(3) Stock Picking: Good Company v/s Bad Company

The so called “Blue-Chip Companies” – what exactly do they mean?
Basically, this term indicates a company which is well established in the market, has a well trusted management, is listed in the main stock indicator index (like Sensex/Nifty), has been giving good profits since last few years and has the potential for further growth (atleast that’s what the majority of the investors in the market should believe). In essence, a blue-chip company is considered to be a “Good” Company.

Now, a few of the questions that come are as follows:
• Is it really worth investing in a so called blue-chip company?
• Can you really differentiate a “Good” company with a “bad” Company with regard to investments?
• Can the experts giving recommendations on various business channels for stock picking really trust-worthy?

I will be taking some specific names of companies here, but that does not mean that these companies are good or bad. It is just quoted for a particular example and for a particular period. Let’s look at some of the examples.

TATA group is one of the highly reputed & well established business groups in India. It has a track record with decades of success. TCS or TATA CONSULTANCY SERVICES, a group company within TATA group brought it’s IPO in 2004. The IPO was offered in price-band of 775 to 900 and finally the price for allotment of shares was fixed at 850. This IPO had all the good things and good indications:
• People subscribed to this IPO in large numbers.
• Banks like PNB and IDBI were offering “IPO loans” to individuals to subscribe to this IPO.
• This IPO also initiated the so called “black market trading” (trading in shares between 2 individuals, even before the listing of the company), which was an indicator of the investor confidence in this particular company.

Now, my questions start here:
• If this IPO was so good, why is it that the price was fixed only between 775 to 900? Why not 1000, Why not above 1200 (and the list can continue)
• Why wasn’t the final price for allotment of shares fixed on the higher price of 900, why was it priced at an intermediate 850?
• Why didn’t the TCS stock, after listing on the exchange immediately made a nice handsome profit? Instead, what had happened, it was listed at an opening price of almost 1200 Rs., but the same day, it came down to close at 988 Rs. If it was a “good” stock, why there was straight fall of 18% on the first day of listing itself between the opening and closing prices?

A few of these questions can be justified by mentioning that it was the trading activities that led to the price fluctuations in the short term. Very true, but don’t these trading activities affect what you are holding??

The actual answer to the above questions lies in what is called “The Market Perception” and is affected by the fundamental question of “Demand and Supply”. The first question, regarding the price band of 775-900, and not a higher value relates to the market perception of the value of the company. It is the market that decides what should be the FAIR value of this stock, not the company (both TCS and Book running lead managers –who brought the shares to the market). When I say MARKET, it means all the market participants (individual traders, fund managers, market-makers, foreign investors and Individuals, who trade or invest in the market). If the company had over-priced the issue, there was a danger of under-subscription of shares – meaning all the shares being offered will not be sold through IPO.
The same reason continues for the final allotment price of 850 (Q2). The majority of bids that were received were probably valuing the share at a max of 850. Hence, the IPO was priced at 850, not on the higher side. Again, it’s the market valuation that decided the price.
Third question – on the listing day, individuals started trading enthusiastically. The opening trade is 1 single trade, it can be for 1 single share or for a hundred thousand shares. So if someone was highly bullish on this stock, he started the trade at 1200. However, ultimately it’s the market that finally decide the fair value of the stock – so by the closing time, it was down 18% (988) and stayed there for a long period.

The market is HUGE – millions of market participants (individual traders, fund managers, market-makers, foreign investors and Individuals) trade and invest in the market. Trying to guess what the majority of them will do is nothing better than fooling yourself, as the size of the market is huge. Ultimately, the market price finally settles at the so called fair value as perceived by the majority of market participants. When you say XYZ is a good company and you will invest in it, it means that you believe that the majority of the market participants will also think the same way. Whether you are right or wrong, it’s a different issue altogether and comes as a later result.

Another example, Reliance stock was trading at a lowest level of 220 in September 2001. Today it has touched the highs of 1700, a straight profit of 675% over 6 year period. There were hundred of individuals, who bought this stock at 220 to 250 levels in 2001. However, majority of them sold their holdings in 2003, when the stock price touched 400 and above, making above 100% profit. The belief was that the stock will not appreciate further. However, the stock continued its run, and today it is at 675% profits. There were many individuals who booked profits halfway thinking that it was the highest price the stock could touch - just to notice that the stock has continued its bull run further. Despite the battle between Ambani Brothers, where the stock took severe hits, it managed to keep up the pace.
The question is: How many of the investors managed to benefit from the continuous profit from this stock? How many could perceive that this stock would give 675% returns despite the brother’s battle for control? The fact is, no body can predict anything. All people do is they take a bet in the market when they INVEST in a stock. If it goes well, they happily book profits – that too indecisive of the profit levels; otherwise the famous reason – “I am a long term investor, I invest for long term” – basically meaning I’m sitting on loss for my investment.

