A simple thumb rule to avoid toxic wealth destroyers! - The 5 Minute WrapUp by Equitymaster
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A simple thumb rule to avoid toxic wealth destroyers!

Jul 10, 2015

In this issue:
» A psychological lesson in the Chinese stock market fiasco
» Will India's growth spurt take it past China's GDP growth?
» ...and more!

I have some good memories of a game I used to play when I was a kid. It was called 'Passing the Parcel'. Actually, why just me? I think the game must have been a part of the growing up years for a lot of you as well.

I still remember how my heart used to skip a beat every time the parcel was passed to me. I just used to pray it's not me in possession of it when the music stops. Because if it is, some or the other punishment will come my way. Other than this small quibble, I think it was a fun activity and a great way to enjoy togetherness and bond as a group.

If you think about it, investing, stocks in particular, has a lot in common with passing the parcel. The parcel in this case being the stock that you buy investing your hard earned money. And you hope that when it is time for cashing out, you will be able to sell the stock and also earn some extra returns in the process.

So far so good. However, there's another possibility that we failed to take into account. What if the music stops while the stock is still there in the portfolio? In other words, the stock crashes by 50%-60% and does not recover by the time you want to cash out? In fact, what if it does not recover at all?

You see, stock investing by its very nature is a bumpy ride. Stocks never go up in a straight line. But if the stock is of good quality, it will eventually recover and also end up giving good returns over the long term. However, what scares us is a small investor's exposure to the second kind of stocks mentioned above. What if the parcel or the stock under question is worthless in the first place and the investor was just relying on being lucky enough to offload it to another investor at a small profit just before the music stops?

Unfortunately, just as in the game, in investing also, there's no knowing in advance when the music will stop? And if you are relying on a big slice of luck for bailing you out every single time, I am afraid it is a game not worth playing at all.

In fact, there are enough skeletons in the closet to make you understand why this is a bad idea. Go back to what happened during the 1999-00 tech bubble. Valuations soared to the sky. And that too for companies that weren't making a single dime in profits yet. Therefore, the only way to make money out of such parcels was to quickly offload to someone else before the music stopped. And this is exactly what the big money i.e. private equity and other institutional investors did. They dumped everything on to the unsuspecting small investor who had very little idea that the parcels he was getting were venomous. And when the music eventually stopped, which it always does, it left a lot of wealth destruction in its wake.

The 2007-08 subprime crises was no different. As a matter of fact, this crisis was unique in the sense that the game of passing the parcel was being played at many different levels. Firstly, there were banks competing against each other to receive and quickly offload the sub-prime parcels at a hefty profit before the music stops. Then there were other financial institutions that came into the picture that also wanted to get and give these parcels, again attempting to make a quick buck. And lastly, the same game was also being played between private institutions and the Government with the very same motive in mind. So, what happened when the music stopped? Wealth destruction at an even bigger level took place. Worse still, firms and institutions that were left holding the parcels were bailed out by the Government with the ultimate cost yet again being borne by the unsuspecting taxpayers and the average citizens.

Well, these are just two examples. But take a look at any crisis of the past and you will see the same game being played out over and over again. And more often than not, it will be the hapless small investor who will be in the possession of the parcel just as the music is about to stop.

Given this, it becomes absolutely vital for investors to check the quality of the parcel before they are ready to receive it. And for this, they have to strongly avoid taking anyone's words about the parcel's quality at face value. I am of the view that even a small back of the envelope analysis at their end can keep their savings from getting blown up.

All they need to do is check whether if the stock corrects significantly when the music stops, does it have the potential to recover. Actually not just recover but also end up giving good returns to the holder when the time finally comes to offload it.

This is certainly possible in case of stocks where the company is a market leader in its industry and has been in existence for many years. Most importantly, it also has a strong track record of profits. However, if all you are getting in the name of the parcel is a stock which has only dreams to sell but nothing else, then you should certainly be wary. Companies that are still making huge losses and despite that are sold at very high prices to investors are the worst possible parcels anyone can hold.

And at a time when exactly these kinds of companies are wanting to tap the market in the form of IPOs so that such low quality parcels can be dumped by promoters and private equity players on small investors like you, this is an advice you would do well to remember. Therefore invest and receive the parcel if you want to. But do ensure that even if the music stops, you end up holding only the high quality merchandise.

What steps do you take to ensure that you don't end up with poor quality parcels when the music stops? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
China for long has been the king of economic growth. The hare, we should say in the proverbial tale of the hare and the tortoise. Unfortunately for the dragon nation, just like the hare loses the race in that often told fable, something similar seems to be playing out in real world. In its latest World Economic Outlook (WEO), the IMF expects China to slow down considerably. As can be seen from today's chart, it pegs China's growth at 6.8% in 2015, which is expected to further slow down to 6.3% in 2016. And the tortoise here is turning out to be none other than India. This is because even as the IMF expects China's growth to decrease over in the coming year, it expects India to continue to grow at a higher rate of 7.5% in 2016, thus increasing India's lead over its emerging market peer. While we will have to wait and watch to see how these forecasts actually pan out, for the moment at least, such expectation means good news for global sentiment towards the India growth story.

India's lead against China set to increase

It's not just the Chinese economy, but even its stock market is facing trouble. However, in this case, trouble would be an understatement. As you probably know by now, its stock market has gone through some crazy fluctuations. But with a whopping 100% or so rise since late 2014 for the Shanghai Composite index, it begs the question - wasn't it obvious to China's investors that a dangerous bubble was building up? Despite all the obvious signs of a highly speculative and heated up market, the sad answer is that it wasn't. How do we know? Well if it was obvious to most investors, then the bubble wouldn't have built up so big in the first place. But how could they have missed something so obvious? One of the biggest reasons we believe is plain and simple herd mentality. "Everybody's doing it, so it can't be that wrong!" When the markets are rising, people do not want to miss out on the action that most other investors around them seem to be part of. So they look out for excuses, and latch on to any positives that they can attribute the rise to. If this continues for a while, the bubble becomes bigger and bigger, just like the Chinese one did. Until a few people realize that the emperor is indeed naked. And then it bursts.

Wise investors will be smart enough to learn the right lessons from this Chinese stock market fiasco. And if you do, you will know how to protect yourself from such stupidity anytime it were to happen back here in India.

The Indian stock markets were trading on a volatile note today. At the time of writing, the BSE-Sensex was trading up by around 30 points. Gains were largely seen in capital goods and banking stocks.

 Today's investing mantra
"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money." - Warren Buffett

Editor's Note: Please note there will be no 5 Minute Wrapup tomorrow on 11th July 2015.

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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3 Responses to "A simple thumb rule to avoid toxic wealth destroyers!"

Ashok Anand

Jul 11, 2015

You are very right & have made me think for future course. Like when one is playing a game, the loser has less opportunity against a strong opponent. But if the loser does &repeat silly mistakes, he is bound to loose.
In share market, one has to overcome the habbit of greed.



Jul 10, 2015

Maxim in stockmarket (for wealth creation) is deal with only good stocks and NEVER with bad stocks (even for trading)


Nirmala baldwa

Jul 10, 2015

Thanks equity master for giving accurate reading most of the time and market trend also. it is worth reading and investing time to read.

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