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“Examination of Efficient Market Hypothesis in Indian Stock Markets and behavioural patterns of
Institutional and Individual Investors in India”
By
SHRUTI JAIN
2006
A Dissertation presented in part consideration for the degree of
“MA Finance and Investment”
ii
ABSTRACT
Over 5 decades a lot of body of evidences have claimed that stock markets are
efficient and it is not possible to beat the market consistently. In recent years,
however, financial economists have increasingly questioned the efficient market
theory. Market efficiency has an influence on the investment strategy of an investor If
market is efficient, trying to find undervalued and overvalued stocks and trying to
beating the market will be a waste. In an efficient market there will be no undervalued
securities offering higher than deserved expected returns, given their risk. On the
other hand if markets are not efficient, excess returns can be made by correctly
picking the winners.
This study examines the efficiency of Indian stock markets and shows that Indian
stock markets are not completely efficient. There are existence of mispriced securities
and opportunities for investors to outperform the market. As against many claims that
it is not possible for any Mutual Fund to beat the market consistently, this study shows
that, in India, active funds exist that have beaten the markets consistently. Behavioural
finance is also important in making investment decisions in India and market
participants are prone to irrationalities like herding behaviour, greed, relying too much
on current information that causes market inefficiency and prices of securities to
deviate from their intrinsic value. The study also outlines how investors can identify
good investment opportunities.
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TABLE OF CONTENTS
List of figures…………………………………………….………………
List of Tables……………………………………………..………………
ACKNOWLEDGEMENT………………………………………………....
CHAPTER 1: INTRODUCTION…………………………………………
1.1 Background of Indian stock markets………………………………...
1.2 Rationale of Research and Gaps in Existing Literature…………….
1.3 Aims and Objectives of the research……………………………….…
1.4 Research Questions and Propositions………………………………..
1.4.1 Research Questions…………………………………………………1.4.2 Research Propositions………………………………………………
1.5 Topics Covered…………………………………………………………
1.6 Summary of this chapter……………………………………………....
CHAPTER 2: LITERATURE REVIEW………………………………….
2.1 Introduction…………………………………………………………….
2.2 Efficient Market Hypothesis………………………………………….
2.2.1 Implications of EMH………………………………………………...2.2.2 Supporters and Critics of EMH……………………………………...2.2.3 Behavioural Finance and EMH………………………………………2.2.4 EMH and Investor’s strategy of Investment or Speculation…………
2.3 The Behaviour of Institutional Investors…………………………….
2.4 EMH in Indian context………………………………………………..
2.4.1 Introduction…………………………………………………………..2.4.2 Studies on Indian Capital Markets in context of EMH………………
2.5 Markets are Efficient or Inefficient? Truce between the two?.............
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CHAPTER 3: METHODOLOGY……………………………………………
3.1 Introduction……………………………………………………………….
3.2 Qualitative Research and Quantitative Research………………………
3.3 Research Map…………………………………………………………….
3.4 Research Methods……………………………………………………….
3.4.1 Secondary Research………………………………………………….3.4.2 Primary Research…………………………………………………….
3.5 Methodology and Data………………………………………….………
3.5.1 Methodology Framework……………………………………………3.5.2 Research – Setting, Procedures, Participants and Materials………...3.5.2.1 Sampling……………………………………………………………… 3.5.2.2 Research Setting……………………………………………………… 3.5.2.3 Research Participants and Procedures…………………………… 3.5.2.4 Data Analysis………………………………………………………… 3.5.2.5 Rationale for interviews for research………………………………
3.6 Conclusion……………………………………………………………
CHAPTER 4: FINDINGS AND ANALYSIS OF STUDY……………….
4.1 Introduction…………………………………………………………….
4.2 Findings to the Research Questions and Propositions………………
4.2.1 Why are IIs not able to beat the market…………………………….4.2.2 How can investors identify good investment opportunities….….…
4.3 Findings in context with literature
CHAPTER 5: CONCLUSIONS AND LIMITATIONS………………….
5.1 Conclusions……………………………………………………….…….
5.2 Limitations of the study and future research…………………….…..
REFERENCES…………………………………………………………….
