Ten common investment strategies and why they may not work
How many times have you been told about 'the next big stock' by a broker, a friend or a colleague? However, once you invest, the stock stops performing, or begins well and then starts to falter. Money Today busts a few myths surrounding some investment strategies.
How many times have you been told about 'the next big stock' by a broker, a friend or a colleague? The stock, you are told, has all the makings of the next blockbuster.
The argument is persuasive, either in the form of anecdotes or backed by data. Maybe an investment guru has made millions on the stock. Or, there is a chart showing the stock's past returns or, maybe, a study listing reasons why it will bring you enormous riches.
However, once you invest, the stock stops performing, or begins well and then starts to falter. You are disappointed and decide never to invest in any stock.
If this sounds familiar, take heart, for you have company. Aswath Damodaran, Professor at New York University, in his book 'Investment Fables,' captures the essence of these stories. "While there are hundreds of schemes to beat the market, they all are variants of about a dozen basic themes that have been around for as long as there have been stocks to buy and sell. These broad themes are modified, given new names and marketed as new strategies," says Damodaran.
We identify some of these strategies that appeal to stock investors and see if they are workable or, as Damodaran says, just fables.
MYTH: BUYING DIVIDEND-PAYING COMPANIES IS AS SAFE AS INVESTING IN DEBT. AND A COMPANY THAT HAS ANNOUNCED THAT IT WILL PAY HIGH DIVIDEND THIS YEAR IS A GOOD BET.
Reality: Investors with little risk appetite prefer the safety of government bonds or bank fixed deposits rather than stocks. The belief is that these are risk-free. Such investors are told that a dividend-giving stock offers safety, regular income, plus scope for capital appreciation. But what is not mentioned is that dividend payments can never be predicted, a big minus for any investor looking for regular income.
Take Bajaj Finance. Its stock went up from Rs 400 on 2 January 2006 to Rs 1,318 on 31 December 2012. The company paid dividend in each of these six years. In 2005-06, it paid Rs 4 per share. In 2008-09, it paid just Rs 2. Some say this is because 2008-09 was a year of economic crisis. But this argument does not hold much water as out of nearly 4,000 companies listed on the Bombay Stock Exchange, or BSE, 662 have paid dividend every year for the last 10 years. One of them is Bajaj Finance. Of these, 100 have been increasing the payout or maintaining it at the previous year's level.
Vikas Gupta, executive vice president, Alpha L50 (India), Arthveda Fund Management, says US pension funds and investment trusts used to invest in only top dividend-paying companies. This forced big companies, especially the market leaders, to pay dividends regularly so that they could qualify for investment from these big investors. Some even borrowed money to pay dividends.
But in India the story is different. "Here, the dividend yield of the highest dividend payers is approximately half the risk-free rate. Therefore, it is not possible to implement the strategy in entirety," says Gupta. Dividend yield shows how much a company pays in dividends each year relative to its stock price.
But if you still want to go for high dividend payers, you must ask the following questions. How consistently has the company been paying dividends? Is the industry cyclical and has the company been paying dividends during tough times as well? And, of course, how does it get the money to pay dividends regularly?
Dipen Shah, who heads private client group research at Kotak Securities, says investors must never lose sight of the company's fundamentals while choosing a stock. "One should look at data for the last three years to see if the company has been paying dividends," he says.
But there are many who vouch for the safety of companies that pay high dividends. Anindya Bera, a retail investor from Kolkata, says, "I prefer safety over risk. High dividend-yield companies are safer in an otherwise risky investment landscape. Most tend to be mature companies with stable revenues. This gives comfort."
Kiran Kavikondala, director WealthRays, says, "We have been recommending stocks that have a long history of earning dividends. But we stick to large companies in this category."
But Ayush Mittal, a resident of Lucknow, says it's not necessary to stick to large-cap companies in the category. After rigorous research, he bought shares of Mayur Uniquoters and MPS Ltd, which had a long record of paying dividends and strong earnings growth. He made substantial profits. "Rather than looking at just the dividend percentage, investors must look at the dividend payout percentage (of net profit) being distributed (a good dividend payout for a manufacturing company is >25% of net profit)," he says. This reinforces the view that focusing on research to find companies with strong fundamentals is important.
