Beware of these biases that brokerage firms face! - The 5 Minute WrapUp by Equitymaster
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Beware of these biases that brokerage firms face!

Jun 8, 2015

In this issue:
» India Inc. finding less investment opportunities?
» Beware of Investing in companies' whose foreign forays have gone for a toss
» A round up on global and domestic markets
» ...and more!

'Occupational hazard' - the term is defined as a substantial risk to a worker's physical or mental well-being which is present in a certain task, job, or profession


An unpleasant, inconvenient, or unusual circumstance which occurs or is likely to occur during the course of one's employment

The nature of these occupational hazards is different in different industries. And brokerage /analyst community is no exception. However, unlike other industries, where such hazards have consequences for employees themselves, as far as the world of investing is concerned, such risks have far more severe implications for the consumers. This implies the investors, especially naive retail investors, who put analysts on a higher pedestal and take their every word of them as a gem of advice that could multiply their wealth.

Having a good number of friends in the brokerage/equity research industry, I often get to know the unhealthy challenges that my analyst friends face. Some of these include the pressure to be a part of forecasting service- about things that are difficult to know and to pretend to be expert on affairs that are hard to develop expertise on - oil prices in the short term being a case in point.

I have seen young analysts hesitant to take a contrarian stand, despite a strong investing argument, just because it does not confirm to the beliefs of the broader community. While independent opinion and ideas are hall mark of growth and success in other careers, here, the price of having a contrary view that fails could be huge.

What matters more than inner conviction is the story that is framed to back that point and panache with which they present their case to the sales team and fund managers. If that works, the analyst is a star. And if that fails, well, every story has a twist. In such cases, the chances are that the analyst has failed with the herd and is unlikely to be singled out. Needless to say, it is the followers of such recommendations that are the worst victims.

A recent article in the Business Standard suggests the analysts' biases that could cloud rationality.

Last year, as the markets caught up the Modi fever, suddenly, the analysts were quite confident of the turn around in the corporates' fortunes in one year and came up with earnings estimates that fuelled the sentiments. The brokers too were selling Sensex at 40k. However, the reality caught up when actual earnings and probable risks such as poor monsoons were announced and the markets corrected. Versus the expected and consensus profit growth of 15% in FY15, the actual adjusted earnings for Sensex are down 2.2%. To call it a deviation is an understatement. The pendulum of forecast has swung in the other direction!

Has that sobered the analyst community? It does not seem so. Despite a poor and much below expectation show for FY15, analysts seem hesitant to accept that they were wrong in the first place and are still forecasting a double digit growth for Sensex companies in FY16. Interestingly, while nothing much has changed at the ground level and risks seem to have gone up since then, consensus forecasts 19% earnings profit growth in FY16. On the basis of such forecasts, the Sensex valuation at 16.7(on the basis of forward Price to earnings ratio) may seem benign, giving an illusion of cheaper or reasonable valuations. However, downgrade the base (earnings) and your margin of safety goes for a toss.

Is the Hidden Treasure recommendation service at Equitymaster any different? Yes, certainly.

First and foremost, we believe that is important to know what we do not know (or what can not be known /predicted), be honest about it and stick to our circle of competence. The process is independent -based on a meeting with the management that makes sure that we get the story from the horse's mouth, followed by our own research and analysis. What further plays importance is long term and bottom up approach of investing. And last but not the least - the focus on margin of safety.

Does this guarantee us a 100% success ratio? No. But this does put in place a robust process which has resulted in a success ratio that is fairly good considering the high risks associated with small cap stocks. A process that ensures that no such biases are at play and that our subscribers' money is not exposed to undue risks. Most importantly, there is no hesitance in acknowledging and highlighting mistakes, both errors of omission and commission.

So next time you come across analysts' estimates that are optimistic or brokers that promise Sensex at 40k in a year, take them with a pinch of salt and feel free to give them a wide berth if the reasoning sounds shallow, irrespective of the interesting story telling.

What kind of analysts' biases come to your mind that you think can have adverse consequences on investing decisions. Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
At a time when India Inc.'s asset turnover and profit margins are at their lowest in many years, here's a statistic that may bring a smile on investors' faces. That of companies paying out excess profits in the form of dividends.

A study done by business daily Mint, taking the help of database tool, indicates that the payout ratio of companies forming part of the BSE-100 index was at its highest in eleven years in FY15. The figure in the last year came in at 34.5% as compared to 29.4% in the preceding year. As per the article published by the paper, it seems that the increase in the payout was largely driven by private firms that form part of the index. On the other hand, the payout ratios of the government owned firms decreased on a year on year (YoY) basis. However, in absolute terms their average payouts were still higher as compared to that of the private firms.