LIST OF APPENDICES…………………………………………………..
APPENDIX 1……………………………………………………………….
APPENDIX 2……………………………………………………………….
APPENDIX 3……………………………………………………………….
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APPENDIX 4………………………………………………………………
APPENDIX 5………………………………………………………………
APPENDIX 6……………………………………………………………...
APPENDIX 7……………………………………………………………...
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LIST OF FIGURES
Figure 1 Research Map 46
Figure 2 Methodology Framework 49
Figure 3 Data Analysis Model 59
Figure 4 Model of how the pressure is created on Fund Managers 89
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LIST OF TABLES
Table 1 Research Questions 07
Table 2 Research Propositions 08
Table 3 Interviewees profiles 54
Table 4 Interviewees codes 56
Table 5 Interviewee classification 57
Table 6 Findings on Efficient markets hypothesis 63
Table 7 Findings on Information interpretation 68
Table 8 Findings on investment strategy 72
Table 9 Findings on existence of overvalued and undervalued stocks 77
Table 10 Findings on motives for investment 81
Table 11 Findings on behavioural finance 83
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ACKNOWLEDGEMENT
An ongoing work of three months, completion of this dissertation has been a
challenging task for me. But all the efforts dedicated to it were worth it. It had been a
great learning and enriching experience and I truly enjoyed the entire process. It
provided me the opportunity to meet very distinguished and knowledgeable people of
the industry.
All this would not have been possible without the help and support of some people.
First and foremost, I would like to articulate my sincere gratitude to Ms Alyson
McLintock, my supervisor. She has been my mentor throughout the project and her
understanding and help made it possible for me to carry out this study. She always
took out time from her busy schedule to meet and discuss and give guidance on
various aspects of this dissertation. She had always responded patiently to my
demanding long emails and steered my work. Her assurance, guidance and valuable
advice motivated me in my study and I am really thankful for all the efforts she has
put in for making this study possible.
I would also like to thank all the professors who have imparted knowledge of different
subject areas during my Master’s program, which proved beneficial for this
dissertation. Mr. Shahid Ibrahim’s lectures on Efficient Market Theory and
Behavioral Finance were the main source of motivation for this study, which was
further extended by other professors.
My sincere thanks to Mr. Arpit Agrawal and Mr. Ashish Maheshwari, without their
help I would not have got the opportunity to get the interviews of such knowledgeable
people and conduct my research. I would also like to thank all the interviewees for
their contributions, without whom, this research could not have been carried out. Their
time is greatly appreciated and is vital to this dissertation.
ix
I must acknowledge as well my friends who assisted, advised, and supported my
research, especially Pratik, who helped me all the while and Vishal who proof-read
my work and suggested many valuable changes, my sister who gave me motivation
and encouragement all the while and also did proofreading for me and my brother
who provided his help and fulfilled all my needs while I was working.
Lastly, I owe a great deal to my parents who made it possible for me to pursue my
Master’s degree. Throughout the period their support, encouragement and trust on me
and my work made it possible for me to complete this course and this dissertation.
They supported and encouraged me all the while. They met all my needs during the
dissertation. At times I was not sure whether I will be able to complete my
dissertation, but my mother encouraged me all along and kept me motivated. Her
optimistic attitude is contagious. All the while my parents made it possible for me to
have the luxury of time to work and gave me encouragement that helped bring this
dissertation to a successful completion.
Chapter 1: Introduction
1
CHAPTER 1: INTRODUCTION
The stock market appears in the news everyday and millions of people invest in the
stock market daily varying from professional investors to a layman. The investors in
the stock market often try to gauge the true share prices of the companies they have
invested in or of the prospective investments, and wonder whether these investments
are worth the price currently quoted in the stock market. Despite the ubiquitous
recommendations of the analysts, investors loose exorbitant amount of money in the
stock market. This study endeavours to find out the reasons why the investors in India
are not able to perform well in the market and also to unearth ways and strategies
with which they can improve their performance.
1.1 Background of Indian stock markets
Amongst the developing countries, India currently leads in stock exchange
development and is attracting investments from foreign investors, both large Foreign
Institutional Investors and individuals. During last one decade, the Indian financial
system has been subjected to substantial reforms with far reaching consequences.
