You have got richer with the knowledge that owning a share means owning a part of a company. You are aware now that investing in equities helps preserve and enhance the process of wealth generation. You have also learnt that investing in equities is not all only about quick and easy money. ‘Khel Risky Hai’. We then discussed how it was possible to make the ‘Khel’ becomes less risky for you. We discussed how to tame that monster called Risk. You’ve learnt about the basic tools in an analyst’s armoury—PE, RONW, ROCE, Enterprise Value…
Welcome to the World of the Informed Investor. You are now armed with the knowledge of why equities are important and how to value them. It’s time we went into overdrive. You are now aware of how to value a stock, but while it all seemed like an intelligent science so far, very often the stock market seems like a mad place.
Is the stock market like the vegetable market?
Well, the answer is NO. In a vegetable market, there are several links in the chain. The farmer, who grows the vegetables, is the primary seller. But he cannot reach us, the primary consumers, directly. Between the farmer and us are several middlemen, each one with his own cut. The farmer has no idea of the price the consumers (that’s us) are willing to pay and we have no idea of the price at which the producer is willing to sell.
What about the market for soaps? Is it any different? To an extent, yes. HLL produces ‘Lifebuoy’. But before the product reaches you, it passes through the vast network of wholesalers, dealers, stockists, and retailers. Each one pays a different price before passing it down the chain. However, in this case the producer does set a final price that you would pay. But you do not have the option to bypass the chain.
Stockmarket operates at the speed of light
The stock market is different. Everybody, starting from YOU to the research analyst, the company insider, the mutual fund, the FII and the trader/operator, participates in the same market . Small wonder that the market works at the speed of light. In the vegetable market, due to the presence of several intermediaries, price responds with a lag to information and events. For instance, if there is a sudden spurt in the demand for apples, prices will not shoot up immediately. The information will travel back to the farmer and if there is a shortage, prices will eventually spiral. In the stock market, price discovery is instantaneous. Information and events are known immediately given that all market participants congregate at one place or on one seamless network.
The stock exchange
The stock exchange is where all participants converge to determine the price of the product, that is, shares. Ownership of a share indicates ownership of a certain proportion in a company. Imagine a world without shares—it would be virtually impossible to create a business and then be able to realise value for it. Shares enable you to separate ownership from management and allow businesses to be traded in pieces without forcing the company/business itself to be broken down. To the outside observer and even to market participants, the stock market often seems to be a place where no logic works and only madness prevails. But as you continue along this voyage into the world of equities, we hope to convince you otherwise.
Only fundamentals work in the long term
At the end of the day, it is the fundamentals which determine the prices. Every investor must understand that the fundamental factors which market prices reflect are the sum total of perceptions of all the investors. A seminal work in this context is the “Rational expectations theory”. Shares prices discount the future, and only the variability of the outcome drives prices.
For instance, the market expects Tisco to announce a profit of Rs100cr. If the profit turns out to be Rs110cr, the market will react positively, driving up the stock price. The opposite would happen if the profit is Rs90cr. Nobody in this world knows what would happen tomorrow and, therefore, markets are perfect only to the extent of available facts and information. Markets can never be perfect with regard to their expectations of the future.
Many times, company insiders would have information about a particular event and their activity may make the stock price move towards a level it would have attained if the event was known in the market. This again is not knowledge of the future but knowledge of an event that has already happened.
However, this information is restricted to only a few people and, from that point of view, it is a past event for the insiders and a future event for others (investors please note that insider trading is a culpable offence in India and other countries). Investors active in the stock market have to look at market-sensitive factors. It can significantly enhance your returns on investment if you carefully play these factors.
Isn’t it all just about money power?
The rules of demand and supply apply to the stock market just like in any other market. At the end of the day, the price of a stock moves up only if the demand from buyers is more than the supply. Therefore, in the short term market participants with huge money power can significantly impact the demand-supply equation and hence prices. Who are the market participants? Literally everybody—the institutions (FIIs, FIs, Mutual Funds, Banks, Corporates), retail investors (You and Me) and speculators & traders. So sure, sometimes it does appear that it is just those few mega speculators or FIIs who are the only ones driving prices. But the market is bigger than just one or 2 of the big boys. Consider: between September 1994 and October 1998 the supposedly big money FIIs pumped in US$6.1bn into the market, but it went nowhere. The reason: without fundamentals, the money power is worth nothing. And while your 100 shares of Cadbury might seem like nothing, think of millions of investors like yourself, all over the country, and that is quite some firepower.
What contributes to the mood swings
Each of them has a different risk profile, return expectation and time horizon for their investments. Very often, each of them also has different levels of information. So the investor who happens to be a shopkeeper may know ahead of most others that Cadbury’s new ‘Perk’ variant is taking the pants off the competition.The fact that the stock market is a congregation of people with such different characteristics often results in wild mood swings. There is the retail investor who might be selling because he wants to raise money for his son’s marriage (these days that happens too, you know). But there is also the retail investor who is squirreling away his savings for the day when he retires and might not have a regular source of income. There is the FII who is buying because Asia is suddenly the hottest market in the world. And there could also be the FI who is buying to support the market under government instructions. Add to it the speculator who has a very short-term horizon—he knows that Badla rates this weekend are going to be high and therefore the market could head lower by the closing today. So, at any given moment, the market trend depends on which of the participants are in control.
Ignore the noise factor
What about events that receive a lot of attention—budgets, political uncertainty, duty hikes etc? Sure, they have an impact on the market. But what is their real impact on good businesses (read good companies)? At most times, it is too negligible to actually impact the long-term potential of a good business. But almost always, share prices will be super-sensitive to such factors. So learn to accept that the market is going to have its moods; but at the same time, learn to ignore them.
What makes this market unique
What makes the stock market so unique is that no matter who is selling or buying, there is always a person on the other side. In other words, when somebody is buying, at the same time somebody else is selling. That is logical, isn’t it? If everybody only always wanted to sell or only wanted to buy, then no trading would take place. Of course, trading does stop sometimes when artificial means like “circuit filters” are forced by the exchange. It is the liquidity of this market and the two-way exchange process that makes it unique. Can you take the vegetables back to the market and sell them? Well, in this market you can do the equivalent.
We hope this has helped you to understand better the dynamics of the marketplace—who are the participants and how prices are determined
