

A few months down the line, profits for the year are actually down 20 per cent because of higher interest rates and depreciation on the diversification project.

The FII has decided against buying because of the increasing redemption pressures on its fund. And the ISP business is not that lucrative after all because the competitors have deeper pockets and are able to provide free service.

The stock crashes to Rs 60. At this point, there are no takers and you are left with an average price of Rs 150 (or even higher depending on how much stock you bought at Rs 200). This story is repeated every time the market begins to look
bullish. During the bull run of 1999, how many of you were tempted to sell your stock when it went to Rs 2,000 (from about Rs 500) but did not because you thought it might go even higher? And how many of you are now willing to buy that
same stock even though it is down to Rs 200? Greed and fear are the two most powerful forces impacting the stock market. The only people left with scars from the bull’s horns are the retail investors who jumped in to make a quick buck. So, while it is possible to make good short-term profits if you are lucky, only a few extremely gifted or unusually lucky people can earn sustainable profits in this manner.

It is important to understand that your stocks represent a small but significant stake in the company, in all its profits, losses, assets and liabilities. Study the profits of the company over the long term. You cannot make your fortune going merely by rumours of increased FII or stock operator activity.

For, over the long term, stock prices reflect the company’s operating performance. Let us take a look at Hindustan Lever – the company has reported earnings growth of about 25 per cent per annum for the last five years and more. So, while the Sensex has barely moved in the last five years, the HLL stock is up XX per cent during the same period on the back of an XX per cent improvement in its profits.

So, stop trying to predict the market. Understand the companies you are buying into. If you feel that you know at least as much about the company and its future prospects as the management trainee who has been in the company for three to
six months, you can consider investing in the company. Ideally, of course, you should not be happy until you know as much as the CEO of the company does.

Intrinsic value. For the long-term investor, the extreme volatility of the market is a blessing rather than a curse. For when the market is extremely bearish and stocks are trading at rock-bottom prices, it allow you to buy at bargain prices. And when the market swings to the opposite end and starts quoting ridiculous prices for the same stocks, when no material change has taken place in the company’s internals, it offers you a great exit price. However, to profit from the market’s follies, you need to know what the intrinsic value of your stock is. Only if you know the company’s intrinsic value can you determine whether a stock is a bargain or is ridiculously overvalued.

The company’s intrinsic worth can be defined as the sum total of all its future cash flows discounted back to today. Does this sound like Double Dutch? While trying to figure out the intrinsic worth of a company is not rocket science, it does require a few calculations and a little understanding of some financial terms. We’ll try and deal with the issue of intrinsic value in another column.