What is Stock Rigging?

Stock rigging is a phenomenon that attempts to pump up a company's stock price by floating favorable news about the company's earnings or future prospects. It actually encompasses a number of activities rather than just one. So say that if an individual with enough contacts in the markets and resources wants to rig a stock X. he will first spread positive rumors about the stock, such as a huge merger or FDI investment or great future growth numbers etc. Then he would use analysts as a medium to extend positive recommendations about the stock. In the process he would create speculation in the market and the stock price would shoot up. This individual can be a part of a cartel of investors, may be a promoter or some other entity.

This is why you would notice that there are certain stocks which only move on news or at the end of every quarter when strong numbers are posted or a positive guidance is set by the management of the company.

Making Sense of Chaos

Chaos Theory has more to do with mathematics and quantum calculations in particular than finance. But in spite of this, its relevance to the field of investments is very deep. Let us try and understand how Chaos Theory helps understand why markets are unsystematic, irrational and volatile but still manage to excite millions who try to predict its behavior. The basic interrelationship for Chaos Theory and finance lies in understanding its connection with Law of Large Numbers. Chaos Theory in Capital Markets states that the market behavior is guided by complete randomness or the absence of any order. This is because the theory sees the universe and everything in it as forces acting in a random and order-less manner and as such everything in the universe has to follow the same pattern.

Now if we relate this theory with the Law of Large Numbers then it states that any random occurrence with a large number of repetitions tends to move towards normal distribution. So over a large observation of occurrences the chaotic and random events tend to form a rational picture and eliminate and noise. But because for this rationale to be visible, the events required to be observed might be close to infinity, any predictions made to judge the outcome are never accurate. But this does not mean that they cannot be close to accurate or actual. This is the main reason why future predictions on stock prices and earnings of companies are never accurate but several times close to it. The accuracy largely depends on how many factors acting in the chaos chain have been considered in the prediction.

Now let’s come to the key point. Why are we talking about this? Try and understand that because predictions rest on the principles of chaos and law of large numbers, they should never be unrealistic, especially when a very small duration of time is considered. So when an analyst tells you that he predicts a stock providing 20% returns in 6 months, ask yourself a question whether the time span taken into consideration is enough to identify a close to accurate trend and the success rate banked on such limited a short duration is too optimistic or not? Now add to this the assumptions made in the model used and you will see that the analyst could be off the mark by much more than 20%. Here is something else you probably don’t know. The target price of a stock is provided to you based on some model that uses estimated future earnings and cash flows. Now in doing so, there are at least 5 assumptions used in any model. Statistically, by making 5 assumptions that are correct 95% of the times, the overall prediction can only be correct 77% of the time.

The long and short of the post is that Capital Markets should be used to take advantage of Market Cycles over a long period (Usually greater than 5 years). Whenever you enter the market for short term gains, statistically there is a 73% chance that you would not meet the prediction. How much the deviation from the prediction will be, depends on how many assumptions you have taken and how many of them are wrong.

Derivatives: Hedging or Speculation?

An interesting discussion on whether derivatives act as a means to hedge or a tool for speculation was partly left incomplete due to lack of time and hence I am taking this discussion forward here. The argument that hedging for many companies is a speculative medium though they try to portray it as a means to hedge their risk exposure is true if looked at from one school of thought. Take for example a company that has invested in bonds with a fixed interest feature. Now if the company enters into a derivatives contact to trade on interest earnings then one might arguably say that the company has no Price Risk or risk from Fair Market Value and hence is indulging in reckless risk exposure.

But there is another school of thought to this. Hedging is done to cancel out unwanted risk or pass it on to others so as to reduce the overall risk exposure. Now, whether one considers a derivative exposure as hedging or speculation depends on how one defines risk. Many analysts consider “Loss of Profit” as risk and hence advocate derivatives exposure to reduce Loss of Profit. Though it might seem that it is fueling speculation and I agree that it does to some extent, the objective with which one enters into derivatives exposure is not enough to decide whether it’s hedging or speculation. Rather it is how you define risk and what you consider as risk for yourself.

