Investment Strategy

Investment Strategy

Red flags

A guide to spotting trouble before taking the plunge into the equity market

An investor buying a house does a lot of research and bargains with the developer to get the best price. However, an investor buying shares does not even spend half the time scrutinising the financials of the company. The reason is the size of the investment.

As matter of fact, this is one of the major reasons for the woes of the small and retail investors in the stock market. This phenomenon can be termed as the side-effect of micro trading. Due to dematerialization, investors can buy even one share. Small individual investors can be seen buying huge quantities of shares trading in single digits.

If the investor divides his investment over several stocks, he becomes even more negligent about due diligence. The end story is that the investor’s gain or loss becomes a game of probability. The equity market is like a lottery for such investors.

A market correction results in erosion of the wealth of such investors. They then walk away, never to return, cursing their luck. However, at the heart of the problem is lax due diligence.

The S&P BSE Sensex touched an all-time highs in March 2015, while the S&P BSE Mid-Cap and Small-Cap indices reported historic highs in April 2015. Over the last year, the Sensex has scaled new peaks at regular intervals. Besides, the rally is broad-based, except for a handful of sectors.

The market mood is far from being termed as madness. Valuations based on price to earnings (P/E) ratio continue to remain close to historical averages. At present, the Sensex is at a P/E of 22.1. Going forward, the Sensex may scale greater heights if the government manages to deliver on promised reforms, prices of crude oil remains subdued, stability is established in Europe and the US Federal Reserve opts for gradual and snail-paced hikes in interest rates.

Investors should tread cautiously in the present market conditions. Whatever may be the corpus available for investment, due diligence should be thorough. If investors have no time for in-depth study of stocks, the mutual fund route to equities is a better option. Other alternative is to stick to frontline large caps about which plenty of information is available. Ideally, investors should have an exhaustive check-list to explore stocks for investment. The list should be referred to on a regular basis while scanning companies for investment.

Stay away from penny stocks. Generally, stocks trading below their face or par values are termed as penny stocks. As these stocks are available in single digits or lowly double digits, small investors are attracted to them. Certainly, this is recipe for self destruction. Investors should care for quality rather than quantity while exploring stocks to make fortune. Buy less but buy quality is the crucial takeaway.

Of the 2,918 stocks that traded on 7 July 2015, 127 were priced less than Re 1. Another 551 were available in single digits, that is, between Re 1 and less than Rs 10.

Avoid T and Z group stocks. Delivery of stocks is compulsory while buying or selling stocks clubbed in the T group by stock exchanges as part of surveillance measure. Intra-day trades are not permitted in the T group stocks. This is essential to curb market abuse and manipulation. The Z group companies are those that have failed to comply with the listing requirement or to resolve investor complaints. There are over 1,000 companies classified under the T category and 1,400 companies under the Z group on the BSE.

Low promoters’ equity stake is another red flag. In India, there are only a handful of professionally-managed companies with nil or negligible promoter holding. The promoter holding and the interest of promoters in a company are directly co-related. Thus, as a rule of thumb, higher the promoter holding, better are the chances that the promoters will take interest in the functioning of the company. Otherwise, these companies could be used for all sorts of illicit activities such as manipulation and money laundering. This is particularly true of small-cap companies (see box: Regulatory rap).

Consistently low delivery volumes despite surge in trading volumes and/ or share price could point to speculative interest in a stock. Also, such stocks could be subject to price rigging and manipulation. Low trading volumes with a sharp surge in the share price is another key indication of manipulation. A stock hitting upper or lower circuits for several consecutive sessions could signify market abuse. Also, wild swings in the volume could be owing to presence of operators at the counter.

No institutional presence for a prolonged period of three or five years or even more is a warning sign. Here, institutional investors refer to mutual funds, insurance companies, private equity, wealth management firms and sovereign funds.

Mutual funds strictly avoid penny stocks. Also, institutional investors stay away from companies with dubious track record of corporate governance. In fact, there are a number of mid caps with no mutual fund holdings. One of the reasons could be of past sins haunting the stock. Institutional investors have long memory compared with retail investors.

Absence of institutional investors in companies with reasonable size of turnover, profit or market capitalization may not be just a warning. It could be a cess pool for small and retail investors. There are 129 firms with turnover exceeding Rs 1000 crore in the latest financial year but without mutual fund holdings. There are many loss-making companies reeling under debt in this long list.

However, this should not be taken as mutual funds staying away due to for poor financials. There are 420 companies that have reported profit in excess of Rs 5 crore in the latest financial year. Mutual funds have no holdings in 75 companies with market capitalization of over Rs 1000 crore. In all, there could be significant reasons for mutual funds to stay clear of certain reasonably big companies.

