Cool advice: stay away when market’s hot
Sasidharan Pillai was in his early 30s. Young as far as age was concerned, but his investment habits were very similar to the way his grandfather operated.
He had never gone beyond investing in fixed deposits, public provident fund etc, anything that guaranteed him a fixed rate of return. After seeing his dad lose a substantial amount of money in the 1992 stockmarket scam, he decided to stay away from the stock market.
But now, times are changing. His girlfriend had managed to drive some sense into him. If he kept putting all his savings into fixed- income instruments, "when you retire", she said "you won't end up with enough money to support yourself". This logic clicked.
Pillai has now decided to have some amount of equity in his investment portfolio. But he was wondering where to start. With the markets touching a new high everyday, he was wondering which stocks he should avoid.
Pillai still remembered the economics he had studied in junior college. "Higher prices dampen demand and lower prices increase demand" was what the law of demand said. But when the stockmarket witnesses a bull run, investors do not behave like normal consumers. As the prices go up, the more stocks appeal to investors.
From this logic, Pillai concluded he should avoid the hottest stock in the hottest industry. As Peter Lynch and John Rothchild point out in their book, One Way Up On Wall Street, "hot stocks can go up fast, usually out of sight of any of the known landmarks of value, but since there's nothing but hope and thin air to support them, they fall just as quickly. If you aren't clever at selling hot stocks, you'll soon see your profits turn into losses, because when the price falls, it's not going to fall slowly, nor is it likely to stop at the level where you jumped on".
A good example of a hot stock in a hot industry phenomenon was Infosys. As Parag Parikh points out in his recent book Stocks to Riches, "the stock price shot up from around Rs 2,000 (Rs 10 paid- up) in January 1999 to around Rs 12,000 (Rs 5 paid-up) in March 2000.
Nothing spectacular had happened to the company to justify such a steep increase. But by the end of September 2000, the stock was down to Rs 7,000. Nothing had gone drastically wrong with the company either since March when it was quoted around Rs 12,000."
The market justified the increase in price on the ground that Infosys was growing at a rate of 100% annually. The foolishness of the entire logic is pointed out by Parikh. "In the financial year 2000, Infosys reported revenues of Rs 882 crore.
If we were to compound this figure at 85% annually for 10 years (as some people believed the growth would continue), then in 2010, Infosys would report revenues of a staggering Rs 4,14,176 crore. At that time, assuming a market capitalisation of 100 times revenues (similar to what Infosys was quoting at its peak), it would put Infosys' value at $9.2 trillion. The GDP of the US was around the same figure!"
Currently, retail seems to be the hot sector with valuations really going overboard. If prospects of any company or sector are phenomenal, then this will be a fine investment proposition next year, and even the year after that.
As Lynch and Rothschild point out, "Why not put off buying the stock until later, when the company has established a record? Wait for the earnings. You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later".
