|»5 Minute Wrap Up by Equitymaster|
On This Day - 27 OCTOBER 2015
Don't Listen to 'Market Experts'
In this issue:
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.
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.
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.
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.
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