‘Financial Markets Are The Ones With Least Integrity’

In his new book, stock market guru Parag Parikh argues that investors should not seek returns in bearish markets. SHANTANU GUHA RAY finds out why

Fair Warning Parag Parikh feels that irrationality is an inherent characteristic of the stock market Photo: DEEPAK SALVI

You wrote that the financial services industry is a jungledevoid of ethics and all about money. Is that the reason you wrote the book?
Of all the professions or businesses the financial markets are the ones with least integrity, where the ruling ethos is how to make money from the other guy at any cost. That’s why we have so many scams. When it comes to money, greed dominates and this is what we saw in the last two years — different financial firms and banks went bankrupt and evaporated. Lehman Brothers, AIG, Merrill Lynch no longer exist today. It was greed which became their graveyard.

wrote the book to share my knowledge and experience of the capital and financial markets from the last 25 years, to empower the investor to make guided rational decisions. Investors need to be made aware that the so-called innovations of the financial markets are always against their interest. Take the case of derivatives – they are good hedging instruments but have been structured in ways people cannot understand. They are thus used as speculative instruments. The credit card, a great financial innovation for convenience, has been turned into a product which gets people into debts as they spend beyond their means and the issuers charge hefty interest, making themselves richer at the cost of their clients. Margin trading, loans against shares and IPO subscription make investors trade more than their capacity, ultimately violating the basic principle of investing – that investment has to be made from one’s own money and not borrowed money, or else it is speculation. It is important for us to teach the right things to our youth. The current environment of competition and mad craze for money is teaching them to speculate – they are under the illusion that money can be made by taking shortcuts.

You have often found bonds and other fixed-rate financial instruments riskier than equity investing. This is surprising because many in India consider the stock market risky and bonds very safe.
On an average from 1979 till date, equities have returned around 17-18 percent. However, we find that investors have lost money and the stock markets are riskier than bonds. Is it not a paradox that investments have done well but the investors have done poorly? The problem is not the equities per se, the problem is the investors themselves who sway between greed and fear on the slightest change in a particular level of comfort. This is the reason that the title of my book talks about “behavioral finance.” I have tried to make the reader aware of the different types of behavioral anomalies that affect us and in turn distort our decision making.

VALUE INVESTING AND BEHAVIORAL FINANCE Parag Parikh Tata Mcgraw Hill 325 pp; Rs 395

We must always look at return on investment; however, when fear grips us when the markets are in a bear phase we are looking at return of our investment. With stock market losses around us we want to see our capital intact and that’s how we find bonds more attractive and less risky. If we buy a bond which matures after five years or keep a fixed deposit with the same maturity we find solace in that our money is intact after the five year maturity period and our getting a steady interest return. However, if one were to calculate the vagaries of inflation and the fast depletion of our purchasing power, bonds are also risky. After five years your principal amount may be intact but its purchasing power would have detoriated. That is the reason stocks are known to be the best hedge against inflation. At different times both have their role to play and we cannot call one more or less risky over the other.

The market is still not growing. Is that a matter of concern?
The markets grew from an index of 3,000 in 2003 to 21,000 in 2007– a seven-fold increase in four years. Can you expect it to just go one way up? We have just seen a year of bear times and we want it to go up again. It’s only bad times that offer great investment opportunities as we saw in the later part of 2008 and beginning 2009. Values were available at a song and I am sure value investors were smiling their way to the bank.

Would you agree that all bull and bear runs are natural? In fact, you mention it in your book that it’s a cycle. Does greed make the runs dramatic?
Anything that goes up must come down and vice versa. Bull markets are followed by bear markets and then again by bull markets. It’s the behavior of its participants that makes it dramatic. Participants include investors, government, mutual funds, financial institutions, stock brokers, the regulator, the banks etc. They are swayed by fear and greed and so are their decisions. This leads to irrational behavior. It is this irrationality which makes markets interesting and difficult to understand.

