Learn From Masters, Avoid ‘Falling Knives’

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Learn From Masters, Avoid ‘Falling Knives’
Yagnesh Kansara - 13 August 2020

In 84 days during the height of the COVID-19 scare, when the global stock markets had tumbled and remained volatile, one company raised a stupendous `152,000 crore. India’s largest private sector company, Reliance Industries, sold almost a third stake in its mobile-Internet venture, Jio Platforms, to 13 institutional investors. These included two strategic partners (Google and Facebook), three sovereign wealth funds of Abu Dhabi, UAE and Saudi Arabia, and eight financial investors.

At the same time, some retail investors tried to chase a category of stocks dubbed as ‘Falling Knife’, which include shares that decline alarmingly in relatively short periods, especially during crises. The rationale to do so is that investors feel that they are hammered way below their intrinsic values and, hence, will bounce back to higher levels in the near future. What such unsuspecting investors don’t realise is that these are exactly the shares that are possibly offloaded by the institutions.

Both examples exemplify the power of the large influential investors to make or break stocks. In the first case, it showed how they honed in on a company, which wasn’t even listed, because they figured out its hidden value before the others did. In the second, they sold in hordes, and left the ailing babies in the hands of the small investors. Clearly, there are lessons that we can learn by studying the ways and investment patterns of the smart and intelligent institutional investors. Hence, it makes sense for the retail investors and individual day traders to keep a close watch on their larger counterparts, and closely monitor the latter’s investments. This data is published regularly, and provides a fair picture about the mood of the institutional investors. In addition, such information allows the range of market participants, including us, to gauge the changing sentiments in the stock market. Generally, the swings and sways of the indices and individual stocks are dictated by them.

 At a global level, says Venkatraghavan S, MD & Head ECM), Equirus Capital, the decisions of the large investors give a direction to the flow of money to specific geographies (like emerging markets), industries, and companies. At the local levels, they can nudge the broad trends in the national stock indices. “Stock markets (in India and elsewhere) are primarily driven by institutional money,” admits Devang Mehta, Head (Equity Advisory), Centrum Wealth Management.

The foreign investors have, historically, had a greater influence in India. This has changed over the past three decades. Consider what happened in the market in the first three week of July. Between July 1 and 19, the foreigners withdrew more than `9,000 crore from equities and debt markets. The BSE Sensex and Nifty still went up due to the sustained inflows from the domestic investors. During the above-mentioned period, the Sensex climbed by more than 2,500 points.

 Over the past several years, the ownership of Indian equities by the domestic institutions rose at a fast clip due to a consistent rise in SIPs, and a deeper shift towards financial savings by Indian investors. In fact, the ownership of stocks by foreigners, which was 2.2 times that of the domestic ones five years ago, has steadily come down to 1.4 times today. For the retail investors, this implies that they need to watch both these sets carefully, and not make overall assumptions. 

What is crucial is that institutions normally invest for the medium and long terms. Although the foreigners have panicked and dumped stocks in the past, they do take a longer view. The domestic institutions invest with a time horizon of 7-10 years, help channelise the savings of the retail investors, and thereby provide stability to stock movements, says S. Ranganathan, Head (Securities), LKP Securities. He adds, “They play a critical role in the financialisation of savings in the economy.”

 For the small investors, it becomes imperative to be on their toes when interest rates fall. High inflation can easily eat away the real yields from traditional products like fixed deposits and their variants. To generate greater alpha (rate of return in excess of the yield of peer products), one has to move towards mutual funds and direct equity. As institutional investors are adept at earning positive returns in such situations, the small investors can benefit from their actions and decisions.

The responsibility of institutional investors has another aspect that helps us. On the supply side, they (commercial Banks particularly) act as suppliers of credit to entities. They lend money they have pooled from account holders with the aim to generate returns in excess of what they pay in the form of interest. “If they fail in their fiduciary responsibility, they are in a soup. This resonates with the current situation of India’s public sector banks,” explains Ranganathan.

Retail investors don’t have the bandwidth to spend time on deep research. However, they can take advantage of the work done by institutional investors, and stay focused on the medium and long term outlook. As Venkatraghavan puts it, “Retail investors may inculcate this philosophy

without daily stock-watching.” In other words, we can make our decisions based on what institutions do, but we need not get boggled by short-term trends.

What is generally not understood is that institutional investors also add to the efficiency of the stock markets. One of the ways in which they do it is in the process of price discovery. This process looks at a number of tangible and intangible factors, which include supply and demand, investor risk attitudes, and the overall economic and geopolitical environment. This happens only because the institutional investors have conducted rigorous analysis of information that includes macroeconomic factors and geopolitical situation. The fact that these large investors have large funds and differential risk attitudes helps. 

According to Mehta, however, price discovery should not be confused with valuation.  “While price discovery is a market driven mechanism, valuation is a model driven one. Valuation is the present value of the presumed cash flows, interest rates, competitive analysis, technological changes both in place and envisioned, and many other factors”, he explains. The retail investor should always keep this in mind.  

Evidently, there are many things that the small investors can learn from the institutions. However, the most important one is to always remember the age-old maxim – action is overrated, patience is underrated. If you are into stocks for the long haul, just like most of the large investors, do not panic or get excited and sell good stocks to earn small profits. Hold on to them for as long as you can.

But when it comes to penny and junk stocks, do the opposite. Do not hold on to them in the hope that their prices will go up, and you will manage to get rid of them at breakeven levels. Instead, just junk them as soon as you can. And then, take a step back, take a deep breath, and pause for a bit. Invest whatever money you are left with in quality stocks. If you follow this practice you will compound your wealth, not your problems.


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