"Our experience is that investors in the 45+ age group prefer public sector companies over private sector ones," says Kavikondala of WealthRays.
"But there is no evidence that public sector companies pay higher dividends than the private sector ones. Investors following the dividend strategy need not skew their portfolio towards public sector companies."
On which group of investors should not bet on dividend-earning stocks, Kavikondala says, "If the aim is capital appreciation, this is perhaps not the best approach." Investors should understand that the strategy may deliver lower returns in bull markets. This is because investors focus on capital appreciation in bull markets and stability of earnings in bear markets.
MYTH: FAST-GROWING COMPANIES WHOSE EARNINGS PER SHARE, OR EPS, IS RISING BY 30% OR MORE A YEAR ARE GOOD INVESTMENTS AT ANY PRICE LEVEL AS THEY WILL KEEP GROWING.
Reality: A present market leader would have been a fast-grower in early stages. There are many ways to define a fast-growing company. The most common is looking at EPS, revenue or sales growth. For retail investors, the best way is to look at the annual EPS growth over the last five years.
When it comes to investing, there is a belief that one can pay any price for a fast-growing company. For example, if an investor would have spotted Page Industries towards the end of 2009, he would have found that its EPS had grown from Rs 5.41 (in 2004) to Rs 28.36, a growth rate of 39% a year. The stock was at Rs 874 on 31 December 2009 and touched Rs 5,878 on 28 February 2014; the EPS grew to Rs 100 during the period. At this stage, the annual EPS growth rate for the last five years was 36%.
There are 21 companies that grew at more than 30% a year in 2006-11, 2007-12 and 2008-13.
All this sounds great. But the investor, who has the unenviable task of predicting the future, should ask if this run can continue. Past growth, as we all know, may not always be replicated. An excellent example of this is ICSA, whose EPS grew from Rs 0.15 in 2004 to Rs 26.31 (growth of 191% a year). After that, the EPS started falling. In 2012 and 2013, it reported negative EPS (- Rs 36.99 and - Rs 171.06, respectively). In the world of investment, past performance tells little about the future.
"The pitfall of using this parameter is that one will end up looking at just revenue or earnings growth. A company can always boost its earnings by borrowing more and then investing that money," says Gupta of Arthveda. He says a leveraged company not growing according to plan is at a risk of defaulting on debt.
Hence, investors who want to follow this strategy should look at companies that are growing fast but without taking on too much debt. It is best to look for companies that are growing through internal accruals.
As Damodaran writes in Investment Fables: "If you put your money into companies with highest earnings growth, you are playing the segment that is most likely to have an exponential payoff or meltdown."
MYTH: STOCKS TRADING AT LOW EARNINGS MULTIPLES ARE GOOD AS THEY ARE BOTH CHEAP AND SAFE
Reality: Benjamin Graham is often named as the proponent of buying stocks trading at low price-to-earnings, or PE, multiples. In his book, 'Security Analysis', Graham says that a PE ratio of 16 "is as high a price as can be paid in an investment purchase in common stock." On the lower side, he says, a PE of eight suggests that the market is not factoring in growth, making it a safe bet.
But what is often missed by those who follow the low P/E strategy is that Graham suggested this as one of the parameters along with debt-to-equity ratio, price-to-book value and market cap.
"The strategy based upon buying stocks with low PE ratios is called value investing. It is based on the assumption that shares of comparable companies should trade at almost the same PE multiples. If shares of a company are trading at a lower PE than that of others in the peer group, they are considered undervalued. The aim of value investing is to buy these shares and expect that their prices will rise to levels at what their peers are trading," says Yashpal Gupta, executive vice president, IDBI Capital.
But the real challenge is finding out the level at which you can call a stock cheap. For instance, for a company in the fast moving consumer, or FMCG, sector, a PE of 20 is considered reasonable. The reasons are stability of earnings and low debt. For the opposite reasons, for an infrastructure company, the figure is 10.
"Therefore, one should always look at PEs of companies in the same industry, plus the overall industry PE," says Patel of Tata AMC.
The effort should be to understand why the company is trading at a low PE ratio. The reasons could be industry-specific or company-specific. If it is the latter, investors must tread with caution.