I found a recent comment by you intriguing: “All the things done in the market — these so-called innovations — are designed to make money for these traders against the interest of investors. It’s an unnecessary web of complexity.”
I have already discussed some of the innovations. Initial Public Offering is one such innovation which is against the interest of the same investors who apply for the offer. I have devoted a full chapter on the same; I’ll give you a gist. IPOs always come in bull markets. Why? Because the investors are willing to pay any price for the stock. They never come in bear markets because the management is not willing to give the shares to the public cheap as they believe that the shares are more valuable. That is the reason we saw no IPOs in end 2008 and beginning 2009. The company appoints an investment banker whose fees are dependent on the maximum value he can get for the shares from the public. The investors read the research report and listen to all the good talk about the company from the same investment banker appointed by the company. Moreover, today IPOs are market priced and if one is paying a market price one has a choice of over 6,000 stocks in the market. Why is there so much hulabaloo about an IPO? Because they spend money on advertisements, the media creates hype, people fall for it and end up paying a fancy price.

Market blues A pensive investor scans figures of companies at the Bombay Stock Exchange Photo: AFP

I just read today that Oil India is revising its price band of Rs 750–850 to Rs 1,250–1,450 for its upcoming IPO as it saw the overwhelming response and the success of the recently launched NHPC IPO. How can investors earn if no money is left on the table?

Is that a herd mentality?
When investors are unable to judge what is happening, they get carried away by the crowd. They prefer the safety of being with a larger number of people even if they believe that they are doing something wrong. They don’t want to be contrarians who are doing anything against the majority. This is known as herd mentality. Quite a lot of people knew that the Reliance Power IPO was highly priced but they applied because everyone was applying. They were following the herd. These are the funny ways of the stock markets.

If investing is simple, why is there a need for analysts, with all their highpowered spreadsheets and endless monitoring of global stock exchanges?
Yes, investing is really simple and you don’t get investment opportunities every day. However, today what we call investing is actually trading and speculating. Everyone is in for instant gratification. So today we have investors acquiring speculative habits thinking that they are investing. That’s a disturbing trend but it suits a lot of people. When the investors trade frequently the volumes go up, the stock exchange’s revenue goes up, the brokers get more commissions, the government gets its taxes, the regulator gets more fees from brokers, the investment banker gets more business, the mutual fund managers get more money to manage and trade and the media’s business increases. A lot of people make a lot of money when investors behave irrationally.

One must always look long term. However, since we have created a society where people seek instant gratification, such analysts flourish. Everyday they come out with tips and go along as long as the markets go up. Analysis does not work in the markets but the jobs of the analysts are always secured. Most people opt for instant gratification. Value investing is all about your ability to delay instant gratification.

Why did you turn away business in 2007 when the Sensex was moving towards 20,000? What bothered you?
Money management and stock broking are professions. As a professional, I have to do what is right for my client. If at an index of 20,000 I am unable to spot good values it becomes my duty to dissuade investors from investing. One must have the courage to do what is right. It is this integrity that attracts clients’ trust and one must do whatever it takes to build this trust. Unfortunately, today this profession has turned into a business and hence the right thing to do is not to turn away the customer, as it would lead to loss of revenue. That’s a business decision which may not be in the interest of the client.

Kindly explain another term in your book — “value investing” — and why it is preferable?
Value investing is buying something less than its intrinsic value. Stock markets offer such opportunities as investors behave irrationally in times of bull and bear markets. In bull markets, investors are willing to pay a much higher price for stocks than their intrinsic value as investors are overconfident and excessively optimistic. Hence stock prices have high built-in investor expectations. However, in bear markets investors are fearful and overly pessimistic and hence stock prices do not reflect any built-in investor expectations. On the contrary, this pessimism leads to investors selling stocks at much less than the intrinsic value justifies. This is what we saw from October 2008 to March 2009. Values were available and one required the courage to plunge in the markets when the herd was avoiding it.

The funny part is that investors find stocks less risky when its prices are going up because everyone is buying. They find it more risky when the stock prices are cheap and no one is buying. A value investor understands this behavioral anomaly and profits from doing exactly the opposite of what the herd is doing. So value investing is all about common sense. This is nothing new I have discovered. It’s age-old wisdom. Life Insurance Corporation of India is a classic example of a great value investor in our country. It follows the simple process of buying low and selling high, and in turn rewarding its stakeholders.

Is there something called a good stock and a bad stock or are there only good and bad decisions?
Investing is all about buying a business run by credible management. Some of the characteristics a business must have are: sustainable business model, strong brand and a distribution network, pricing power, market leadership and innovative products. The price one pays for such a business is important. You may have a very good company with all the above characteristics but you cannot pay any price for it.

WRITER’S EMAIL
shantanu@tehelka.com