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The Stock Market's Biggest Illusion That Causes Huge Losses

Mar 30, 2017

In this issue:
» The real benefit of GST
» Another regulatory risk surfaces in the auto sector
» ...and more!
00:00
Sarvajeet Bodas, Research analyst

There's stuff we know. And there's stuff we don't know.

Seems obvious, doesn't it?

But the trouble begins when we mix up the two. When we start believing we know stuff we actually haven't the faintest clue about...

As you would imagine, this mix up can lead to a lot of trouble. Imagine you set up home next to an active volcano, believing you could predict the next eruption. Or tried to fly a plane, believing you knew how. You can risk your life if you don't stick to what you know.

In the stock market, mix-ups of this kind risk loss of capital.

But aren't we humans smart? Isn't it fairly straightforward to separate what we know and what we don't know?

No. Well...at least in the stock market, the mix-up is quite common. Don't believe me?

When the radical liberalisation reforms of 1991 were announced, investors were certain that from then on stocks would only go up. So certain were they that, in just three months from January to April 1992, they bid up stock prices in multiples and the BSE Sensex rose 129%!

But it was not to be. This illusion of knowledge cost them dearly. Stocks crashed 55% over the next year:


Fast forward to the early 2000s. Indian investors were certain the global boom of 2007, led by the US, was here to stay. Everything became an excuse to buy stocks. Nothing mattered, not even valuations, which reached eye-popping levels during the two-year 172% rise in the Sensex.

But they were wrong. Global boom turned to global bust in just a year. The Sensex lost 60%. Investors lost their shirts...and then some:


Just out of the market crash, in May 2009, the UPA government won a second term. Investors were certain this was the best possible thing that could happen to India's economy. Such a forgone conclusion it was in their minds, that the day the result was announced, the index surged 17%. In just one day! It continued to rise, and rose a total of 157% over the next year and a half.

But during the tenure of UPA 2 came a raft of scams and nationwide chants of 'policy paralysis'. The index fell 28%, and languished until the next government came in:


When it comes to stocks and the economy, the illusion of knowledge can be disastrous. Many complicated situations tempt investors to believe they know the answers. But the reality is that the moving parts are too intricate. There are too many variables. And the outcomes are anything but certain.

The media, the financial industry, and a pervasive herd mentality only exacerbate the problem.

That's why the Microcap Millionaires team operates under the assumption that they know very little and can forecast next to nothing with great accuracy. So they employ a quantitative approach to stock picking, as laid out by Benjamin Graham. This grounded approach ensures emotions don't run away with one's imagination.

In the three years and one month since the service's inception in February 2014, it has given a cumulative return of 140.1%. Overwhelmingly better than the Sensex's 44.1% returns during the same period.

Mind you, this track record spans a period of major market ups and downs, including the rise following NDA government's win in 2014...and the commodity-bust-induced crash in early 2016.

Understanding the illusion of knowledge has helped the team ensure their subscribers not only survive but thrive through these ups and downs. I strongly encourage you to try out this unique way of investing.

02:50

The Lok Sabha on Wednesday passed four GST related bills. This clears the road for the July 1 rollout of the GST that will subsume all central and state taxes for a unified tax regime across the country. The proposed GST rates range from 5% to 28%, with 12% and 18% being the standard rates.

What remains now are the rates for various goods and services which will be decided in the near future. The real benefit of GST comes from a 'level playing field'. A common floor tax across India means that the most efficient producer will win the consumer. We believe that GST is one of the key reforms that has the potential to bring about a structural change in the Indian economy.

If you would like to dig deeper into the practical implications of GST, I strongly recommend you download Vivek Kaul's free report, What the Mainstream Media DID NOT TELL YOU about GST.

03:45 Chart of The Day

In another important development, the Supreme Court (SC) yesterday banned the sale of vehicles which are not compliant with Bharat Stage (BS) IV emission standards which will be effective from 1 April 2017. This means automobile makers have just two days to dispose of hundreds of thousands of BS III vehicles.

This decision leaves automobile companies saddled with a large inventory of BS-III vehicles estimated to be worth Rs 60-70 billion at the end of the month. The below chart shows companies with an unsold inventory of BS III vehicles.

Inventory Pile of Unsold BS III Vehicles

No doubt, automobile companies will feel the pressure as the move to ban BS III vehicles will have an impact on revenues and profitability. At this stage, it's difficult to estimate the exact impact. To minimise the damage, most of them will try to divert the vehicles to export markets. Likewise, these companies will offer higher discounts to clear the inventory. Also, it is important to note that low availability of BS-IV compliant vehicles could hurt commercial vehicle sales in the upcoming month.

This is the second major blow for the automobile industry from the SC in the past 15 months. In December 2015, the SC had imposed a ban on sales of diesel vehicles with an engine of 2,000 cc and above in the National Capital Region. This ban was lifted in August 2016.

Investors should consider the impact of regulatory risks such as the above while considering auto stocks for investment. We, at Equitymaster, rigorously follow Equitymaster Risk Matrix (ERM®). The risks are objectively evaluated via the ERM® score. This helps us keep our analysis objective and casts aside all pre-conceived bias.

04:40

In the meanwhile, after opening the day on a positive note, share markets in India have continued their upward momentum. All sectoral indices are trading on a positive note. Stocks in the capital goods sector and the consumer durables sector are leading the gains.

At the time of writing, the BSE Sensex was trading up 76 points (up 0.26%) and the NSE Nifty was trading up 15 points (up 0.17%). The BSE Mid Cap index was trading up by 0.47%, while the BSE Small Cap index was trading up by 0.9%.

04:55 Investing mantra

"What you have to learn is to fold early when the odds are against you or if you have a big edge, back it heavily because you don't get a big edge often. Opportunity comes, but it doesn't come often, so seize it when it does come." - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Sarvajeet Bodas (Research Analyst).

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