Stock Market Investment: Some pitfalls

Source: Amran Hossain

My student Shaheen, who is very active in stock market investment, purchased some stocks by looking into their net asset values – NAVs  and lost money.  One day, he came to me and wanted to know the reason for the decline of prices of those stocks. I asked him whether he looked at the earning per share or EPS. He said yes, but he emphasized more on the NAVs. I told him, here you made the mistake.  In stock purchase, the EPS criterion should have more importance over NAVs. If EPS and NAVs both are in favour, the loss will be temporary, but if only NAV glitters but EPS is dismal, then relying on NAV is a folly.  I further explained to him that EPS gives you the current business position of the company, where NAV gives you the asset backing per share after the deduction of the liability. Now the assets may be active ones or idle ones. Idle assets which contribute nothing to the company profit also constitute NAV. Idle assets not only contribute nothing to the profit ratio but they also reduce it when depreciation charge is taken into account. Then Shaheen raised the issue of asset revaluation.  I told Shaheen that if assets are revalued, the NAV will go up, but it does not contribute to profit rise. EPS comes from the current activities of the company. If a company can combine its assets with the managerial skills and out do the rivals in the market place, EPS is expected to go up. A unique position, such as owning a famed brand, greatly helps the company to increase EPS. Overtime, many companies develop their own brands and they will be in a position to consolidate their positions against their rivals in the actual market place.  Shaheen wanted to know how to identify the potential growth oriented companies.  I told him, look for who are managing the company and what they did for the company in the last few years.  Remember cheaters cheat again and again, may be every time in a different way.  Also, do not believe everything that the company says.  Many local entrepreneurs give so called price sensitive information only to befool you or deceive the ordinary investors who do not know how to read things behind such news.  Then Shaheen asked me, how to know which stocks are over-valued and I told Shaheen, there is no one-measurement for knowing if a stock is overvalued. It all depends on the market condition and the company specifications.  At some point the whole market may become overvalued. Caution must be taken then. In other times, see whether the stocks you are buying are overvalued. No expert knows exactly the right price for a stock, but any price near the right price is alright.S ometimes p/e(x) (price-earning multiple) between 10 to 15 is fine, sometimes a higher ratio is also fine, sometimes a lower one.  No rigid p/e(x) will apply in every case.  You can buy the stock of a potential company at a higher p/e(x).  Many great investors pre-empt in stock buying, meaning that they buy at a higher p/e(x) given the market condition. The important thing you have to know is the potential stock or stock of the future.  Also, buy those stocks before other investors buy them.   Un-attended but potential stocks will give you above average return in the long-run.  Our market is small and rumors driven. Speculators, who are mostly gamblers, determine the tone of the market, but do not be the blind follower of those so called market trend setters. You can be the winner in one or two cases, but at the end you will lose out if you follow them.  Fundamentals mattered in the past, they matter now also and will matter in the future. Company fundamentals may change. You, as a stock investor, must know which items in the fundamentals are getting changed.  You can tolerate every other adverse change but not the inefficiency of the company.  Inefficient companies will eat up the money you left in the company or the so called reserves or retained earnings. Remember, if an efficient company retains a higher proportion or all of the profit as retained earning there will be reason to be unhappy. But when an inefficient management retains your profit there will be even more reasons to be unhappy. Do not buy that many stocks, a few good stocks will bring the boon for you and in the same way, a few mistakes will wreck you as an investor.

The author is a Professor of Economics, University of Dhaka.