Want to Outperform Markets? Test This.

Jul 22, 2016

In this issue:
» What GST Bill may have in the store?
» Headwinds for Indian IT
» ....and more!
Tanushree Banerjee, Co-Head of Research

Recency bias has a huge impact on our behaviour, thinking, and beliefs.

We tend to be more careful with objects we recently hurt ourselves with. We tend to avoid talking to people we recently argued with. We tend to not eat at restaurants where we recently had a bad experience.

But the recency bias of negative experiences tones down over time. The opposite is true for positive experiences. The recency bias here can linger. You'll long remember a rejuvenating holiday, a world-class restaurant, a brilliant movie, or an inspiring book.

Unfortunately, because of recency bias, basing predictions on recent positive experiences can be dangerous.

Loads of newspapers, magazines, and blogs cover the latest multibagger stocks. And people devour them!

Almost everyone looks for stocks in sectors that have performed well in the recent past.

Invariably, the majority of investors will put their money in stocks near the peak of a bull market. This is based on the false underlying assumption that the recent good times will continue in the future - that is, recency bias.

In the stock market, avoiding recency bias in favour of a contrarian approach can work wonders.

We all know that buying stocks at cheap valuations, especially when fear is driving the market, is a tried and tested approach. But what about looking at non-recent trends?

Think of the framework of corporate profitability...

Let's assume for a moment that corporate profitability has recently hit an all-time high. What happens next?

Competition comes in to take the extra profits, capacities go up, a fight for market share ensues, and profitability eventually starts to fall.

And what happens when profitability is low? Well...there won't be enough profits. Businesses shut down, competition falls, and profitability eventually starts to rise.

Whether profitability is falling or rising, taking an approach opposite to recency bias would have helped.

When profitability is high and other investors are piling into stocks, our corporate profitability framework tells us that profits could be headed lower. So we turn cautious. And when profitability is low, it's time to turn optimistic.

In this vein, your mental framework when selecting stocks needs to be tuned to look for earnings patterns that have been absent in recent past.

Incidentally, a couple of months back, this framework led my research team to some very interesting discoveries. We actually identified an undercurrent in Indian stock markets that no one has talked about for years!

But we needed to look at the numbers thoroughly. And consider the possibility that our assumptions are wrong.

Our diligence led to the release of a special report - Sensex 40,000: 4 Stocks to Profit from the Coming Stock Market Wave. This is still available for download.

The report explains the undercurrent driving the market that 90% of market participants are currently ignoring.

Testing the framework to select stocks based on long-term trends could be a game changer.

The only caveat is that the framework will only work when both earnings trends and valuations are favourable.

Has recency bias ever impacted your decision on stocks? Let us know or post your comments on Equitymaster Club.

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02:30 Chart of the day

The Goods and Service Tax or GST bill is one of the most awaited legislations that investors are hoping will get passed in the ongoing monsoon session of the parliament.

GST has been a widely accepted concept and around 160 countries have implemented the same. So how do the rates across the countries looks like? Today's chart of the day, highlights the same.

What would be India's GST Rate?

Undoubtedly, a single tax replacing all forms of local taxes at the state and central levels has advantages. The bill helps in removing inefficiencies one witnesses in the form of the long queues of truckers at the border between states. The basic idea is to create a single, cooperative and undivided Indian market to make the economy stronger and powerful. This structure is likely to bring in structural changes that will benefit organsied players over the long run.

So theoretically there is no doubt that GST increases transparency. However, the real test of GST rests upon the way it is implemented.

As on a news website - The Wire highlights, the countries which failed proper implementation of GST ended with little or no benefit in terms of higher economic growth and lower inflation. While some saw increase in the inflation rate for the medium term as various new services and goods, earlier untaxed, began to be taxed, thus hurting the consumers.

We would wait to see more development on this front. But with no clarity on the quantum of benefits to accrue from GST implementation, stocks of some companies have seen sharp spike. It would make more sense for readers to the know the likely impact on a company rather than investing on the mere conjecture.


The National Association of Software and Service companies (NASSCOM) has come up with a bleak outlook on the IT sector.

The report highlights that the jobs in the IT sector will decline, as the companies are moving towards automation and robotics. Re-skilling and self-learning is something that would be gaining momentum. NASSCOM has also believes the future consequences on the IT companies of the macro events like Brexit, can impact the companies' growth.

Our in-house IT analyst believes that the trends discussed above have already begun. And they will further gain momentum. So apart from valuations, one also needs to look into these aspects before committing money into IT stocks.


What moves the markets? Why do the stock prices change so frequently when nothing appears to have changed on the ground? Why does the stock price change every second, every minute and every day?

If you want to know the answers to these questions, then read this interesting piece by Apurva Sheth, my colleague over at Daily Profit Hunter and the managing editor of the trading service, Swing Trader.


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In the meanwhile, the Indian indices after opening on a flattish note have gained momentum. At the time of writing, the BSE Sensex was trading higher by 70 points with power and capital goods stock leading the gains. Both BSE midcap and BSE small cap stocks are trading firm today.

04:50 Investing mantra

"The difference between a good business and a bad business is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time" - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst).

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