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The Madness of Crowds and What You Can Learn from Them

May 30, 2016

In this issue:
» Should you buy when the Government sells?
» How to benefit from 70% upside in Sensex
» Market roundup
0:00
Sarvajeet Bodas, Research analyst
  • There are three great forces in the world: stupidity, fear, and greed.
    - Albert Einstein

John and Alex were astute business partners known for creating opportunity from nothing. One day, they each went to a village on the east coast. It was a small village with a population of about 1,000 to 1,500.

John approached the villagers with the intention of buying their donkeys. He promised to pay Rs 5,000 per donkey. The villagers thought this was an excellent deal. They agreed to sell all available donkeys.

Now, here comes Alex (remember...he and Alex are partners). Alex went to the villagers and said he wanted to buy all of their donkeys and offered to pay Rs 10,000 for each of them.

The villagers were confused. They'd just sold all the donkeys for Rs 5000, and now someone was willing to give them Rs 10,000. They thought they came up with a brilliant idea: Let's buy them back from John and sell them to Alex, they concluded.

So they approached John with an offer starting from 5,000. It quickly went up to 5,500, 6,000...10,000. Then the villagers went mad and offered 10,500, 11,000, and as much as 15,000...figuring another buyer might offer Rs 20,000, 25,000, or more for these donkeys).

John was more than happy to sell donkeys for Rs 10,000 for a 100% return on investment. Alex, of course, did not turn up to buy the donkeys for Rs 10,000.

What happened with the villagers? They got their donkeys back for upward of Rs 10,000. Everyone was confused by what had happened. Many of them had taken loans to buy back the donkeys for Rs 10,000.

John and Alex left the village in search of a new village. They knew the power of greed.

Rewind two years. In May 2014, we had a majority government in the center. The equity markets had clearly given a big thumbs-up to the new government, and we saw a strong rally across the indices. People were optimistic and ready to invest in the stock market without looking at the valuations or underlying fundamentals.

I ran a screener to find out how the stocks from small-cap index fared. Take a look a look at the results:

Small Cap Madness
Name of the company Returns in CY 2014 Returns in C.Y 2015-till date Total return
RISA International Ltd. 153% -99.5% -99%
PMC Fincorp Ltd. 74% -98.7% -98%
Castex Technologies Ltd. 18% -90% -89%
Vimal Oil & Foods Ltd. 50% -82% -69%
Jyoti Structures Ltd. 29% -75% -66%
Metalyst Forgings Ltd. 213% -84% -47%
Amtek Auto Ltd. 146% -78% -45%
Alok Industries Ltd. 23% -56% -44%
IL&FS Transportation Networks Ltd. 42% -60% -42%
SRS Real Infrastructure Ltd. 22% -50% -39%
Hathway Cable & Datacom Ltd. 26% -47% -33%
Prakash Steelage Ltd. 22% -42% -32%
Speciality Restaurants Ltd. 44% -52% -27%
Syndicate Bank 40% -48% -26%
Mangalore Chemicals & Fertilizers Ltd. 59% -49% -20%
Atlanta Ltd. 46% -47% -19%
Jindal Saw Ltd. 86% -55% -15%

Source: ACE Equity

Investors overbought shares in anticipation of future gains in 2014. However, a disastrous year followed, and total returns went negative.

Take Amtek Auto for example. Due to concerns over debt default, investors dumped the shares. They had clearly ignored the rising debt-to-equity ratio. In the case of Syndicate Bank, investors ignored rising NPA levels. Mangalore Chemicals & Fertilizers collapsed due to rising debt, a fall in the interest coverage ratio, and weak performance, which led to a downgrading of credit rating.

Examples of human greed abound throughout market history: the dot-com bubble...Tulip mania...multi-level marketing schemes...Ponzi schemes.

Human nature has not changed over the centuries. Greed and fear come back again and again. The characters might be new, but the script is unchanged.

Learn from your successes, sure. But great failures can be your greatest teachers. Control your emotions when someone offers a great deal... As my colleague, Richa, the managing editor of Hidden Treasure puts it:

  • Focus on facts and reasoning. While not everything about a successful business is quantifiable, strong stories are no substitute for quality. Have a process and disciplined investing approach that leaves little scope for storytellers to incite fear or greed.

What are your experiences of market emotions such as greed and fear? Did you become a victim of herd mentality? Let us know your comments or share your views in the Equitymaster Club.

