Investors, play the games you are likely to win; don’t count on luck
Indian stock markets have seen substantially increased participation from retail investors over the past year. The volume of transactions by foreign and domestic institutions has decreased, while the proportion of retail participation has increased significantly. This trend is supported by a rapid increase in the total number of mat accounts held by individuals, which grew by 14 million in 2020-2021, almost three times more than in the previous fiscal year. Data from new and old brokerage firms also shows a dramatic increase in retail demat accounts.
New post-covid entrants have so far benefited mainly from rising markets. Since the Nifty 50 briefly traded at less than half of current levels in March 2020, markets have quickly recalibrated, ignored the effects of the pandemic, and surpassed previous highs. The rally that started with frontline index stocks in 2020 has moved into the mid and small cap space in 2021. Here, lower free floats and higher retail participation create dramatic price moves that attract the attention of retailers. When the momentum changes, the last of the line remain standing after the game of musical chairs is over. In other words, prices are a pattern of Ponzi schemes; you really don’t want to go into it towards the end.
Investors are now being helped by the democratization of information. Ten years ago, it would be hard to find many companies that publish more than press releases. Now investor calls and in-depth presentations are the norm even for small businesses and provide a constant flow of data for analysis. While institutions are expected to take forecasts with a dose of salt and factor execution risk into their estimates, retail investors might be less skeptical and not contextualize a deluge of seemingly useful information requiring their action. In the coming days, we will likely see exceptional financial performance from listed companies, thanks to the low base in the first quarter of 2020-21. The question investors need to ask themselves is: How far has the future already been assessed in specific stocks and sectors? Stock markets are forward looking and, for the most part, efficient. Information as well as expectations are usually billed instantly or even in advance.
In times of high liquidity, it’s a seller’s market, and sellers dictate prices to an increasing number of buyers. Experienced investors will see the euphoric conditions as games where you step more and more into a weak position as the playing field is asymmetric, tilted against the buyers. When everyone wants to buy, all incremental price estimates are realistic, but when sentiment changes, no price is too low to sell. This change can affect individual stocks, sectors or even markets.
Risk assessment is necessary when participating in a seller’s market, as investors almost always pay up front for the growth and performance of the business that occurs much later. Shares of a company bought at 100 times its earnings, for example, could be 30 times higher than earnings in 3 years according to consensus growth estimates, and even better. But a lot can happen in 3 years. Investors should assess whether current valuations provide sufficient margin of safety if growth assumptions do not hold true. Altered feelings or expectations can be a double whammy of falling price-earnings multiples (PEs) as well as falling expected earnings. Here’s a simple example to show why rating is important:
Say X is bought from ₹1,000 with earnings per share of ₹10, a PE ratio of 100. Profits should reach ₹15 in 2022, ₹25 in 2023 and ₹33 in 2024 at a growth rate of 44%. This equates to a multiple EP of 30 in 2024. So you paid 100 EP today to get 30 EP in 2024. But X faces headwinds and cannot win ₹15 in 2022, messages only ₹13, and should now win only ₹17 in 2023 and ₹22 in 2024. Growth goes from 44% to 30% and PE from 100 to 50.
X share price of ₹1000 to 100 PE will be re-priced at ₹650 to 50 EP, or 30 EP in 2024. It is still a fast growing company, but the investor is losing money.
With a simple change in the underlying assumptions, the invested capital decreases by 35% (i.e. ₹350 down) and the investor must sell or wait several years for a return to par. The investor always assumes all risk of any change in the underlying assumptions.
An adage worth repeating: there are many slips between the cup and the lip.
Initial public offerings, or IPOs, are perhaps the most unfavorable asymmetric situation for retail investors. Growth markets are a “Goldilocks Zone”, where sellers decide prices and the public has almost no background information about a company related to the IPO. The pricing of an IPO is done at the sole discretion of the company or its selling shareholders, and there are no restrictions in the form of upper or lower limits. The price is what potential buyers are expected to be prepared to pay. Sellers are therefore making considerable efforts to attract institutional and individual investors. It is a marketing exercise for stock sellers as well as an investment opportunity for the general public. What better time to announce a sale than when the stock markets are in a festive mood and people want to spend the money?
This is not to say that an investor cannot find fair opportunities in such market conditions. Valuation is only the collective perception of a stock’s fair value, and investors must individually determine whether its perceived value is unrealistic or provides an adequate margin of safety for error. Ultimately, stocks and markets always find a reason to stagnate or correct, just as they do to recover.
Play the games you are likely to win, not the ones where luck plays a major role
Tushaar Talwar researches and writes on capital markets.
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