Looking at the above 2 examples, can we conclude that TCS is a Bad company for the initial period and Reliance is a Good company for the 2001-2007 period? Definitely Not. We have NO IDEA how a particular stock will perform – today, tomorrow, in one year, in 5 years, in 30 years, nobody is confident about anything. All people do it make BETS – nothing better than a monkey throwing several darts on a dartboard – occasionally, 1 or 2 darts hit the bulls-eye and the monkey feels happy. What it ignores is that there were many more no. of darts that missed the bulls-eye by a distance.

Let’s take this discussion further:
Can you name the first 3 companies in the following industries?
• Radio
• Television
• Rail
• Computer
• Airplane
• Internet
• Mobile

OK, may be naming first 3 is difficult, so can you try to name the first company of each of the above industry? Probably not.
The reason is that the pioneer companies for almost all the above industries did not survive for long. Either they collapsed due to mis-management or due to competition or due to other factors. Innovation CANNOT guarantee any success for anytime. Interestingly, all the above industries are the once which have transformed our lifestyles significantly – but yet, the pioneers inventing the technology, or trying to make business out of it, failed miserably.

If it was so easy to make 10/15/20% returns in the stock market, why is it that the Mutual Fund Managers don’t guarantee even a 1% return? Why is it that every advertisement for a Fund or investment comes with the tagline: “Mutual Fund investment are subject to market risks, please read the offer documents carefully before investing.”

The fact is that things work randomly, and in the investment industry – the word RANDOMNESS rules. We all become victims of RANDOMNESS, looking only at the success and survivors like the monkey mentioned above. One of my favourite expressions is “Everything is Random”. Right from the job that you’re doing, to the salary that you draw, to the money you spend, to the money you save – things happen randomly. You have very little control over how things will proceed in your own life – especially with respect to your success/failure and more particularly with respect to the finances that you have. More on randomness in a later article.

A request to all my audience: Some of the readers have placed request for forwarding the articles directly to their friends. Due to my busy schedule, I find it a bit difficult to take up such tasks. I request you to please ask you friends to visit this blog regularly. Thanks.

(2) Do equities (stocks) guarantee good returns even in the longer run?


Very often I hear this reason from people who trade in stock market – “I am a long term investor, as equities always give a better return in long term” OR “I do NOT trade in short term, I invest for long term – equities give better returns in long term”.

Most of the times, this kind of justification come from people who have bought a particular stock, and now the value of that stock has come down. Hence, they are sitting on unrealized loss on their trade. It’s human nature to justify their own deeds – either by an explanation or by a counter action. I usually hear the explanation as mentioned above, and I’m convinced that the person quoting the reason has made a loss on his trade.

An honest confession I want to make here is that some 2-3 years back, I was also one of these losers quoting similar reasons J

My colleague, whom I’ve talked about in my past article , also quoted the same reason for the loss-making stocks in his portfolio.


Having worked in the pension fund industry for some time after my finance studies, I could get the understanding of the dangers of this kind of long term strategy. Try this: Search on Google the following term (without quotes) - “UK pension fund problems” and you will see a list of articles coming up on the results page. One of these articles is published by BBC and comes as the first result (http://news.bbc.co.uk/2/hi/business/2082800.stm)

Read this article carefully, and you’ll find the main reason being quoted is as follows: “But the problem has been exacerbated in recent years by dwindling stock market returns.

This is the reason which is quite commonly quoted by the pensioners as well as the common man for the pension fund problems of UK. However, the reasons for pension fund crisis go beyond that. Let me demonstrate this with some historical real-time data instead of a hypothetical example. During this case-study, I’ll also refute two most commonly believed myths about the stock market.