Low PE is just an indicator. You should sift through low PE stocks and choose your investments on the basis of fundamentals. However, some companies will always trade at lower PE ratios while others will be valued higher because of the nature of their businesses or management-related issues, etc. So, it is imperative to understand the reason for the low PE ratio before investing.
Shah of Kotak Securities says, "If my view is that the market will remain subdued, I should not be looking at low PE as the criteria. But when a sector is not doing badly but its stocks are down due to negative news, I should look at low PE stocks."
MYTH: MULTINATIONAL COMPANIES, OR MNCs, THAT ARE LIKELY TO DELIST WILL PAY INVESTORS A GOOD PREMIUM OVER THE MARKET PRICE AND, SECOND, MNCs HAVE HIGH GOVERNANCE STANDARDS AND LOOK AFTER THE INTERESTS OF SHAREHOLDERS.
Reality: MNCs which have presence in India are highly regarded. But there are two types of stories that investors must be cautious about.
The first is that MNCs will pay any price to buy back shares and delist from the Indian market. This belief has taken hold ever since the Securities and Exchange Board of India, or Sebi, the market regulator, said two years ago that all listed companies must ensure that at least 25% shares are floating on the exchange.
Astrazeneca Pharma India shares rose after the Sebi announcement as the promoter owned 90% of the company and the market expected that it would delist rather than comply with the new shareholding norm. However, the stock fell 30% after the company told the BSE that it will dilute promoter holding to 75% in a span of 45 days between March and April 2013. "Using delisting as a strategy is speculation. One can only guess when a company will delist," says Patel of Tata AMC.
Experts say delisting can at best work as a speculative strategy. There are other strategies that one can employ while keeping MNCs as the base requirement.
"Investors can consider the buyback strategy as whether a company will delist or not is something one can only guess," says Kavikondala of WealthRays. He says in a buyback, one must look at whether the company has opportunities to expand. If not, one should see if the management would like to reduce the number of shares in the market, as this would raise the possibility of buyback. But amid all this, it's important not to forget the prospects of the company. He says an aggressive investor can use this strategy but should not commit more than 15-20% funds to it.
The second story often narrated to investors is that MNCs have high corporate governance standards, strong brands, use capital efficiently and are in India for the long term.
These factors seem to be working well for investors in MNCs. For instance, the CNX MNC index, comprising 15 companies, has been outperforming the Nifty over the last few years.
Deepak Ladha, executive director, Ladderup Corporate Advisory, says, "There are MNCs which are not fast growing but pay regular dividends. Some do not give dividends but grow fast. There are many examples of MNC strategy that have worked, for instance, Glaxo Pharmaceutical, HUL and Siemens."
But one grey area, says Patel of Tata AMC, is wholly-owned subsidiaries set up by some MNCs. "This means one may not get a clear picture of which costs are being charged to the listed entity and which are being charged to the wholly-owned subsidiary." At times, these subsidiaries may start operating in the same line of business as the listed entity, harming the interests of the latter's small shareholders.
Also, the local listed entity can decide to increase royalty payments to the parent. This is not in the best interest of shareholders. "Dividends are fine as they benefit small investors also, but not royalty payments," says Gupta of Arthveda.
Investors should look at the sector the MNC in question operates and understand the industry situation to see if the bet will work. "For example, Siemens is in the engineering sector and will, therefore, benefit from a stable government and pick-up in infrastructure activity, whereas if you take Glaxo Pharmaceuticals, it is a perpetual story, as pharmaceuticals will continue to grow at a certain rate."
MYTH: FOLLOWING AN EXPERT'S PORTFOLIO IS REWARDING.
Reality: Copycat investing involves following an expert. This is common in developed countries. It is also called tail-coating or sidecar investing.
In 2008, Prof Gerald Martin and John Puthenpurackal published a paper titled, "Imitation Is the Sincerest Form of Flattery". They created a portfolio that mimicked the investments of Warren Buffett's Berkshire Hathway. The hypothetical portfolio bought stocks at the start of the month after Berkshire's disclosure of its stock positions. Despite the delayed investment, the portfolio earned a return of 10.75% over that given by the S&P 500 index. The study supported the copy-cat strategy.