However, this is not a hard and fast rule because institutional investors could stay away from certain small-cap for technical reasons. For instance, mutual funds prefer liquid stocks where entry and exit is easy and, thus, avoid stocks with low trading volumes, which could be owing to a smaller equity base.

Basic documents should be available with ease including annual reports, quarterly results and the shareholding pattern. This information is filed by companies with the stock exchanges. A significant delay in submitting annual reports and quarterly results should be treated as a danger sign.

Next, investors must glance through the statutory auditors’ report and annexure to the audit report. Any adverse comments, observations and qualifications should be taken into consideration while exploring stocks for investments. The audit reports can provide valuable insights and could reveal the real picture. A frequent change in statutory auditors could be a sign of trouble. In such cases, statutory auditors may not have been comfortable with the management and, thus, could have put in their papers.

Healthy financials with track record of consistent profitability but no dividends could be an indication of weak health. Worse, the books of accounts could be manipulated to attract gullible investors. Investors could find companies paying token or nominal dividends to draw a picture of robust health. In such cases, investors should check the cash flow statements, with focus on the operating cash flows.

To put things in perspective, there are 649 companies that have reported profit in each of the last three financial years but have not paid any dividend in this period. Of these, 255 firms are trading in single digits. Moreover, 391 companies have market capitalization of less than 25 crore. Is something fishy about these stocks?

Unnecessary corporate actions should be a cause of concern. Corporate actions could be merely for creating hype around the stock and push the prices to the upper levels. These corporate actions could be de-mergers, stock-split and bonus issues.

There is no reason for a stock trading in double digits or low triple digits to go for stock-splits. Further, announcing and issuing bonus shares without adequate reserves and profitability could be to boost the stocks price. Bonus issue in reality is akin to a stock-split. Despite this fact, many individual investors get excited when bonus issues are announced.

The seemingly beneficial de-merger of a small company splitting its businesses into two and offering shares of new companies could attract investors in hoard. But why should a small company go for a de-merger? This could be a trap to deceive investors.

Avoid unsolicited advice on stocks or so called tips via SMS (short messaging service). The web and SMS have emerged as an inexpensive means of spreading information among investors. Technology has its own pros and cons. Stock market regulator Securities and Exchange Board of India (Sebi) has came down heavily on the business of spreading tips via SMS. Though the volume of SMS has come down, the business of providing tips continues on the Internet.

Companies with limited trading history should be avoided. Largely, these are firms that have raised funds in recent past through initial public offering. Such stocks require greater attention and scrutiny. Such companies carry higher risk as the management and their credentials are still not established in the market. Street-smart promoters raising money from the market and siphoning it for other activities is not uncommon. With the market at an all-time high, the primary market could bounce back to life. If this scenario emerges, the credentials of promoters should be examined thoroughly.

Companies with consistent trading record over the years should be preferred. Companies that are compulsory de-listed or suspended from trading during intermediate periods should be avoided.

Next, pledging of shares by promoters is not an encouraging sign. The promoters could be trading in their own stocks by using their shares as collaterals. It is in the interest of the promoters to keep their companies healthy to avoid offloading of pledged shares by the lenders. Clearly, there is a conflict of interest at play. This is because promoters will make every attempt to keep stocks at elevated levels by means fair or foul.

Abnormally low valuation could be a honey trap for investors. There are 531 companies with price to book value (BV) of 0.33 or lower. This means these companies are available at one-third of their BVs or even less. Why are these companies trading at such dismal valuations? Of these 531 stocks, 388, or 73%, are trading in single digit, a danger zone. Ideally, investors should avoid temptation to explore their dream stocks in the midst of scrap. Quality comes at a price.

Also, investors can check certain alert ratios such as price to sales ratio, which is determined as market capitalization upon turnover. An abnormally high ratio is a clear pointer to trouble. Among the T group stocks, there are three companies with price to sales ratio in excess of 500. Invariably, this means each rupee of sales is valued at 500 times! Further, there are nine stocks trading in single digit, with price to sales ratio exceeding 100.

Similarly, companies trading in single digit or lowly double digits and commanding an abnormally high premium over their BVs could indicate manipulation.

Companies can even create artificial price benchmarks that innocent investors will take for granted. This factor is difficult to discover. Intelligent promoters of small-cap companies go for preferential allotment at higher prices compared with the prevailing market prices to artificially create higher price benchmark.


SOURCE: CAPITAL MARKET