These reforms have helped in dramatic improvement in transparency level in
financial markets including stock market. The regulatory changes that have taken
place during last one decade of financial sector reforms have resulted in financial
markets becoming more efficient with respect to the price discovery mechanism and
Chapter 1: Introduction
2
have helped the market to grow exponentially. There have been significant changes in
the regulations for smooth and efficient functioning of capital market in the country.
The market has undergone substantial change due to introduction of hedging products
like futures and options. The concept of developing a large order book in the stock
market made the pricing of stocks more accurate and efficient and also resulted in
bringing down the bid/ask spread benefiting the investors community as a whole.
International investors’ access to the domestic market has also helped in increasing
liquidity. All these helped in better dissemination of information and hence possibly
increased the level of efficiency in asset prices (Nath, n.d.).
Indian stock markets are gaining momentum in the world and are the fastest growing
markets in the world amongst the developing countries. Between July 1997 and
February 2005, the BSE Sensex Index went from 4306 to 10980 and the NSE Nifty
index rose from 1221 to 28541. Despite this growth in the market, not much research
has been conducted on Indian stock markets and the various ways in which the Indian
analysts predict the movements of the Index and determine good investment
opportunities. There is also a gap in the literature on Indian stock market as the
studies that have been so far conducted have concentrated on quantitative techniques.
Behavioural finance has not attracted much attention of Indian researchers and no
study has yet made an attempt to study the behavioural patterns of investors and other
market participants in Indian stock markets.
1 Yahoo Finance
Chapter 1: Introduction
3
I have previously worked in a stock broking company in their research department
and my work experience has been the main source of interest development in this
research area and imparted me immense knowledge about the subject. This in turn has
helped me to choose this topic for research
1.2 Rationale of Research and Gaps in Existing Literature
In spite of the conceptual and empirical evidences on the validity of Efficient Markets
Hypothesis (henceforth EMH) in Indian stock markets, a critical review of the
literature indicates that very little pragmatic attention has been paid to behavioural
finance in context of Indian stock markets. Shiller and Thaler (in Anonymous, 2005)
assert that research in behavioural finance has important applications. The research
can guide in portfolio allocation decisions, both by helping us to understand the kinds
of errors that investors tend to make in managing their portfolios, and also by
allowing us to understand better how to locate profit opportunities for investment
managers. Shefrin argues that financial practitioners must acknowledge and
understand behavioural finance, the application of psychology to financial behaviour,
in order to avoid many of the investment pitfalls caused by human error. Despite so
much effort put in by the investors, it is becoming difficult for fund managers to
outperform the market consistently. There are certain irrationalities the institutional
investors (henceforth IIs) and individual investors succumb to that cause their
performance to topple, which have not been uncovered through any researcher so far.
Chapter 1: Introduction
4
This study, therefore, tries to understand and find out the errors and irrational
behaviour that the investors, money managers, security analysts, investment bankers
and corporate leaders are subject to in Indian stock markets, which affects their
performance in the market. This research also investigates the human behaviour that
guides stock selection, financial services, and corporate financial strategy.
Moreover, although a lot of statistical research has been produced to find out if
Indian capital markets are efficient, no study has concentrated on finding out what the
stock market participants perceive about the efficient markets theory. And only a
small number of researches have made an attempt to find out the reasons for why the
markets are not efficient. It is important to understand what the market participants
perceive because ultimately they make the markets and their perception would have
an impact on the efficiency level of the market. Thus, this study has also made an
attempt to find out what the market participants perceive about the efficiency level of
Indian markets and the reasons for their perceptions.
The rationale of this research is to find out whether it is possible to outperform the
market and if it is, then what investment strategies should be adopted by investors,
what commonly made errors they should avoid, how they can identify good
investment strategies. Concisely, this research attempts to find out ways to make
money from the stock markets in India.
Chapter 1: Introduction
5
The key research question that dominates this dissertation, however, is to find out,
what actual investors think about the concept of efficient markets and its implications
from their experience in the stock markets in India. And therefore this study seeks to
take views of experienced investors and money makers in the market, who
understand the stock markets.