2:31 Chart of the day

FY16 was fourth year in succession when the Government failed to meet the disinvestment target. But it has not lost hope yet. The companies it has lined up for IPOs in FY 17 are - Housing and Urban Development Corporation (Hudco), Hindustan Aeronautics (HAL), Rashtriya Ispat Nigam (RINL) and Cochin Shipyard. The amount the government expects to add to its kitty post divestment is Rs 80 billion, 14% of the targeted collection this year.

Disinvestment Realisations Fall Short of Target


In FY16, weak markets did not allow the Government to execute disinvestment plans. Commodity slump was another dampener. With an optimistic forecast for monsoons and corporate earnings showing signs of turn around, Government is focusing back on disinvestment opportunity.

So should you buy when the Government sells?

Government's stake sale often comes up with a discount (on the offer price) to retail investors. This may look tempting to the retail investors. But falling for these discounts and making them the reason for your investment in such companies could be risky for your portfolio. A lot of PSUs are reeling under crisis due to bad management, adverse policies, government interference and so on. In the long term, your returns on such PSU stocks will depend on fundamentals of the company and the valuations at which you invest in them. So do not get carried away by disinvestment theme and focus on the basics while deciding to invest in these offers.

3:44

These are interesting times for Indian stock markets. Not because of what is happening to commodities, GDP growth, monsoon or the RBI's monetary policies.

As proponents of long term and value investing, we believe that market movements will ultimately reflect the health of corporates.

Majority of the companies that have announced March quarter results have beaten earnings estimates. While we do not focus on short term or quarterly earnings, this could suggest the beginning of a turn around that my colleague Rahul Shah has been writing about.

Legendary investors like Warren Buffett and Jeremy Grantham believe that profit margins are the most

mean-reverting series in finance. The aggregate data for Nifty companies suggests that the profit margins were at a ten-year low at the end of FY15. So if they were to rise to the average of the last ten years, let's say over a period of three years, the upside would close to 70%. Which means that markets could go up 70% over the next three years if profit margins revert to the mean.

This is just a probability. Moreover, even when the markets move up, not all the companies will be riding along. An investor will need to do more than just bet on mean reversion.

Tanushree Banerjee, the editor of StockSelect and her team have been scouting for the companies that fundamentally look strong enough to see this 70% upside. Along with others, capacity utilization levels is one of the key metric that the team is looking at while selecting companies that look attractive now and could make the most when the market reflects overall recovery in the corporate profits.

With the right blend of optimism and skepticism, the team has shortlisted four stocks. In next couple weeks, it will release a report exclusively for StockSelect subscribers - Sensex 40,000: 4 Stocks to Profit from the Coming Stock Market Wave.

Do keep an eye out for it.

4:45

After opening the day on a positive note, the Indian stock markets registered some losses and are presently trading near the dotted line. Sectoral indices are trading on a mixed note with stocks from the IT and metal sectors leading the gains. Power and oil & gas stocks are trading in the red.

The BSE Sensex is trading up by 32 points (up 0.1%) and the NSE Nifty is trading up by 10 points (up 0.1%). The BSE Mid Cap index and the BSE Small Cap index are also trading in the green, up by 0.1% and 0.3%, respectively.

4:56 Today's investing mantra

"You need to divorce your mind from the crowd. The herd mentality causes all these IQs to become paralyzed. I don't think investors are now acting more intelligently, despite the intelligence. Smart doesn't always equal rational. To be a successful investor you must divorce yourself from the fears and greed of the people around you, although it is almost impossible."- Warren Buffett

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

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Equitymaster requests your view! Post a comment on "The Madness of Crowds and What You Can Learn from Them". Click here!

2 Responses to "The Madness of Crowds and What You Can Learn from Them"

Ananda Rao

May 31, 2016

Greed is the reason to plunge in the stock market. Like gambling one should take chance but not choice to enter, continue or exit. Stock prices surges on forecasts and rarely on forecasted happening e.g. forecasting timely monsoon affects stock prices rather than timely happening of monsoon. Once I noticed nominating particular person as a Miniter surged the prices of certain stocks. In short run sensex faces up or down but in long run only upside but may not for a chosen or purchased stock unlike bullion and other precious stones. However, even persons who bought gold and silver bought at surging price 5 years ago are still repenting. Greed is such an evil even repeated Maha Bharat episodes could not deter some from casinos, horse racings, cricket betting etc in spite of being illegal unlike legal stock markets.

Like (1)

Savio

May 30, 2016

You should limit the peddling of other services in your newsletters. At least spare the Premium Wrap section.

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Equitymaster requests your view! Post a comment on "The Madness of Crowds and What You Can Learn from Them". Click here!
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