India Inc: Fewer avenues to invest in?

As mentioned above, the earnings per share movement of the Sensex companies in FY15 was negative. As such, with companies looking to keep the dividend per share at par with what was paid out in the previous year, this would in itself lead to a high payout ratio. Also, what needs to be considered is the special dividend paid out by firms.

With seemingly lesser avenues to reinvest the capital, excess capital being paid out should be welcomed by investors. As we had highlighted in one of our earlier editions of the Wrap up, dividend investing can be a very powerful tool for long term investors. Investors would do well not to simply discard low dividend yield stocks; instead it would be advisable for them to factor in the same in conjunction with the growth potential that such businesses throw up.

What is common between companies like Tata Steel, Hindalco, Crompton Greaves, GVK, and Coal India? Well... apart from the fact that they are heavyweights in the respective sectors they operate in, they have also incurred heavy losses due to their aspirations of going global. Over the past few years, all of these companies have incurred losses on their foreign investments. As reported by the Business Standard, the investments made by Tata Steel, Hindalco, Adani group companies, GVK, Essar group companies and Crompton Greaves were to the tune of US$ 13 bn, US$ 6 bn, US$ 3 bn, US$ 1.26 bn, US$ 600 m and US$ 220 m respectively.

It is believed that some of the companies that are in this mess are trying to fix the situation by selling off stakes in order to improve their balance sheets. However, in the process, this has only gone on to hurt the investors considering the poorly timed and debt heavy acquisitions made by them. A key factor that investors should consider is whether the combined entity does improve or worsen the overall quality of the business - as gauged by factors such as return ratios - when compared to the standalone entity; rather than worry about how much more market share or revenue growth such an acquisition would provide.

At the time of writing, the Indian markets were trading weak with the benchmark index, the BSE-Sensex trading lower by about 230 points or 0.9%. All of the sectoral indices were trading lower, with consumer durables and realty stocks being the least preferred. Weakness was seen in stocks from the BSE Mid Cap and BSE Small Cap space too, with their respective indices trading lower by about 1.4% each.

 Today's investing mantra
"The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst) and Devanshu Sampat (Research Analyst).

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4 Responses to "Beware of these biases that brokerage firms face!"

Krishna Murthy

Jun 9, 2015

Never ever trust the brokers, advisors, and marketing people. Study of the company management people,s long history, reliability, and trustworthiness. Instead of company please study the promoters background, culture, caste, religion, and their bad characters. If not, they become kings and other will eat rotten fishes, like Mally, Ruias, Thanthis, neer radia, burkadatta, Jcts, agarwals, etc,


kalyan kumar sandilya

Jun 9, 2015

If the analyst acts like he is going with the wind, why should I call him analyst? if he spreads out the market sentiments or emotions more fast in addition to normal spreading & has no strict mind set to depend upon self research, then I think I will call him catalyst in favour of market emotions & no self devotion (confidence)which is against Buffet's statement of value investor policy.



Jun 8, 2015

I cannot agree more with Ms Richa Agarwal here. Most Analysts, according to me cannot give a balanced unbiased report. Internally there is pressure to come up with sound ideas. Ideas that can generate money for the firm. Analysts often seem to be grasping for straws, despite them seeing the writing on the wall. I personally have been scalded by their rather unfortunate predictions. Anyone who says 'sure shot call' is lying to you. Any one who says that his predictions are 100 % accurate is lying to you. Anyone who says that he can make you a ton of money is definitely lying to you. In this business, only slow and steady wins the race. There is no get rich quick schemes which will work. Most of the analysts who call us, are relatively new, fresh out of college and a mere pawn in the hands of their employer. Pity, they start a career by selling falsehoods. Sooner or later, these will snowball into scandals and scams. End result is that the greedy along with innocent investors go down.




Ganapathy Sastri

Jun 8, 2015

Many of the large Indian companies are no longer Indian. On consolidated basis, a big chunk of their revenues, expenses come from countries out of India and in many currencies. One needs to question, whether Indian analysts are able to travel to many of those countries or have access to research assistance and or channel checks to verify claims of companies. As your article in a later part says, many of the large companies have significant INWASTEMENTS outside India and eventually will be writing them off. Market seems to ignore such realities.

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