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MYTHS ABOUT STOCK MARKET - (PART 2)

We discussed some general myths in the last article. Here we will discuss some valuation related and some risk related myths.

Valuation Related Myths

  • Fallen Angels will Go Back Up, Eventually

    Many investors pick stocks that have done well in the past but have fallen drastically at present, in the hope that it will again reach its high levels. Nothing is more destructive to amateur investors than thinking that a stock trading near a 52-week low is a good buy. This can be explained with an example. Suppose there are 2 stocks

    • Share price of X reached an all-time high last year of Rs 500 but has fallen to Rs 100 since

    • Share price of Y, a smaller company, has recently gone up from Rs 50 to Rs 100

    All things being equal, majority of investors choose X over Y because they believe that X will go back to its high levels. This is a grave mistake in investing. Price is only one part of the investing equation. The goal is to buy good stocks at a reasonable price. Buying companies solely because their market price has fallen will get you nowhere. Do not confuse this practice with value investing, which is buying high-quality companies that are undervalued by the market.

    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.

    Similarly, IVRCL made a new 52-week low in 2010 by breaking the Rs 140 level. On November 17, 2015, it was trading at Rs 8.70.

  • Stocks that Go Up must Come Down

    The law of gravity does not apply to stock market. There is no force that will pull down a stock price if it has risen. Many shares have broken their 52-week high year on year.

    This however, does not mean that a stock never undergoes correction. The entire idea is that the stock and its price is reflection of a company, and if you find a great company run by excellent managers there is no reason to believe that the stock will not keep going up.

    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 2015, it made a peak of Rs 979.

  • Growth Beats Value

    Strong revenue and earnings growth draws attention of the investors. Such growth makes for great news and everybody likes a winning stock. Therefore, it only is expected that soaring growth should lead to increase in stock prices.

    However, the past has shown that value stocks have given more return than growth stocks. There is a very simple reason why value works better than growth. Expectations tend to be higher for growth stocks and higher expectations lead to more opportunity for disappointment (similar to the myth- The Best Companies Make the Best Stocks).  When a company is doing well, investors expect it to continue doing well. As strong rates of revenue and earnings growth are sustained, more investors buy the stock and the valuation rises. Eventually, the company reports sales and earnings that don’t meet expectations and the stock price plunges. It doesn’t matter how strong the actual rate of growth is; if the rate of growth is slower than what investors were expecting, the stock’s price will fall.

  • Price-to-earnings ratios are the perfect measure of a stock’s value

    P/E ratios are very important and useful ratio to value a business. However, they are neither a perfect measure nor a magic shortcut to stock picking.

    High P/E ratio suggests that investors are expecting higher earnings growth in the future; however a stock can have high P/E even when their EPS is low. Similarly, low P/E can suggest that the stock is undervalued and it can also mean that the stock does not have potential to grow further.

    This busts another myth that stocks trading at low earnings multiple are both cheap and safe. But P/E needs to be followed along with other parameters like debt-to-equity ratio, price-to-book value and market cap.

    No single measure tells you everything you need to know.

    Among the BSE-listed 4,000 stocks, 239 were at PE ratios of between 8 and 16 on February 28, 2014. 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.

    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.

  • Large-Cap Stocks Are The Only Option

    The media focuses more on large stocks because they are the most widely held and are familiar companies. However, there are many stocks outside the large cap index that can make good investments. Also, as you go down in company size, the potential returns go higher.

    Smaller companies tend to be overlooked more, and therefore their stocks have a greater chance of being underpriced. But we also have to understand that smaller-cap stocks are subject to more price volatility and will have lower levels of trading volume, so there is a trade-off for the higher level of returns.

  • It’s Easier For A Low-Priced Stock To Double In Value

    A low priced stock requires lesser increase in absolute value to double than a high priced stock. A stock trading at Rs 50 will double if the price rises by Rs 50. However, if a stock is trading at Rs 300 it will double if its price increases by Rs 300 which is difficult to achieve than Rs 50. So it’s easier to make money on Rs 50 stock. Right?

    Wrong. The basic investing concept is, in order for a stock price to double in value, the company’s entire market capitalization also has to double in value (assuming no change in the number of shares outstanding).This is because market capitalization—the value of the entire company—is determined by multiplying the number of shares outstanding by the current share price. This simple formula explains why it doesn’t matter if a stock trades for Rs 50 or Rs 300; investors have to believe the entire company is worth twice as much as its current value in order for a stock’s price to double.