In India, the most renowned stock investor is Rakesh Jhunjhunwala. So we tried to get data to see companies in which he has a stake of more than 1% (it is mandatory for companies to disclose the names of all investors who hold more than 1% shares). This proved tricky as there were many permutation combinations ranging from Rakesh Jhunjhunwala to Rakesh Radheshyam Jhunjhunwala and some shares were in the name of his wife Rekha Jhunjhunwala. In some cases, both their names were combined as Rakesh-Rekha Jhunjhunwala. So, we took names where we had confidence that it would be Rakesh Jhunjhunwala.
As this shows, one challenge the investor who wants to follow the copycat strategy faces is the deployment time-frame. Gupta of Arthveda says, "There is no proper way to do copy-cat investing in India. One hurdle is that you will never know when the investor you are following has sold his investments. You may not even know when he bought it."
"In the Indian scenario, copycat investing can work only in undervalued companies or when you are following someone who follows a contrarian style. The contrarian approach takes a long time to work out. You need patience." He explains that in US, the reason why the strategy works is the 13F filing. 13F is a quarterly filing by institutional investment managers with over $100 million in assets. It is done at the end of each quarter within 45 days. Another benefit of the 13F filing is that it is not restricted to 1% shareholding. Hence, you get to see the full portfolio of the manager.
Therefore, the perennial question for an investor following a copycat strategy is: Why did the big investor bought it? And, of course, how long does he plan to hold?
Those who want to use the strategy should understand the temperament of the people they plan to copy. This is because a person interested in short-term trading can never make money by following a big investor such as Buffett whose holding period is very long.
MYTH: IF FOREIGN INSTITUTIONAL INVESTORS, OR FIIs, OR DOMESTIC INSTITUTIONAL INVESTORS, OR DIIs, ARE BUYING A STOCK, IT MUST BE VERY GOOD.
Reality: The market can take a stock in any direction. In the BSE 100 index, there are 26 companies in which FIIs have been increasing their stake since March 2013. Of these, nine gave negative returns between April 2013 and February 2014. Similarly, in March-December 2012, there were 34 companies in which FIIs increased their stake. Of these, 13 gave negative returns in 2012-13.
For instance, FIIs increased stake in Tata Power Company from 24.54% in the quarter ended March 2013 to 24.78%, 25.05% and 26.03% in quarters ended June, September and December 2013. However, on account of muted cash flow, the stock plunged 17% from Rs 95.8 on April 1 last year to Rs 79.45 on February 26 this year.
Likewise, concerns over high debt and soaring interest costs are keeping Jaiprakash Associates under pressure. The stock fell 38% to Rs 41.90 between 1 April 2013 and February 28 this year. This was despite FIIs increasing stake from 22.77% in March 2013 to 27.41 in December 2013.
What retail investors forget is that FIIs and DIIs have their own parameters for taking investment decisions. Pankaj Pandey, head of research, ICICIdirect, says, "If FIIs are facing a liquidity crunch they may sell even good stocks to raise money. In this case, a retail investor who follows FIIs/DIIs and sells the stock will miss the chance to make money."
"The risk appetite, the investment horizon as well as the holding power of retail investors are different from that of institutional investors. Hence, if an investor buys a stock that FIIs are buying and it falls in the near or medium term, retail investors without deep pockets will tend to exit, losing money." However, institutions, which have deep pockets, may be able to wait for longer to get out of the investment.
Vikram Dhawan, director, Equentis Capital, says the strategy suits long-term investors who have the discipline and resolve to accumulate stocks at every sizeable correction or short-term traders who have fixed profit and loss targets.
"One also needs to understand that what may look like a huge stake may be a minuscule portion of the FII's portfolio. So, they can dump a few stocks anytime without a big impact on their overall portfolio," says Patel of Tata Asset Management.
MYTH: THE STOCK WILL RISE WHENEVER PROMOTERS SHOW CONFIDENCE IN THE COMPANY BY RAISING THEIR STAKE.
Reality: There is no direct correlation between the two. In the BSE 500 index, there are 270 stocks in which promoters have been increasing or maintaining their stake for the past five quarters till December 2013. Of these, 140 gave negative returns during the period.
Take Rei Agro, Ruchi Soya Industries, Parsvnath Developers, JBF Industries and Future Retail. These stocks fell over 30% this year till March 3 despite promoters increasing their stake since December 2012.
Rajesh Sharma, director, Capri Global Capital, says, "Following promoters is perhaps one of the best possible ways of investing. But it requires a lot of hard work."
