Seeking abnormal returns from Stock Market often leads to wealth destruction
‘Never catch a falling knife’ is a famous saying in stock markets which suggests that investors should never invest in companies witnessing rampant fall in share prices. However, it is seldom followed by retail investors (individual investors). More often than not, a steep fall in stock price is accompanied by an increase in ownership by retail Investors leading to their wealth destruction
Retail Investors often see falling stock price as an opportunity to generate mega returns. This is quite ironic because at the same time, the institutional investors including the major mutual funds who supposedly manage the ‘smart money’ are exiting the company fearing more losses.
Yes Bank, DHFL and Jet Airways are few examples of increasing ownership by individual investors despite plummeting stock prices
Example 1: DHFL
Source: BSE Filings
Example 2: Yes Bank
Source: BSE Filings
Example 3: Jet Airways
Source: BSE Filings
All the three companies showcased above witnessed rapid increase in ownership by retail investors even when the market was worried about its going concern (ability to operate for foreseeable future). Unfortunately, the investors are likely to incur huge losses or will have to wait for significant amount of time to exit from their investments even at buying price.
The deep corrections in stock prices for companies result on account of various reasons with primary reason being corporate Governance issue. The institutional investors never want to associate themselves with companies where there is issue in Corporate Governance (atleast known publicly) i.e lack of trust in financials, misuse of company funds, issue with regulator, etc. This leads to drop in stock prices and retail investors perceive the stock to be available for ‘cheap’. However, majority of the times, the earnings catch up with these cheap valuations and stock goes further down.
However, this begs the question as to why retail investors look to enter companies even as stock prices are in a free-fall. We discuss some of the reasons below:
Inability to understand difference between ‘Value Trap’ and ‘Value Stock’
A value stock is an investment into a company, whose price is low due to temporary factors such as cyclical slowdown, one-time losses reported by the company, price correction due to broader market correction or any other factor which the investor deems to be short-term in nature.
A value trap is an investment into a company, whose price is low due to long-term headwinds which will impact the performance of the company for a substantial period of time. For example, corporate governance issues plaguing a company is not a temporary factor and it take considerable efforts and time to re-gain market trust. A fall in demand for a company’s product category due to disruption in industry may be long-term in nature. A company in financial distress due to high leverage may take significantly more time than anticipated for turnaround due to its inability to restructure debt, downgrades by credit rating agencies, and many other factors. Therefore, though the stock of such companies may appear to be cheap, the market is discounting for the strong headwinds the company may have to deal with in foreseeable future.
Information Asymmetry
Despite all the efforts undertaken by SEBI (Securities and Exchange Board of India), there will always be information asymmetry in the market. This asymmetry widens whenever the company is going through volatile times as many institutions have access to more data points and primary information. The people who are party to this latest news will have an edge over others. Therefore, on knowledge of a major negative news, even as the institutions exit the company, the individuals investors enter the stock due to their inability to foresee risks.
Under-estimating corporate governance risk
Once a company is under the radar for its weak corporate governance, it becomes difficult for the stock to find ‘strong hands’ i.e investors and institutions who want to own in good volumes and for longer tenure. Therefore, as the demand shrinks the stock price corrects significantly. Also, once the trust is lost in the company among the institutions, gaining it back is a very long-drawn process that requires minimum of 6-8 quarters. Therefore, investing during such period merely on basis of financials should be avoided.
Fear of losing million dollar opportunity
We have discussed this point even during one of previous posts of Managing Personal Finance – Do’s and Dont’s . Whenever a well-known stock corrects, individual investors believe that it can be their opportunity to generate quick returns and they find it too enticing to miss out on this million dollar opportunity. Therefore, despite the underlying risks the individual investor chooses to takes the punt on many occasions. More often then not, it is a value trap.
Investing a small amount with lottery mindset
We have come across many retail investors who invest a small amount like INR 10,000-15,000 in struggling companies with a mindset – “I am ready to lose the money if the company fails to turnaround. But if the company revives, the upside it can provide is staggering”. This is ‘hope’ investing and the reason why individual investors constituted 58% of the shareholding in Kingfisher airlines when it stopped trading.
Always resists the temptation to invest in companies with volatile stock movement
We learnt above lesson the hard way. ‘Kaveri Seeds’ was one of our first investment way back in 2014 and had enjoyed the journey from around INR 600 per share to INR 900 per share, where we made partial exits. The company reported very subdued numbers in Q1 fiscal 2016 owing to multiple factors including drop in demand for its products, fear of change in Government regulations with regards to price ceiling for BT cotton, pending litigation of company with Monsanto, etc. Despite the stock price correcting from INR 1000 levels in April 2015 to INR 500 levels in October 2015, we further accumulated the stock merely basis financials. However, the price ceilings by Government on cotton prices and pending litigations continued to be a major deterrent to the stock performance, as it trades at INR 460 levels as on date. Perhaps it was a value trap at INR 500 levels?
However, we invested in Infosys in August 2017, when the stock corrected from INR 500 levels to INR 430 levels due to stepping down of then CEO – Mr Vishal Sikka as we thought company’s strong pedigree will ensure operations to be back to normal over medium term. Further, more recently we invested in Bajaj Finserv when the stock corrected to INR 5000 levels in October 2018 due to the broader liquidity crunch facing NBFC space. We had a view that being a leading player in the space, fund raising would not be an issue for the company. Both the calls resulted in decent returns.
However, we refrained from investing in any other company in last one year undergoing volatile movements despite its availability at attractive valuations due to concerns around corporate governance. In stock markets, avoiding mistakes is equally (if not more) important as identifying multibagger opportunities. Few mistakes can wipe out your entire portfolio!
HAPPY INVESTING!