1.3 Aims and Objectives of the research
This dissertation seeks to research the efficiency level of Indian stock markets and
expert’s opinion on market efficiency, assess the behavioural patterns of market
participants as gleamed from a review of the literature, to assist the investors in their
investment decisions (in context of Indian stock markets). This research will be of
practical benefit to the researcher in her understanding of the markets and for the
research department of the company she would be working with. It will also help the
investors in identifying the irrationalities committed by them and how can they
improve such irrational behaviour and also to understand what investment strategies
should be adopted by them, assisting in their investment decisions. It has also made
an attempt to fill the gap in the literature and studies conducted on Indian stock
markets.
The main aim of the research project is to:
provide an evaluative summary of the efficiency of the Indian stock market.
Chapter 1: Introduction
6
present an argument on the existence of overprices and underpriced stocks in
the stock market.
provide an evidence on whether behavioural finance is important while making
investment decisions in the stock markets.
identify the strategies for investors to discover good investment opportunities,
i.e. how can they make money in the stock markets.
To achieve the ultimate goal, the research is broken down into several objectives.
Therefore, objectives of the research project are to discover:
the differences in the efficiency level between Indian stock markets and other
developed stock markets (like USA and UK).
what irrationalities investors succumb to that causes their performance in the
market to topple down.
why despite all the research undertaken by the IIs are they not able to beat the
market?
1.4 Research Questions and Propositions
In order to achieve the research goal it is critical to clarify the key questions for which
answers are sought and why are they important. Precise key questions determine the
focus and scope of study. It will help the researchers direct the literature review, the
framework for study, tools and techniques, and the analysis (Potter, 2003).
Chapter 1: Introduction
7
1.4.1 Research Questions
Table 1 outlines the key questions that this study seeks the answers.
TABLE 1
Research Questions
Question 1 Are Indian markets as efficient as other developed markets
like US and UK? Why?
Question 2 Is the information that is disseminated in the market
interpreted correctly by the investors? Are there smart
arbitrageurs in the market who correct any mispricing in the
stock and make markets efficient?
Questions 3 What investment strategy should be adopted by individual
investors? What factors affect their choice of investment
strategy?
Question 4 What irrational behaviour or emotional biases investors
capitulate to that affects their investment decisions and also
market prices and returns? Why are IIs not able to outperform
the market?
Question 5 How can investors identify good investment opportunities? Is
technical analysis helpful in making investment decision?
1.4.2 Research Propositions
There are key issues emerging from the literature review of the topic area and
previous studies and an examination of these issues have led to the creation of
propositions (outlined in Table 2) for this dissertation, which will be empirically
tested through the research conduction.
Chapter 1: Introduction
8
TABLE 2
Research Propositions
Proposition 1 Complete market efficiency is a utopian idea. Markets cannot
be completely efficient nor are they completely inefficient.
Proposition 2 Stock markets price the securities correctly in medium to long
term. In other words, over a long-term the price of a
company’s shares reflects its intrinsic value.
Proposition 3 It is possible to outperform the market on a consistent basis
and skill plays an important role in such performance. The
chances of consistently outperforming the market are low,
albeit possible.
Proposition 4 Most of the people putting-in money in the stock markets are
guided by the short-term speculative motives. Therefore, prices
of securities often deviate from their intrinsic value.
Proposition 5 Behavioural Finance (BF) plays a vital role in understanding
investor behaviour and making investment decisions. With the
use of explanations on investor behaviour propounded by BF
theory, investors can improve their returns in the market.
1.5 Topics Covered
To gain a solid foundation for studying these queries, a literature review will be
produced. The academic sphere has produced a plethora of findings on validity of
Efficient Market Hypothesis and its implications, behavioural finance and efficiency
level of Indian stock markets. This literature will be sufficiently reviewed and
assessed throughout the course of this paper. The topics discussed include
an explanation of EMH, the three forms of EMH and its implications;
Chapter 1: Introduction
9
an explanation of the behavioural finance theory and its implications on
investing;
argument on whether the markets are driven by investment or speculation;
the irrational behaviour of IIs.
an outline of various studies conducted on Indian stock markets in context of
EMH.