RIGHT Answer

A mundane topic turned interesting all of a sudden today when understanding Rights Issue sparked up a thought. In October 2008, three of the biggest names of Corporate India came out with a rights issue especially when the markets were not doing well. So were they stupid? I don’t think so. If one were to think that people running multimillion dollar businesses came out with a Rights Issue just because they needed the money, then probably one might be underestimating their expertise a little too much.
Investopedia defines Rights Issue as “Issuing rights to a company's existing shareholders to buy a proportional number of additional securities at a given price (usually at a discount) within a fixed period”.

So why did the companies come out with a rights issue despite knowing that the chances of it being a failure was very high. These aren’t your average mom n pop companies. We are talking about names such as Tata Motors and Chettinad Cements.

Rights issues are issues at a discount and this theoretically acts as an incentive for existing shareholders to buy the shares. But when times are bad and the markets are not doing well, investors might prefer staying away from additional investment in the markets and as a consequence not subscribe to the rights option they have. This in turn sends a bad signal to the market when existing shareholders are not willing to buy a stock and the stock might be sold as a result. So then why take the risk?

A rights issue tends to cost the company far less than a Follow On Public Offer and also gives the company an opportunity to test the pulse of the market. Companies also understand that existing investors work partly on emotion when buying the stock, especially when it has given them stable returns over a period of time. Even if the rights issue fails, it helps the company prevent the irreparable damage done from a failed FPO.

So if the company is planning to come out with an FPO in an year’s time or so and if the markets are not doing well, companies tend to go for a Rights Offer to gauge the market and accordingly plan for the FPO. This is the reason why one would see that companies with failed Rights Issues tend to come up with an FPO within the following 15 months.

Pump and Dump: Don't Fall for the Trap

The year 2008 was definitely not the best for most stocks and Penny Stocks are one of the worst hit. This post is to specifically warn my readers about a certain threat in 2009. Several large brokerages in India have lost millions in Penny stock holdings and I have come to know from my friends in the market that the year 2009 will witness widespread use of the Pump and Dump strategy to trap investors.

"Pump and Dump is a form of microcap fraud that involves artificially inflating the price of a stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price". (Source: Wikipedia)

So don't fall for a call or an e-mail by your broker this year if he claims to have some inside information on a stock or assures you very high short term returns. You just might fall victim to an oversold stock while your brokerage house mints money in the process.

Be Informed. Be Safe. Be Smart

The Ten Percent Rule

The Ten Percent Rule sees its application in various fields and in fact is tweaked based on where it finds its use. It has been used as a thumb rule from sports to investments.

Originally the rule came into existence based on empirical observations when it was seen that out of an action, objects or elements infused, only 10% would reach a pre-desired state and of these, only a further 10% would reach the ultimate desired state. Think of it as a reformed form of a principle similar to the 80/20 principle. It is a conservative but safe approach to investment and particularly applies to new forms of investment instruments or practices.

Let us try an understand it with the help of hypothetical example. Let us say that you invent a new form of investment instrument which tries to price speculation or emotions. As per the 10 Percent Rule, out of your target investors, only 10% would ever come to know about this and understand it and of these only 10% will actually invest in the instrument. This in other words means that only 1% of you all probable customers will actually invest. This rule does not state that this will happen every time, but the chances are that more often than not, this rule will apply to any new action infused into the world i.e. the success stories we talk about are the 1% which succeed after 99 previous failed attempts. Arguably a theory with a lot of limitations, but interesting nonetheless....