Before following the strategy, he says, one must look at disclosures about the promoter and the management. The company, if it is to qualify as an investment, should have manageable debt and good brands and products. Also, one must see how the management and the stock have been performing in downturns. "Following promoters like Ajay Piramal and Mahindras has been rewarding for investors. But if you don't understand the company and its business model and have not done proper due diligence about promoters and their business associates, you run the risk of suffering losses."
MYTH: MOST PEOPLE THINK THAT COMPANIES THAT ARE GOING PUBLIC ARE FLOURISHING. SECOND, THE ISSUE PRICE IS THE FAIR VALUE OF THE STOCK AND ONE CANNOT LOSE MONEY BY INVESTING AT THAT PRICE, AND LASTLY, IF THE ISSUE IS OVERSUBSCRIBED, THE STOCK IS A 'MUST BUY'.
Reality: Some companies go public at a very early stage, before proving their financial feasibility. Therefore, it is important to know whether the company is raising money for expansion or clearing debt. You may want to avoid the issue in the latter case unless you are convinced about the feasibility of the business model and other aspects of the business.
Many believe that initial public offer, or IPO, prices are fair and so buying at this stage is the safest way to make money. Chethan Shenoy, vice president, investment products, Anand Rathi Private Wealth Management, says this is not true as a company's fair value can be calculated only after taking into account various financial parameters and the overall economic environment. There are many good and popular companies whose shares listed below prices at which they were allotted in IPOs.
Listing gains can be expected only in bull markets or when the market sentiment is positive. For example, in 2007, when the markets were bullish, 100 companies came out with IPOs. Quite a few generated triple-digit returns on listing. The examples are Everonn Systems (241%), Allied computers (214%), Religare Enterprises (182%) and Mundra Port (118%).
Similarly, in the bear markets of 2008 & 2011, Tree House, Reliance Power and Omkar Speciality shares listed below their issue prices. In 2008, nearly 50% IPOs gave negative returns on listing, whereas in the bull market of 2005 just 12% IPOs gave negative returns on listing. In 2005, the Sensex had risen 42%. In 2008 and 2011, it fell 110% and 25%, respectively.
Shenoy says oversubscription does not guarantee high returns either. Misreading the initial demand for a public issue can have damaging consequences. This is because oversubscription in itself does not prove that the shares are fairly valued.
While there are enough instances of IPO investing working for small investors, there is no shortage of cases where they have disappointed.
For instance, CARE announced its IPO in December 2012 at Rs 750 per share. The issue was subscribed 40.98 times. The stock ended the listing day at Rs 923.95, around 23% higher than the issue price. Similarly, ICRA announced its IPO in March 2007 at Rs 330 per share. The issue was subscribed 75 times. The stock ended the listing day at Rs 797.6, over 140% higher than the issue price.
However, there have been some big flops too. Reliance Power announced its IPO in February 2008 at Rs 450 a share. The issue was subscribed 73 times. However, the stock fell 17% on the listing day.
Experts say IPOs should be approached just like any other form of equity investing. As such, investors should first analyse if the price at which the shares are being offered is right. For this, they can look at the PE ratio, the price-tobook value, or P/BV, ratio, earnings growth and prospects vis-a-vis peers to check if the issue is undervalued, fairly valued or overvalued.
S Ranganathan, head of research, LKP Securities, says, "An IPO investor should also study the promoter background, competitive positioning, pricing power and valuation so that he is better prepared to take a call on listing."
Gupta of Arthveda says the IPO strategy does not work anymore. This is because the issues are overpriced as companies' sole aim is to raise as much money from the public as possible, he says.
MYTH: SOME INVESTORS SELL STOCKS WHICH ARE ABOVE THEIR PREVIOUS 52-WEEK HIGH ON EXPECTATION OF A CORRECTION AND BUY THOSE BELOW 52-WEEK LOWS.
Reality: Contrarian investors try to bring the price of securities back to their fair value by adopting strategies like "winners are punished" and "losers and purchased". According to market experts, the investor who always sells stocks when they are above their 52-week highs is taking a high risk; in a bull market, good stocks will move first and poor quality stocks will follow. If the investor does not know the correct value of the stock but wants to create a short position, he may end with huge losses.