The debate over whether the stock market is efficient or not is an ongoing one. The
key issue remains how to invest in the market and devise strategies to get good
returns and identify the mistakes people commonly make in the market and learn
from them.
1.6 Summary of this chapter
This chapter gave a brief introduction to the Indian stock markets and the way the
markets have been evolving. This was followed by a discussion on the rationale for
the research and subsequent presentation of the aims and the objectives of this study.
It also outlined the research questions and propositions that will be used to meet the
aims and the objectives of this study.
The topic of efficiency level of Indian stock market, application of behavioural
finance and behavioural patterns in Indian markets has been approached as follows:
Chapter 1: Introduction
10
The literature on the EMH and behavioural finance and Indian stock markets
is reviewed (Chapter 2).
The research methods used to answer the research objectives are then outlined
(Chapter 3).
The author’s findings from the research undertaken are presented and there
follows a discussion of what these findings mean for stock market participants
and their investment strategies and investment decisions (Chapter 4)
Conclusion and limitations of the study is presented (Chapter 5).
Chapter 2: Literature Review
11
CHAPTER 2: LITERATURE REVIEW
2.1 Introduction
The amount of research on stock markets and predicting the stock prices and the
markets is overwhelming. There are various schools of thoughts on the subject, where
on one side there are academics and scholars who can be divided between those who
claim that stock prices or their future trend cannot be predicted and others who assert
that it is possible to predict the prices of securities or future trend; and on the other
side there are investors and traders in the financial markets who strongly believe that
it is possible to beat the market and henceforth profit through careful investment
strategies.
2.2 Efficient Market Hypothesis
One of the most popular and widely adopted theories, and the most criticised one, in
the financial markets is the Efficient Market Hypothesis. EMH was first proposed by
Samuelson (1965) and Mandelbrot (1966) and was successively popularized by Fama
(1965, 1970) (Mandelbrot and Hudson, 2004; Zheng, 2005). Following Fama’s work
many studies were devoted to examining the randomness of stock price movements
for the purpose of demonstrating the efficiency of capital markets. One of the
pioneers of the EMH who has popularized this framework is Burton G. Malkiel
Chapter 2: Literature Review
12
(Shostak, 1997)2. According to EMH, in context of equity markets, one cannot predict
stock prices or their future trends. The theoretical basis of the EMH states that the
investors behave rationally and, consequently, they value the securities consistently
with their fundamental value.
Proponents of Efficient Market Hypothesis assert that:
“In an active market that includes many well-informed and intelligent investors,
securities will be appropriately priced and reflect all available information. If a
market is efficient, no information or analysis can be expected to result in
outperformance of an appropriate benchmark.” (Fama, 1965)
The theory purports that there is perfect information in the stock market, which
follows that any new information that becomes available to the market will be very
quickly reflected in the prices (Fama, 1970). Thus, neither technical analysis (which
is the study of past stock prices in an attempt to predict future prices) nor even
fundamental analysis, (which is the analysis of financial information such as
company earnings, asset values, etc. to help investors select “undervalued” stocks)
would enable an investor to achieve returns greater than those that could be obtained
by holding a randomly selected portfolio of individual stocks with comparable risk
(Malkiel, 2003).
2 Work of Malkiel includes Malkiel (1973), Malkiel (1987), Malkiel (2000). See references for detail.
Chapter 2: Literature Review
13
EMH is “endowed” with three distinct forms of “informational efficiency,” namely,
the weak, the semi-strong, and the strong form of efficiency. The weak form implies
a random walk (meaning stock prices are not predictable and patterns are merely
accidental) of some form (part of Fama’s 1965 definition of efficiency) and that one
cannot take advantage of the knowledge of historical price movements to earn
superior returns on investments. In other words, technical analysis is of no use to earn
superior returns. The semi-strong form implies that prices at any given time
incorporate all publicly available information (including financial statements and
news reports), i.e. when new information is released, it is fully incorporated into the
price rather speedily. This is supported by the availability of intraday data-enabled
tests which offer evidence of public information impacting stock prices within
minutes (Patell and Wolfson, 1984, Gosnell, Keown and Pinkerton, 1996). And the
strong form implies that prices at any given time incorporate all information, whether
public or private (Frankfurter and McGoun, n.d.). Even insider information is of no
use.
