»5 Minute Wrap Up by Equitymaster

On This Day - 27 OCTOBER 2015
Don't Listen to 'Market Experts'

In this issue:
» All IPOs to disclose dividend policies from now on?
»  US companies warn of upcoming recession
»  ...and more!

Let me ask you a question. When talking stocks with fellow investors, do you ever bring up the buys of famous investors? These discussions are quite common. It seems perfectly reasonable to consider the moves of so-called 'experts'.

I remember when I first developed an interest in stocks ten years ago. I would eagerly discuss the hot market news with my friends. It would usually be about a well-known investor's latest stock buy.

But my real question for you is this: Why do we feel more comfortable buying a stock after an expert has brought?

I used to think it had something to do with knowledge. We know our knowledge of stocks is limited, so we think following a presumably more knowledgeable 'expert' is a good idea.

Unfortunately, this is not true. The answer has less to do with the knowledge of the expert than the 'authority bias' in our own minds.

I recently read the thoroughly delightful book, Influence, by Robert Cialdini. The chapter about authority was a real eye-opener. He wrote about a shocking experiment conducted many years ago. I'll briefly describe it here.

The psychology department of an American university conducted this famous experiment. They placed ads for volunteers in the local newspaper. When the volunteers arrived for the experiment, the researchers introduced them individually to another 'volunteer'. This man, let's call him Mr X, was actually an actor, a very good one. Mr X was part of the research team, but the volunteers didn't know that.

One at a time, the lead researcher led the volunteers into a room. The room was empty except for a table with many buttons on it. One of the walls had a one-way glass window. Through this window, the volunteers could see Mr X sitting on a chair in the next room, but Mr X could not see them.

The researcher told the volunteers that Mr X was bound to the chair and that electrical wires were connected to his body. The volunteer's job was to deliver electric shocks to Mr X by pressing the buttons on the table.

The buttons were numbered from 30 to 450 volts in multiples of 30. The researcher explained to the volunteers that they were going to test Mr X's tolerance to pain. He told them to start by pressing the 30 volt button.

The volunteers thought the shocks were real. Mr X, the actor, was following a script. His screams got louder as the volunteer's increased the voltage. But the researcher told them to keep pressing the buttons to increase the voltage.

The true aim of the experiment was to test how many of the volunteers would continue all the way to the 450 volt button.

How many do you think went all the way?

The answer, disturbingly, is an overwhelming majority.

Why - despite a real concern for Mr X's life, and the mental trauma of pressing the buttons causing him so much anguish - did the majority of the volunteers follow the researcher's instructions to the end?

The answer is authority bias. No matter how much Mr X screamed and protested, the researcher insisted the experiment continue. And most of the volunteers kept pressing the buttons because they trusted the authority of the lead researcher.

This simple but devastating experiment helps explain why we love to talk about the moves of market experts. We perceive the experts as an authority (even if many of them are merely actors like Mr X). This creates a bias in our minds and grants them undue importance.

The experiment proves that blindly following authority can led lead to destructive results. So the next time you feel compelled to buy a stock because an expert has already brought it, just remember that you could end up with 'shockingly' bad returns.

What do you think? Do you believe market experts are competent authorities that influence your stock picking? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
As you all would be aware, there was a good amount of controversy surrounding the ongoing Indigo IPO. After all, the negative networth of the company just ahead of the IPO did not go down well with the investing community. This matter seems to have got the market watchdog SEBI to mull over the idea of putting in place a new set of guidelines that will make it mandatory for companies hitting the market to disclose their dividend policies upfront.

But then... it gets one thinking...why limit this only to companies taking the IPO route? What about the already existing companies? An article in the Hindu Business Line touched upon this matter. While the business daily discussed its own set of data, we curated a list of our own. The following chart gives an indication about the varied dividend payout ratios of all the listed companies on the NSE.

Are Indian Cos Generous Dividend Payers?

Turns out that nearly half of the listed companies did not pay out any dividend in the latest year. Companies paying dividends up to a fourth of their profits formed about 25% of this pie. About 15% of the companies paid dividends between 25 to 50% of their profits. And only 7% of the companies paid out dividends of more than half their profits.

As per the data curated by the business daily, the average payout of the companies that paid dividend stood at 36%. But this seems low considering that a third of the assets of the total NSE listed companies was parked either in investments or was held in the form of cash balances. The business daily further goes on to share that the dividend yield of the Sensex stands at 1.4%. This seems quite low when compared to the 3 to 5% figures offered in markets such as China, Malaysia, Singapore and Thailand.

There are two broad aspects to ponder over...

First being the need for high payout. Well...you would agree that it would make sense for a company to do so only if it is unable to generate good return on its invested capital. After all, if the company's core business is unable to meet the minimum rate of return required by an equity investor, it would only make sense to pay out the excess capital; rather than invest it back in the business, which would only destroy value in the long run. If a company is able to earn above average return on capital, retaining of profits should not really be a cause of concern for an investor as high growth would only add to the value.

The second point to consider is that of dividend payment not being the most shareholder friendly way of distributing profits. This we say because a fifth of the proposed dividend amount is paid in the form of taxes. Having said that, other forms of wealth sharing have their limitations as well.

US analysts' predictions for the quarter ended September 2015 indicate dull times ahead. 'Profit and revenue are falling in tandem for the first time in six years, with a third of S&P 500 companies reporting so far. Analysts expect the index's companies to book a 2.8% decline in per-share earnings from last year's third quarter, according to Thomson Reuters. Sales are on pace to fall 4%-the third straight quarterly decline. The last time sales and profits fell in the same quarter was in the third period of 2009.' - reported the Wall Street Journal.

A large proportion of this anticipated decline is due the recessionary trend being witnessed by the industrial sector. Companies that have their ears to the ground do not have good things to say. For instance, Caterpillar Inc. last week reduced its forecast as it continues to be amidst its sales slump, which zerohodge.com reports has been ongoing for nearly three years. Further, the management of Fastenal on its concall has this to say -"The industrial environment is in a recession - I don't care what anybody says, because nobody knows that market better than we do. You know, we touch 250,000 active customers a month."

With the US seemingly running out of options to boost its economy, we are keen on seeing how it would react to this expected negative earnings growth scenario. While there are people of the view that the high dividend payouts and strong balance sheets are keeping the stocks upbeat, we wonder how this scenario would play out as and when the QE and ZIRP scenarios actually start disappearing; and real impact of dull consumption levels kicks in.

After opening the day on a weak note, the Indian stock markets continued to trade below the dotted line during the post noon trading session. At the time of writing, the BSE-Sensex was trading down by around 120 points (-0.4%). Stocks from the metals and consumer durables spaces were amongst the least favoured. Mid and smallcap stocks on the other hand were trading firm, with their respective indices up by about 0.1% and 0.2% respectively at the time of writing.

 Today's investing mantra
"Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now." - Warren Buffett

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