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Putting Elliott Wave Theory to the Test

When I found out about Elliott Wave Theory, I couldn't wait to put it to test and find out whether the theory actually holds good in practice or not. To put things in perspective, Elliott Wave Theory derives its argument from the concept of Mass Psychology, i.e. the general tendency of people to behave in a general way in the long run. For example say when we eat something spicy, the general tendency is to drink a lot of water while only a few probably go for a glass of juice or beer or something else.
The Elliott Wave Theory proposes that market prices unfold in specific patterns, which practitioners today call Elliott waves. The wave principle posits that collective investor psychology (or crowd psychology) moves from optimism to pessimism and back again. These swings create patterns, as evidenced in the price movements of a market at every degree of trend. (Source: Wikipedia)
To put the theory to test, I have picked the BSE 30 stocks and marked the Elliott Waves for each of their stock prices. Based on this, each of the stock prices should reach a certain bracket within the next 3 months. Whether it actually happens or not will tell us based on a probability study whether the principle holds good or not. The graph below for GMR explains the concept.

As per the Wave Theory, the next wave should be that of an upward trend or the "motive" wave. Based on this GMR should reach a price between Rs 95 and Rs 105 within the next 3 months. Similar would be the analysis for the BSE 30.


Lets wait and watch whether the Wave Theory actually works or not.....

Are Women Better Investors?

I know that I am exploring uncharted waters here but it's an interesting topic for a debate nonetheless. There are various theories about which gender is a better investor and a few suggest that women have better IQ than men because they use both hemispheres of the brain simultaneously.

Digital Look, a financial website did the study in which they found out that women balance risk in a portfolio better. On average, a portfolio managed by a women in the study gave returns of 17% whereas those managed by men gave 11%. As compared to these two, the Index gave a return of 12%, which means that the women outperformed the Index by 5%. The survey analyzed 1,00,000 portfolios and saw that men invested based on "fads" whereas women diversified the risk by investing in different classes of stocks.

Another survey by Merrill Lynch which interviewed 500 men and 500 women found that women make fewer mistakes in investing than men. But the study also found that they make the same mistakes and that accuracy of investments depended on their understanding of the market fundamentals and experience.

The Economics of Addiction

What addicts realize with time is that the habit they are addicted to seems to get more expensive by the day. An experimental adrenaline rush turns into a life dose before you realize it and the more you get high on it, the more you want it.

I am not talking about drugs, but something equally worse and effective. I am talking about the addiction to easy money...the easy money that an unfortunate few are lured by, until every last ounce of their energy and every penny they own is sucked by the markets. It might seem that I am exaggerating but when I talk about addicts here, I talk about the people who don't learn from their mistakes. They are ever so foolish and optimistic to gain. They start by loosing a few thousands and carry on until quite a few zeros are added to the number. Of course, in between there are a few moments of gain and glory.

Let me tell you about Arvind. He started in the markets are the age of 19 with a lucky sweep when he took back Rs 3000 in a day trade in Opto Circuits. Then it became a weekly affair and in less than 3 months he was skipping college to trade. He has in the past 1 and a half years lost close to Rs 137000 but is still adamant in trading. He says that investing for long term is a waste of money and though day trade is risky, the returns are higher and for him its worth the chance.

That's Economics of a Habit for you. It gets more expensive by the minute. A guy who is 34 today and would have started smoking 19 years back, would be paying 960% more for each cigarette today than when he started. Similarly a trader who used to trade 9 years back would lose 7 times as much as he would have lost when he started trading. The fact is that a very few people actually make money from intraday trades. I say this because I have seen a trader with over 40 years of experience lose more than Rs 20 lakhs on a good day. There are no guarantees and trading does not work on fundamentals.

Toxic Trading in ICICI Bank

Around 2:45 pm today, I got news from my friends at BSE that rumours were widespread about ICICI bank thinking of filing bankruptcy but the RBI not allowing it to do so. This was when Sensex had tanked by more than 280 points and Nifty was down by more than 90 points.
When i got the news confirmed, I was told that the rumour was injected on purpose by some traders are BSE so that ICICI stock gets slaughtered and can be bought at throwaway prices for short term gains. I must admit, I had heard about “toxic trading” but this is the first time I saw it in action. My source told me that the traders made more than Rs 37 lakhs per trade because of this and they entered the strategy in 3 phases. That means that these people took away more than Rs 1 crore by the close of the session at the expense of retail investors.