Below is the graph that shows year-on-year average return on S&P 500 index (green bar graphs) and the red line indicates the risk-free 1 year bond return. (S&P index is US stock market equivalent for the Indian Sensex or Nifty). The graph is from 1975 to 2004:



Suppose that you believe in the commonly accepted principle: “Equities (Stocks) give better returns in long term” and you start investing in the equities market in the year 1975, thinking that in the long term you will make decent returns. This was what majority of the individuals did when they were working in 1975 and planning for their retirement, which was suppose to happen sometimes in 2003-04. Over the period 1975-2004, they regularly invested in equities following the same principle. However, at retirement, they found that most of their savings have gone down.

How??

Look closely at the green bar graphs for the period 2000 to 2004. The stock market has gone down consistently. This resulted in a total accumulated 60% loss on the stock holdings that people have been accumulating since 1975. Since they had to retire by 2004, they were relying on their “intelligent investment” in stocks. At retirement, they were not having any further scope to work and get salary – so they were forced to sell their holdings. All this resulted in a big mess for them, as their holdings had to be sold at the much lower market prices, due to the downfall of the stock market consistently for 4 years from 2000-2004.

This historical case demonstrated the dangers of investing in equities based upon the “long term better equity returns” concept. Remember, everything has a deadline – no investments can last or is secure forever. When you will need the money, you never know. Imagine how will you feel if have been saving your hard earned income continuously for last 30 years, and at the end when you’re about to retire you discover that the value of your savings has gone down drastically in the last 3 years of your investment period, and you’re left with only 40% of your money –rest 60% going in a loss?? This was the case with retirement planning investment, but the same can be extended to other similar situations as well –for e.g. Let’s say you just had a new born kid, and you started investing for 18-20 years period, so as to secure money for his costly college education (MBA/Doctor/Engineer), once your kid grows up. It is possible that you find that by the time you needed money, your stock holdings have come down in market value drastically.

This case refutes our first myth – the myth that equities (stocks) give better returns in long term.

Now let’s look at the red line which indicates the RISK FREE Bond returns (interest rates) for the same period 2000-2004. What do we see?

The returns from bonds have gone done consistently over this period. Also, we’ve already discussed that the returns from stocks have also gone down consistently. This refutes our second myth – the myth that bond returns (interest) and the stock market returns go in opposite directions – when one falls, the other rises and vice-versa. As it can be seen from the above graph, they both have gone down together, consistently for last 4 years.

In the beginning of this article, I’ve mentioned that the problems with Pensions funds were not just by the losses from the stock market. The additional reason being there were low returns from the bond market as well.

So, let’s not live under some false assumptions and commonly accepted principles. The case that I’ve presented in this article in NOT a hypothetical case, but it is what has happened in the past. Let us not believe that “This Cannot Happen” or “X is better in Short term and Y is better in the Long term”. Things happen randomly. Forget about the common man, even the highly sophisticated and educated financial investment managers and experts with decades of experience in the finance industry could not predict what we’ve seen in the period 2000-2004.

It’s risky - Play Safe, don’t get carried away by emotions.

(1) Are you really making money in the Stock Market Trading???

One of my colleagues in the office trades heavily using an online trading portal. He claims to have made a pretty good profit over the past few years consistently.

As a common young Indian, he also hails from a middle class family, has done his engineering from a XYZ college of Engineering, and learnt programming languages to a sufficient level which enabled him to take up a job at the offshore center of a US based MNC. He started working in 2001. Came across the knowledge and fantasies of the stock market business and started trading in 2002.

Today, he’s a happy man with more than 40 stocks in his portfolio – which he keeps switching every now and then, claims a staggering “self-calculated” profit of 50% and feels proud that he did not keep the money in the bank or tax-saving schemes, else he would have ended up with a mere 5-6% returns. His career path has gone well since he started working. He switched 3 jobs in last 5 years, getting a decent salary hike each time, and enough money for him to play around in the stock market.

His daily routine today includes the following schedule: Reach office in time (basically, when the market opens), place the orders; carry on the usual tasks of office while continuously refreshing the webpages of his online trading portal so as to “track” the market. Occasionally he walks through the office, so as to discuss with other like-headed “trader” colleagues - on what to buy, what to sell and what to hold on.

Situations like these are quite common in the IT industry. All “Smart-Alecs” are today having sufficient money to trade/invest in the stock market.

Let us begin the analysis of this gentleman for his trading activities over the duration of his investments. He started trading in early 2002. Today he is sitting on a smooth 50% profit for all his investments. If we assume that he has invested 1 Lakh rupees in the market over the period 2002 to 2007, then with a profit of 50%, he is having an equivalent of 1.5 Lakh Rs.

