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Stockmarkets: Opportunities in disguise! - Views on News from Equitymaster
 
 
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  • Mar 29, 2007

    Stockmarkets: Opportunities in disguise!

    The much-hyped 'efficient market theory' proclaims that all the investors in the stock market are quite knowledgeable and behave rationally and hence, it is virtually impossible to outperform the market consistently over a long period of time. However, a lot of evidence has been found to the contrary and there exists a whole list of investors that have managed to outperform the markets consistently over long periods of time, thus blowing a big hole in the theory of efficient markets or quite simply, have turned the theory on its head.

    These investors (the outperformers) have largely benefited from what could be called as 'psychological tendencies' of we humans whereby we have a habit of doing things in extremes. This habit can result in investors resorting to selling stocks indiscriminately during bad times and bringing prices to such levels that they become an attractive buy with an adequate margin of safety. The same can also happen on the upside in the sense that, during good times, investors become so much obsessed with stocks that caution and rationality ('irrational exuberance' - a term that has become synonymous with excessive greed in the financial markets) are thrown out of the window, thus making investments vulnerable to strong declines. In this write up though, we will focus on some of the key reasons that lead to selling among investors for reasons entirely non-fundamental and how a rational, value-seeking investor stands to benefit from it.

    Panic selling: Remember May 2004! With the then ruling party surprisingly failing to retain its majority in the Indian Parliament, markets had reacted in a rather extreme way, wiping off billions of rupees in value in a single day. Another huge sell off happened in May 2006, when the Sensex made what then was an all time high of 12,671 and then plunged to 8,799 in little more than a month, pegging the Sensex back by as much as 31%, a huge slide by any stretch of imagination. Here again, the investors had overreacted to the US Fed raising interest rates for the sixteenth consecutive time by 0.25%, to 5.25%. On both these occasions, markets bounced back handsomely to touch new highs, thus underlying the fact that the sell off of the magnitude that happened was indeed unwarranted or uncalled for.

    Investors can take advantage of such an opportunity by buying into beaten down stocks, companies that are trading at historical lows but the ones that possess good long-term historical track record and have an honest and competent management at the helm. Investors are so preoccupied at dumping the stocks during such a sell off that they indulge in selling, regardless of the quality of the companies and this can provide a good opportunity for the discerning investor to enter into a good quality stock at attractive valuations.

    Going nowhere: Akin to the first point, this scenario also involves buying into beaten down stocks but while in panic selling, the window of opportunity in terms of time frame may be small, here the investment horizon can be a tad prolonged. This scenario is your typical bear cycle which plays itself out after every prolonged bull run and during which, most of the investors out of psychological reasons, become wary of stock markets and take their money out, once again, without paying heed to the fundamentals of companies. However, employing this strategy requires patience since one does not know when the cycle might turn and sometimes, the waiting period might run into years. But the rewards that one gets at the end of the day are equally big. This is simply because of the fact that while earnings of well-managed companies continue to grow at decent levels, price does not go anywhere due to the overall negative sentiment. But when price starts moving upwards, investors stand to benefit from both, expansion of valuation multiples as well as earnings.

    Failing to meet estimates: To elucidate this scenario, let us go back in time to the aftermath of the 9/11 attacks in 2001 and the SARS outbreak. During this period, business confidence had reached its nadir and investors had become skeptical of stocks. In such times, Infosys, the company that had become synonymous as the new Indian corporate gave a rather muted earnings guidance for the forthcoming year. Once again displaying the extreme psychological tendency, investors dumped the stock, resulting into one of the steepest intra day decline for the stock. Please remember that the company did not anywhere say that it is going to post a loss or not even a decline in bottomline. It just gave muted earnings guidance and such was the skepticism prevailing in the markets then that the stock was hammered. Needless to say, savvy investors who correctly gauged the psychological overreaction and bought into the stock after that decline are now laughing all the way to the banks. However, this is not just a one off case and it will keep on happening to good quality stocks in the future as well. So, the next time a good quality stock fails to meet so called the 'quarterly' earnings estimates or gives a muted guidance, you know what to do!

    While the above mentioned scenarios do highlight the benefits of being a contrarian and taking advantage of the 'unjustified pessimism' of the markets, it should however be borne in mind that playing contrarian 'for the sake of it' is not going to take investors too far. Only when stocks fall to such an extent that they look attractively valued and have a sufficient margin of safety incorporated into it, should one invest in the company. Further, not paying heed to the long-term track record and the quality of management might also lead to poor results. Thus, while indiscriminate selling by investors is likely to result into buying opportunities, it has to be blended with thorough research and understanding the risk profile of the beaten down stocks.

     

     

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