Toxic Trading is a strategy which is unethical in nature. In this, rumours, which act as toxic news, are spread in the market to adversely or positively impact the stock price of a company and trade on this in order to make short term gains. This works well when the stock in consideration already has some negative or positive event affecting it. This impact is multiplied by using such toxic news. Toxic Trading was possible today in ICICI on back of the news that it had exposure to Lehman Brothers and as a consequence of Lehman going bankrupt, it would book a huge loss.

What Not To Do When Investing

These were the 8 things an investor should not do while investing, as per a Ned Davis research:
1. Reacting to market fluctuations
2. Reacting to daily economic reports and news articles
3. Not buying during a downturn
Warren Buffett once said, “The best time to buy is when everyone is selling.”
4. Trying to time the market
Rick Willeford, M.B.A. and CPA/CFP, in Atlanta, says, "Market timing and day trading are for suckers.”
5. Changing investment strategy often
6. Not maintaining asset class suitable to one’s personal objectives

7. Not ploughing back profits booked

8. Investing for short term, expecting high gains

Investors lose more often not because a stock’s bad performance but because of short term objectives and trying to ride the market. The most fundamental rule in any form of investment is to invest for long term and assuming a 100% erosion of capital. This approach assumes that the money invested never existed and gains, if any, would occur only in the long run. It also suggests that profits booked should never be ploughed back in the market by a retail investor. However, it should be remembered that this approach only considers retail investors who invest small sums.

The Dummy Owner - Mr.Shareholder

"Shareholders are the legal owners of the firm and the management has a fiduciary obligation to act in their best interest".

Sounds great!! doesn't it? But experience has taught me that most of the rights the shareholders have are only on paper and that the management first acts in Self Interest and then probably in shareholder interest.

If shareholders were really the "owners" of the firm and could exercise the rights they think they have, then we would not have had instances like those of Enron, Tyco, Worldcom would not have occurred in US. Neither would have companies in India such as DCM Financial Services and Morepen Laboratories Limited faced investigations.

I was a shareholder of United Breweries Holdings, the holding company for UB Group which belongs to Vijay Mallya. One evening I got a letter in the mail for a voting consent for the company's future JV. It is usually a practice to take the consent of the majority of the shareholders for key decisions about big changes in the company which would impact the shareholder's wealth. It gives the company an idea about the shareholder's perspective and also whether they agree with the decision or not. After all -- they are supposed to be the "real owners".

I was eager to fill it up and mail it when a friend of mine who happens to be the owner of a big brokerage company in Kolkata told me that mailing or not mailing the letter will make no difference. He told me that even if a majority of the shareholders were against the decision, the company would put dummy votes to ensure that its decision goes through.

That made me realize for the first time, how "real" an owner I really was. Speak to brokers and experienced investors and they will tell you that such instances are not unheard of. It is very common and practical at times for companies to keep the investors in the dark. Most of them are not even aware of their rights when they hold the shares of a particular company. Information asymmetry is what gives these companies the "Power". Rest is just limited to your Financial Management books.

A Theory is called a Theory 'cause its a "Theory"

Try and think about all the possible investment theories you know of and then try and name at least one that is not based on assumptions (stupid ones at that) and has not been criticized by someone or the other.

That's where reality starts and authors undersigning such theories take a nap. Agreed that these theories form a firm foundation for an understanding of fundamentals but try and ask your investment advisor about the bearing of such theories on their investment decisions and they will tell you that most of the times, their best judgement overrides such theories.

I have nothing against the likes of Parot and Adam Smith but it's easy to wonder that if a third person could figure out stupid limitations to the application of their theories, being such great minds themselves, how the hell did they miss it?

I guess I will stick to the theories for the foundation bit of it only. For the rest of the structure I rather conform to what Warren Buffet says and does:

If someone suggests you a better way of doing something, first ask why he didn't do it himself?

Then ask why wasn't I able to do it?

Pour in your thoughts about theories. Do they guide you or does your brain?