Risk Related Myths

  • Investing in Stocks is Equivalent to Gambling

    The reference of gambling given to investing in stock markets leads to people staying away from it. To understand the difference between ‘investing in stocks’ and ‘gambling’, it is important to fully understand what buying a stock denotes. When you buy a common stock, you actually own a part of the company which entitles you a claim on the assets as well as a fraction of the profits.

    The stock prices fluctuate, because the investors are constantly trying to assess the value of the company which isn’t an easy task. The outlook of business conditions and also company’s future earnings are constantly changing. There are so many variables involved in determining the value of the company that short term price movements may appear to be random. However, over the long term, the company should be worth the present value of the profits it will make. In the short term, a company can survive without profits on the expectations of future earnings; however, eventually a company"s stock price is expected to show the true value of the firm.

    Gambling, on the contrary, is a zero-sum game. It merely takes money from a loser and gives it to a winner. No value is created. However, by investing, we increase the overall wealth of an economy. As companies compete, they increase productivity and develop products that can make our lives better. Hence, we cannot confuse investing and creating wealth with gambling"s zero-sum game.

  • The Best Way To Minimize Risk Is To Diversify Investments And Hold For The Long Term

    This is an advice for people who are ignorant about investing basics; if you are not sure about the worth of a business, you will have to diversify to protect yourself from your limited knowledge. But the truth about real investing is quite different; almost no great investors diversify.

    Warren Buffett’s portfolio of over $100 billion is focused on just about 10 stocks. As Buffett said, diversification is for the ignorant. The right way to invest is to get an inch wide, mile deep, stick to it and own maybe 5 to 10 great companies.

    Risk comes from not knowing the business and not by not diversifying. The concept of holding long term is good, but when things change in the long run the investments needs to be changed as well. Holding a bad company long term is a recipe for a disaster and will convince any ignorant investor that diversification is the answer.

    But the real answer is to only invest in what you understand and only when it’s on sale. If you do that, essentially you’re buying Rs 500 worth of things for Rs 300. If you can do that, diversification is a waste of time and likely to lower your returns.

  • Penny Stocks are so Cheap that they can make a Person Rich Overnight.

    There are a number of penny stocks which have made investors rich. For example, Core Education & Technologies, which was trading at Rs 0.12 on 1 March 2004, rose 122 times in 10 years; it touched Rs 14.44 on March 3 this year. 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. Probabilities of huge profits usually come with even bigger probabilities of suffering losses. Hence, it is best for a risk-averse investor to avoid these stocks. However, if the investor has the risk appetite, he must understand the company"s financials and the risks involved and decide the time 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.

    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.

    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.

  • Young People Can Afford To Take High Risk

    Of all the myths in the market, this may be the cruellest and the most foolish. Everyone knows that the elderly are not supposed to take risks. They must be very conservative because their earnings power is limited. They can"t afford to lose their money. But who decided that young people could afford to lose their money?

    If any group needed to watch every penny, it"s the young. They need money to start a family, buy a house, buy furniture, save for the future and on and on. Furthermore, young people usually are at the low end of the earnings scale. They have precious little disposable income.

    Young people have an invaluable asset on their side, however, that is ‘Time’. They don"t need to take risk. They can invest in tried and true companies that make money year in and year out. At 10% per year growth, their investments will double every seven years. By the time baby is off to college that initial safe investment has increased by a factor of eight.

    When you have time, you can afford patience. Patience pays off in the market.

  • You Must Assume High Risks To Make Good Money In The Stock Market

    Many investors shy away from the stock market because they fear they will lose their hard earned money. And this is not baseless, as stories of investors losing substantial sums of money in the market is common and wide spread. Along with this, various scams, crash of the market, etc have also contributed to the casino image associated with stock investing. 

    This is very unfortunate because stock investing is one of the best ways the average person has of accumulating substantial wealth. It just requires a few simple techniques and some discipline. In fact, it can be a lot safer than investing in real estate, collectibles, or your own business. Stocks with consistent, predictable earnings growth are the safest stocks you can buy. 

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