How to take advantage of the short-sighted and over-reactive market to create long term wealth

How to take advantage of the short-sighted and over-reactive market to create long term wealth

Efficient market theory is one of the key theories of modern finance. Widely taught in all Ivy league universities, it says that it’s impossible to beat markets consistently as markets are super-efficient in capturing all the relevant and latest information and events Therefore no living mortal can achieve better returns than market consistently.

Many of the big investment gurus have scoffed at the efficiency of the market .

Warren buffet once said that “if markets were so efficient as the academicians would like us to believe , then I would have been a bum sitting with a tin cup”

Benjamin Graham(father of value investing and mentor to Warren) once said that “market was a voting machine in short term and weighing machine in long term”. That means markets are unpredictable in short term but eventually prices the value of the assets right in the long term.

He likened market to “manic depressive” guy who had frequent bouts of extreme mood swings and was either very ecstatic or depressed on a given day. He called the guy “Mr Market”. He taught his numerous disciples that if you get carried away by Mr.Market’s wild mood swings , you are doomed as an investor. However , if you learn to exploit his mood swings in a wise manner , you would be a winner.

Market by the nature of its participants is very short term focused (short-sighted)  and over-reactive as 95% of its participants(including FIIs, mutual funds, Institutional brokerages, brokers and retail investors) are focused on short term gains and trying to beat each other to the last penny or dime. Though the institutional investors and mutual funds speak of long term and safe investing (value investing), its only for lip service . Their actual track record and behavior on the market has been the opposite. Consequently, In short run, market is driven more by liquidity, sentiments and momentum and less by fundamentals, though it eventually catches up with reality or fundamentals in long run.

This short term mentality and over-reactiveness of the market  is a big boon or blessing for the value investors like us who wait for such market madness when market over-reacts to a temporary bad news and hammers a fundamentally strong business ‘s stock, making it available at a mouth watering discounted price.. I am going to give 2 short case studies which recently happened in Indian markets to illustrate my point.

Rural Electricity corporation(REC) – It’s a public sector company which is focused on providing loans to the power sector projects(in generation, transmission and distribution sectors), predominantly to central and state govt. agencies, mainly in rural / semi urban areas.  It has an amazingly consistent operating history with fantastic return on equity and profitability track record. Its ROE(Retun on equity) at 23% , is better than private banks. Its NIM(Net Interest margin) @5% and  ROA(Return on Assets)  @3.5% is at world class levels and better than any private bank/NBFC in India. Its NPA(Non-performing Assets or bad loans) is at 0.7%(<1%) of its loan book , again at par with the best in India . EPS growth in last 5 to 10 years has been >22 percent consistently. Yet it’s hovering around an un-believable PE (Price to earning ratio)of 6 at a price of 300 Rs.  Recently , the stock was hammered down by 15-20% to Rs 250 , after the coal block cancellations , though its loan portfolio was not significantly hit by those cancellations.

Reason/ rationale of the market for this glaring mis-pricing is that the business belongs to power sector  and hence it could be hit with NPAs due to delayed execution of projects, delayed approvals, land acquisitions, SEB (state electricity board) mess etc. I could not believe this because of its excellent NPA track record and did some research . I discovered that 85% of its loan portfolio is with central and state govt. projects with payments guaranteed and protected by central government. Remaining 15% of project portfolio is with private companies in which only 2 accounts  are in stress which amounts to < Rs 2000  crores which is 1.3 % of its loan book. NPA after restructuring and provisions is at 0.7%. With the focus on power sector and coal reforms , this track record is only going to improve with the company not expecting any more fresh NPA slippages.  On top of this gross under-valuation , market further hammered it down a month ago due to coal block cancellations, along with other banks which good exposure to power sector , though its portfolio was not significantly impacted by the cancellations. I couldn’t believe my luck and loaded as much money as I could in the stock(selling  few other not so attractively priced stocks in my portfolio to generate more cash to invest) to make this business/ stock as my single biggest stock in terms of value in my portfolio. Market , realizing its own mistake has appreciated the stock back to Rs 300 in last few weeks.  At Rs 300, am still buying as this stock is easily going to go above Rs 400 in 6-12 months(giving me >30% returns from this level) because of its strong business fundamentals (growth/ profitability track record) and will continue to grow at 15-20% per year for many more years. The stock has already given me 37% returns this year. With govt. focusing on electrifying all villages by 2016 . demand for its services is only going to improve.

HCL Technology – HCL Tech along with TCS has the most consistent growth and profitability track record among Indian IT firms in last 5-10 years. Its ROE has been @33%(5 year average) and shown a growth of sales @35% and profit @48% for last 3 years CAGR. Its available at a very reasonable PE of 18 and price of Rs 1610 for this kind of return on capital and growth. Over and above that it was hammered very badly by 15% last month by an over-reactive and short-sighted market . It was hammered from 1753 to 1480 , just because it missed its market’s revenue estimate by $20 Million(Rs 100 crore), though it met the market expectations on net profit. Now $20 Million is just 0.5% of annual revenue of the company. Now missing revenue estimates by 0.5% of total annual revenue , the market hammered it down by 15% as if there was no tomorrow , despite growing at a decent level and meeting  market estimates on profit. I couldn’t believe my luck and again invested as much as I could in the falling stock. The market since then has partially realized its mistake and gone upto 1610 Rs. I continue to invest in the stock for long term as I know it will easily exceed Rs 2000 in 9-12 months (giving me 25-30% returns from this level )and continue to grow at 15-20 percent after that for many more years. The stock has already given me about 30% returns this year.

So , in summary, market in its myopic moments sometimes provides mouthwatering opportunities to load up  your favorite business/ stock due to temporary bad news. When you get those sitting ducks , load up your gun with as much bullets(cash) as possible and fire. These temporary bad news could happen due to primarily three kinds of situation – Individual business calamity , sector recession/ issue or market correction/ panic selling.  Once you are convinced that these individual or sector or market calamities are correctable, controllable and temporary in nature and that the market has over-reacted, there is no looking back on loading your favorite stocks which have been hammered down .

Good examples of Individual business short term calamites have been given in the HCL and REC case studies. Example for sector recession or calamity could be Banking sector in 2013 when even fundamentally strong banks in private and public sector like Axis bank and Bank of Baroda were available at PE of 10 and 6 respectively, through their ROE, growth records and NPA were decent compared to their peers in private and PSU banks. Market likes to paint all the businesses or stocks with the same broad brush in bad times, generating great value opportunities for us . I loaded up on these stocks like hell and they gave me 84% and 54% returns Year till date and still growing fast. Example for market correction or short term panic selling is when we got rumors of US Fed reducing its Quantum easing (Bond buying program) or when we had sovereign debt crisis in Europe in 2013.

Hopefully , you will find this article  useful and productive. I always wait for temporary bad news events and react with happiness and glee when we have one, as its time to act for me when people are over-reacting and panicking on these events.

Warren once said “Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised by the market”

Happy investing

Cheers

Amar

I am an IIM Bangalore Alumnus & NIT Allahabad Engineering graduate with 18 years of global experience into service and outsourcing industry. Value Investing has been one of my passions for last 8 years.

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