Capitulation - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
Capitulation A  A  A
3 JULY 2008

Investing is a battle. And investors are at the losing end.

Over the last few weeks, we have been hearing the word "capitulation". I checked to see what exactly the word means - and how it applies to stock markets and investing.

And this is what the Merriam-Webster dictionary had to say.

Main Entry: ca·pit·u·la·tion
Pronunciation: \k?-?pi-ch?-'la-sh?n
Function: noun
Date: 1535
1: a set of terms or articles constituting an agreement between governments
2 a: the act of surrendering or yielding b: the terms of surrender

More searches and I landed up on Investopedia.
"A military term. Capitulation refers to surrendering or giving up.

In the stock market, capitulation is associated with "giving up" any previous gains in stock price as investors sell equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling."

India in a panic.
Well, see the share price graphs of a few companies over the past one month.
It sure looks like we are in "capitulation" - or in a children’s park on a pretty steep slide.
The BSE-30 Index, the one that the world watches, took 5 months to decline 22% and has taken 2 weeks to decline 20%.
This sounds like "capitulation".
The "I give up" waving of the white flag.

Graph 1: BSE-30 Index: the world is really watching - unfortunately!

In times of panic, all stocks tend to decline sharply.
Some "good stocks" decline by association and may be victims of the investment environment.
Fear is in, and greed is out and investors wish to sell everything.
The baby, as they say, is thrown out along with the bath water.

We own HDFC for our clients - we think of it as a "good stock".
And we have watched in disbelief as it "capitulates".
The investment thesis for us to own the stock for the long term is still intact, in our opinion. We would have been happier (and possibly the HDFC stock may have been hit less) if HDFC Bank had not done that over-priced merger with Centurion Bank of Punjab.
But a 27% decline in one month?
"Why not?" say some people, "every other finance stock is down a lot so why should HDFC not decline sharply?"
Guilty by association.
Guilty, unless proven innocent.

Graph 2: HDFC - punished by association?

Some like DLF or ICICI Bank may decline because investors are nervous of their aggressive growth plans and the difficulties they may face in a tougher economic environment.

Graph 3: DLF - an over-valued land bank?

Graph 4: ICICI Bank - the risk of aggressive growth?

Scraping the bottom?
The question is: what should investors do?
Investopedia has this follow-on view: After capitulation selling, it is thought that there are great bargains to be had. The belief is that everyone who wants to get out of a stock, for any reason (including forced selling due to margin calls), has sold. The price should then, theoretically, reverse or bounce off the lows. In other words, some investors believe that true capitulation is the sign of a bottom."

Money Magazine in USA carries these views of "The Mole", a financial advisor who tries to educate investors. This is what The Mole has to say: "Let's start with some data. When it comes to investing, human nature is not our friend, and will consistently lead us to do the wrong thing at the wrong time. The chart (below) shows how investor funds have flowed into stock mutual funds so far this decade.
Notice how we poured money into the stock market after the great years and panicked and sold after declines. A clear pattern of buying high and selling low, something I'm pretty sure investors didn't consciously set out to do."

Table 1: Is that why we invest - to buy high and sell low?
Equity mutual fund flows in USA
Year Event Fund Flows
2000 Market High UP $309 Billion
2002 Market Low DOWN $28 Billion
2006 Last Strong Market UP $159 Billion
2008 May YTD Down Market DOWN $16 Billion
Source: Investment Company Institute

In India, the retail investor base is still small - and growing - so clear patterns don’t really emerge. Also, the distribution channel in India is pretty much built against the interests of the investors. Many distributors advise investors to buy inappropriate funds based on commission pay outs that the distributors get. This prompted the previous Chairman of SEBI, Mr. Damodaran, to say that the mutual fund industry in India was "of the distributor, by the distributor, for the distributor".

Hence this framework may distort the "bull" market inflows. In bear markets, like the one we are in now, outflows may be distorted again as investors may be pushed into life insurance policies - higher paying products that seem a lot safer in this environment. So the "exits" may be higher. The data collated so far does not show any significant outflows in the recent Feb to June 2008 sell-off. But, over the long term, the statistics may support the "human" error: selling when we should be buying, and buying when we should be cautious.

Table 2
Equity mutual fund flows in India
Period Event Fund Flows
2001 - 2003 Market Low DOWN Rs 75 billion
2004 - 2007 Market High UP Rs 218 billion
2008 January to June Market Low UP Rs 93 billion
2008 January, market was peaking Market High UP Rs 77 billion
2008 February to June Maket Low UP Rs 16 billion
Source: Securities and Exchange Board of India

A prescription for panic.
Governments, world over, encourage savings and investments. These pools of savings are the foundation on which we build the long term economy. One can leave "capitulation" to market forces to work its way out. And one may wait for the trigger event of "greed" to surge back in full force. No one knows when that will happen.
There is another solution. Governments can nudge people into saving more of their money in mutual funds and stock markets by giving individuals the tax incentives to do so.

Table 3: Encouraging long term domestic investments in India
Number of taxpayers Amount invested Total pool in mutual funds Tax loss to government Tax loss to government
360,000 Rs 10 lakhs Rs 36,000 crore 35% Rs 12,600 crore
360,000 Rs 5 lakh Rs 18,000 crore 30% Rs 5,400 crore
35 million Rs 25,000 Rs 87,500 crore 10% Rs 8,750 crore
Total 36 million   Rs 141,500 crore   Rs 26,750 crore

If "capitulation" leads to a wringing out of all the fear and the panic, then hopefully it also gives way to wisdom to policy makers.
Successive governments were ill-advised when they created this P-Note structure that made the Indian stock markets swing to the beat of short-term foreign flows.
Now we are hanging by a thread.
Hopefully, we will give ourselves the rope to pull ourselves out of this mess.

Suggested allocation in Quantum Mutual Funds
Quantum Long Term Equity Fund Quantum Gold Fund
Quantum Liquid Fund
Why you should own it: An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 15% 5%

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

Note: Ajit Dayal, the author is a Director in Quantum Information Services Private Limited and Quantum Asset Management Company Private Limited. Views expressed in this article are entirely those of the author and may not be regarded as views of the Quantum Mutual Fund or Quantum Asset Management Company Private Limited or Quantum Information Services Private Limited.

Mutual Fund Investments are subject to market risks. Please read the offer documents of the respective schemes before making any investments.

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