Myths you can fall prey to... - Views on News from Equitymaster

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Myths you can fall prey to...

Dec 10, 2007

The bull market of the past four years has created so much wealth for traders and investors, that financial learning and the need for a proper investing education has taken a backseat. So much so, brokers and expert communities have led gullible investors like leaders of herds to buying into anything and everything. In this write-up, we mention three myths that even the long-term investors have fallen prey to, in the lure of getting more bang for their buck."This company has announced a 1:1 bonus. This means that the Rs 10,000 I invested in the stock will become Rs 20,000 as I will get one bonus share for every one I hold."
The second part of this assumption - of getting one bonus share for every one held - is absolutely true. However, so untrue is the first part! A bonus issue, say in the ratio of 1:1, not only doubles the number of your shares, but also those of the issuing company itself. So, if the company had an issued capital base of 100,000 shares earlier, a 1:1 bonus shall make it 200,000. However, that will not change the business earnings of the company, shall remain the same as prior to the bonus issue. As such, not only will the 'earnings per share' share value halve (as the denominator - number of shares) doubles, so will the stock price. As a result, the while the 100 shares you held in the company will become 200 post the issue of bonus shares, your investment value shall remain Rs 10,000 as the per share value will halve.

This issue of 'doubling' investments by virtue of bonus issues is probably one of the most illogical aspects of stock market investing. Gullible investors do not understand this, and their brokers do not educate them of this! That is the reason one sees so much euphoria with respect to a stock, where the company has announced a bonus issue.

"This stock is selling for Rs 100. So it 'must' be cheap as compared to the one that is selling for Rs 1,000. Right?"
Absolutely wrong! A stock selling at a lower market price (Rs 100) is not necessarily a cheaper option than one selling for a higher quote (Rs 1,000). What is important to for investors to understand here is the underlying business earnings that support such stock prices. A Rs 100 stock with underlying earnings of Rs 2 per share (P/E of 50 times) is definitely not cheaper than a Rs 1,000 stock with underlying earnings of Rs 50 per share (P/E of 20 times). What determines the 'expensive' or 'cheap' nature of stock is not its stock price but the multiple that this price is to the earnings of the company.

And the most vibrant of the myths follows. Now, this is not a fundamental issue, but one of foolishness.

"'XXX Energy'? That stock/IPO seems a 'must buy' as it has the name 'energy' attached to it. You see, all the 'energy' stock have done so wonderfully over the past few months. So this will surely work wonders as well."
Remember 'sys', or 'tech' of the late 1990s when companies with such end-names saw their stock prices zoom? And what followed in the year 2000? Most of these technology (or non-technology) startups failed to match business growth (earnings) with the kind of valuations that their stocks traded at in the market. What followed in 2000 was utter chaos and panic, as investors saw their paper wealth dwindling 90%, or sometimes 99%! A similar euphoria seems to be catching up with 'energy' (especially power and power equipment) stocks. One can hear brokers and speculators shouting from their rooftops, asking investors to buy into anything that ends with 'energy'. This is touted to be the next sure-shot way of making money on stocks.

Ben Graham, the legendary investment guru and the proponent of value investing, if alive and in India, would have died of an overdose of madness and valuations! So much for his investing principles that everyone talks about, but only before the pre and post market hours.

It is important to note the first two cases discussed here are cause of lack of proper financial knowledge and can be overcome if investors educate themselves with some basic rules of investing and stock markets. However, the third issue is of sheer financial foolhardiness, which gets propagated even by the so-called 'experts' of stock markets.

It is high time investors arm themselves with proper financial education and investing principles before committing money to stocks. As Charlie Munger, Warren Buffett's partner said, "If you're a duck on a pond, and it's rising due to a downpour, you start going up in the world. But you think it's you, not the pond." We are in such times now.

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