However, in a bear market, fundamentally poor stocks will touch new lows every day. Buying these can erode wealth as there is no way one can know when the fall will stop. A good example of this is infrastructure stocks, which fell 30-75% in the four years to December 2013.
Sahil Kapoor, chief technical strategist, retail capital markets, Edelweiss Financial Services, says, "Technical analysis is based upon the belief in buying strength and selling weakness. Hence, if a stock has made a new 52-week high, it means it has strong relative strength compared to others. A 52-week high breakout after consolidation has even more significance as there is a range expansion and the stock is ready for a strong and a sustainable trend."
"An important reason to avoid bottom-fishing in 52-week-low stocks is the difficulty of spotting winners. The probability of losing money is higher. If you were to buy stocks making new highs, the probability that you will pick more winners than losers is higher," says Kapoor.
Varun Goel, head, portfolio management service, Karvy Stock Broking, says, "Fundamentally, there is no reason to buy/sell a stock if it is at a 52-week high/low. Some technical analysts do look at these figures but just to understand the momentum in the stock. If a person is buying a stock just because it is at a 52-week low, he could fall into a value trap."
For example, Hindustan Unilever (HUL) made a new 52-week high in September 2010 by crossing Rs 300 after 10 years. Investors would have earned handsome returns even if they had bought the stock at these levels. The stock rose more than 100% after that to touch a new high of Rs 718.90 in July 2013. In March, it was at Rs 555.
Similarly, IVRCL made a new 52-week low in 2010 by breaking the Rs 140 level. On March 4, it was trading at Rs 11.06.
"Investors should maintain a 5-7% stop loss once a stock touches a 52-week high. If the strength and range expansion persist, there is a high probability that the stock will give 20%-plus returns in the medium term. Only those who have trading skills and discipline should use the above style," says Kapoor of Edelweiss Financial Services.
MYTH: PENNY STOCKS ARE SO CHEAP THAT THEY CAN MAKE A PERSON RICH OVERNIGHT.
On the other hand, SMS Techsoft (India) has fallen over 76% in the past 10 years, and was at Rs 0.09 on March 3 this year. Nu-Tech Corporation Services fell over 66% during the period.
A penny stock normally trades at a very low price, usually below Rs 10, or is issued by a company whose market capitalisation is less than Rs 100 crore.
"Penny stocks are risky. Chances of huge profits usually come with even bigger chances of suffering losses. Hence, it is best for the risk-averse to avoid these stocks. However, if the investor has the risk appetite, he must take pains to understand the company's financials and the risks involved and decide the horizon for which he wishes to hold the stock. Penny stocks may yield good returns due to changes in business fortune or management, favourable policy changes or takeover by a good company," says Yashpal Gupta of IDBI Capital Market Services.
According to experts, penny stocks are not great options if one is looking for a way to get rich quickly. When one invests in penny stocks, a huge profit isn't guaranteed. Just because a stock is cheap does not mean that it is a good bargain. Hence, investors must do thorough research and be ready to hold such stocks for long periods.
The other reason for buying these stocks is that these are available at low prices and can be bought in huge numbers with a small capital. People perceive these stocks to be 'cheap' and a way to overnight fortunes.
Rakesh Goyal, senior vice president, Bonanza Portfolio, says, "Stocks cannot be tagged as cheap or expensive solely on the basis of their market price. Stocks are valued on the basis of their fundamentals-their net worth, business potential, income growth, etc. So, if a stock is trading at a low price, it is primarily because markets do not value it much in terms net worth or growth. Thus, every penny stock may not be a bargain. People also buy penny stocks in the belief that a small addition to the price can bring in huge profits."
For example, if someone spends Rs 10,000 to buy a stock valued at Rs 2 a share and if the share price reaches Rs 3, he will earn a profit of Rs 5,000 on an investment of Rs 10,000. However, for the stock to give a return of Re 1, it will have to move by 50% in a particular period.
In case you are keen to buy a penny stock, it is advisable that you start only after reading the company's financial statements and doing proper research about business plans and strategy.
"One should stop investing in the stock when the company is not performing well. Further, if there is negligible possibility of a company turning around, then also one should stop investing in such stocks," says Yashpal Gupta of IDBI Capital Market Services.
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