Cometh the little guy, cometh the speculative froth

Tracking market froth. They say that a rising tide lifts all boats. That expression fails to incorporate an often hard denouement – Planetary gravitational forces ensure that high tides are followed by low ones and some of those boats crash if they weren’t judicious enough to avoid the change in current. That’s probably a fair analogy to describe asset price movements in liquid but inefficient price discovery markets, such as Indian equities, where speculative froth often drives companies with poor accounting clarity to lead bull-runs before cleaning up late-tothe-party momentum chasers. As our investors are aware, we closely track market’s speculative froth, because it acts as one of the key variables for us in determining optimal exposure level.

Our work across market cycles helps us better understand how heightened unsophisticated investor engagement influences speculative froth in Indian equities. To illustrate, we identified stocks which get flagged through forensic work (indicating poor earnings quality) and traded heavily (higher frequency than even widely held DJIA constituents) – These included names such as Delta Corp (nearly 13% of floated stock exchanged hands daily in F2011), Everonn Education (8% of float exchanged hands daily in F2008), Era Infra Engineering (8% of float exchanged hands daily during F2006 and F2007) etc. No other industry has featured more prominently in our work than Real Estate (see Exhibit 1), with Everonn Education and Indiabulls Real Estate being the two biggest names that got most flagged over the years. Our hypothesis was that serious investors wouldn’t aggressively trade in these securities, leaving chartists, “certain kind” of fundamental investors, and retail guys to drive volume. The most unsophisticated of momentum chasers among this bunch tend to begin viewing these names as great longterm buys, leading to increase in delivered positions. This is around the time that valuations recede from such over-bought situations (they either drift downwards in a sideways market or drop sharply on broader market declines). Our work suggested that high number of deliveries in such stocks, more often than not, precede sharp drops in broader markets. Our flagged names typically run ahead in mind-numbing bull runs (the average flagged constituent in our speculative universe was up nearly 45% in the first 2 months of 2012, 3x as much as the largecap benchmark), before cleaning out late momentum chasers in subsequent drops – Flagged stocks during each of the last five fiscal years underperformed the broader markets over any meaningful measurement period (See Exhibits 2a and 2b on next page). We view a dynamic basket of such names as a valuable indicator in assessing
market froth.

Unless these stocks are picked during market bottoms, they are likely to lose capital over time. Each equallyweighted basket of our flagged securities underperformed the broader markets, with 4 out of 5 losing substantial capital (compare Exhibit 2a with Exhibit 2b). The only time when such securities didn’t lose capital was when they were picked at market bottoms (notice the F2009 series in Exhibit 2a). However, even then, if investors held on to these stocks, they would have materially underperformed the benchmark.

The small guy had been nibbling again…….and deliveries in our flagged stocks are on the rise. After a prolonged absence, retail buying turned positive in second half of 2011, before receding again just as the market made its strong upside run in 1Q12 (see bottom part of Exhibit 3). While retail participation is nowhere near levels that one would view as ‘alarming’, deliveries in our flagged stocks have clearly been on the rise (see top part of Exhibit 3). However, deliveries in these stocks are still a few points away from levels that usually precede sharp drops in broader markets. Also, valuations are not (yet) unreasonable, even on singledigit reported earnings growth. All said, we appear to be at a point where we are unlikely to see sustainable broad based gains and are likely back in a market that will (hopefully) be partial towards effective bottom-up stock pickers and we hope to fully capitalize on the opportunity.

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Piyush Sharma, born and raised in India, is investment manager of the Globe Minerva Fund. Having spent time with Citigroup and Bombay Stock Exchange in India, he moved to United States in 2002, where he covered stocks within Business Services, Autos, Consumer Products and Financials with Sanford Bernstein, Longbow Research and Avondale Partners, working in teams that received accolades by leading institutional research arbiters , including Institutional Investor (II) and Greenwich Associates. Piyush received an MBA from University of North Carolina at Chapel Hill, MS from MNNIT, and BS in Accounting from University of Allahabad.  Piyush will be sharing his fundamental views periodically.