However, what has happened in the market over the same period? In early 2002, the stock market was down. The Sensex was at 3200 level. Today, it is smoothly sailing at 14,000 levels. The % increase in the market has been


(Final Value-Initial Value)

(14000 – 3200)



Profit =

--------------------------

------------------------

=

3.375 times or 337.5%


Initial Value

3200



Compare this to the profit margin made by the individual – its only 50% v/s 337.5%

In terms of percentages difference between Sensex and Individual Investment:


(337.5 – 50)



Profit =

------------------------

=

5.75 times or 575 %


50



What it means? This person is actually LAGGING behind the market by a whopping 575% or 5.75 times – and still he seems to be very happy with his decision of investing in the stock market.

Now, let’s consider some more investments:

Suppose that instead of investing the money in stocks, he had invested it in Tax-Saving Infrastructure bonds (usually issued by banks like ICICI/IDBI/others). Lowest amount of interest these bonds paid during the period 2002-2007 was 6%. These bonds come with a lock in period of 3 years.

So, if my colleague would have invested in these tax-saving bonds, that too at the LOWEST interest rate of 6% – he would have made a year on year profit of 6%, which amounts to 18% for 3 years (roughly 18% - though some time-value calculations will give a slightly different value – only a few decimal places different). Along with the interest, he would have also saved on his taxes – 30%. Hence, the total saving would have been 30 + 18 = 48%, that too in just 3 years as compared to his stock returns of 50% in 5 years. This amounts to a yearly average return of 48/3 = 16% per year from bonds, while a 50/5 = 10% return from the stock market.

So, what is the problem here??

Well, the problem here is in terms of understanding and measuring the risk and returns.

The above example clearly shows the difference in our valuation and understanding. The Bonds are RISK FREE, they don’t carry any major risk – but the Stocks carry a major risk that we do not realize. The market is going up by almost 3.5 times, and the person trading in the market feels happy for a mere 0.5 times. He feels happy with 10% average annual HIGH RISK return from Stocks, but he does not realize the benefit of 16% RISK FREE Return from bonds.

After explaining this mathematics to my colleague, I also asked him if he has considered the demat account charges and the brokerage he paid on the trades he made. His response was NO. If you take these charges into consideration, the profit for stock trading would come down further.

It is quite possible that some of you may have made a 100% returns, but that would still be much less than the market return of 375%.

The above REAL LIFE example demonstrates a simple and clear practical situation that every individual can find him in. The ignorance that we have in terms of calculating the profits/losses and in terms of understanding the method to see exactly what is going on with our money clearly indicates a dangerous situation.

The evaluation period for our case study was 2002-2007, when the market had gone up 3.5 times. Imagine what could have happened if the market had gone down, as it happened in 2000-2001 period. In the good period, no body can pick up shares to match the market performance, but in the bad period, everyone still looses more than what the market lost. This gentleman would have lost money on his trading and investments, and also paid heavily on the brokerage and demat account charges.

So to begin with, please make sure you know how to calculate the profit/loss on your trading and investment activities. Most of the brokers and online trading sites do NOT have the facility of “Portfolio Tracker”, where you can see your NET profit and loss. They probably want you to live under the false myth that you are making good money on your investments, so keep trading and keep paying them the brokerage. Some online portals have the portfolio tracker functionality, but individuals don’t know how to use it and how to extract useful information from it.

Here is a simple way to calculate your profit/loss

  1. Generate a list of all the trades that you made during your investment period
  2. For every pair of Buy and Sell for a particular stock, calculate the profit/loss after deducting the brokerage charges on both the Buy and Sell legs of the trades
  3. Take the sum of all the profits/loss so as to arrive at a NET value. From this net value, deduct the demat charges that you paid during the investment period. Let’s call it (a)
  4. Take the total amount of money that you invested (b). Calculate the profit % as (a)/(b)*100 – Let’s call it (c).
  5. Take the level of Sensex (or Nifty) on your 1st day of Investment period and last date of investment period.
  6. Take the % return for Sensex as shown in table above (d).
  7. Compare (c) & (d) – where do you stand???
  8. Also compare your returns (c) with the tax-saving risk free bond investments. – Did you perform better??

In next few articles, I’ll be talking about making efficient investments, so as to maximize profit and minimize risk/losses.

If you have any questions, do let me know. I’ll be happy to offer you advice and help. Please post your comments on this webpage with you Name and Email-id, so that I can respond to your query.


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