2.2.1 Implications of EMH
Fama persuasively made the argument that in an active market, that includes many
well-informed and intelligent investors, securities will be appropriately priced and
reflect all available information. The bottom line of the theory is that it is not possible to ‘beat the
market’ since there is no way to know something about a stock that isn’t already reflected in the stock’s
price and it is not possible to predict stock prices or their future trends. Any attempt to
try and predict any patterns or pricing movements is rendered ineffective and useless.
Chapter 2: Literature Review
14
An efficient market also carries other implications for investment strategies
mentioned below. In an efficient market:
A strategy of randomly diversifying across stocks or indexing to the
market, carrying little or no information cost and minimal execution costs in
order to optimise the returns, would be superior to any other strategy. This
is also known as passive investment strategy. There would be no value added
by portfolio managers and investment strategists.
Equity research and valuation would be a costly task that would provide no
benefits. The odds of finding an undervalued stock would always be
random (50-50 chance). At best, the benefits from information collection and
equity research would cover the costs of doing the research.
(Damodaran 2002)
From the implications of EMH, it is not surprising to note that EMH evokes multitude
criticism and strong reactions particularly on the part of portfolio managers and
analysts, who view it as a challenge to their existence.
2.2.2 Supporters and Critics of EMH
The debate about efficient markets has resulted in hundreds and thousands of
empirical studies attempting to determine whether specific markets are in fact
‘efficient’ and if so to what degree. It may be surprising to note that myriad
researches have been found to confirm the EMH. Unarguably, no other theory in
Chapter 2: Literature Review
15
economics or finance generates more passionate discussion between its challengers
and proponents. For example, in 1978, noted Harvard financial economist Michael
Jensen famously pronounced that “there is no other proposition in economics which
has more solid empirical evidence supporting it than the Efficient Market
Hypothesis,” while investment expert Peter Lynch claims “Efficient markets? That’s
a bunch of junk, crazy stuff” (Fortune, April 1995).
Malkiel (2005) argues that markets are indeed efficient and provides evidence that by
and large market prices do seem to reflect all the available information. Under-
reaction to news events appears as frequently in the data as over-reaction to events, as
has been stressed by Fama (1998). Many of the predictable patterns seem to disappear
as soon as they are discovered, as emphasized by Schwert (2001) (in Constantinides
et al, 2003). Event studies, pioneered by Fama et al (1969), found that stock prices
respond quickly to new information, and subsequently display no apparent strong
trends following major events such as mergers, stock-splits or changes in firms’
dividend policies. Their study also revealed that the market appears to anticipate the
information, and most of the price adjustment is complete before the event is revealed
to the market. Studies carried out by Working (1934) and Cowles and Jones (1937)
which have been reported by Dimson and Mussavian (1998), confirmed that prices of
US stock and other economic variables fluctuate randomly.
Malkiel (2003) and Eugene Fama (1970) summarize many early studies, conducted
from the 1950s-70s, that show that after trading costs are considered, the returns
Chapter 2: Literature Review
16
generated by many technical strategies underperform a simple buy and hold strategy.
Proponents of technical analysis counter that technical analysis does not completely
contradict the efficient market hypothesis. Technicians agree with EMH in that they
believe that all available information is reflected within a security’s price; that is why
technicians say a study of the price movement is necessary (Anonymous I, 2006).
Technicians argue that EMH ignores the realities of the market place, namely that
many investors base their future expectations on past earnings, track records, etc.
Because future stock prices can be strongly influenced by investor expectations,
technicians claim it only follows that past prices can influence future prices.
Technicians point to the new field of behavioural finance. The topic of behavioural
finance is discussed later in detail. For present purpose, it suffices to note that
behavioural finance essentially says that people are not the rational participants EMH
makes them out to be. Market participants can and do act irrationally. Technicians
have long held that irrational human behaviour influences stock prices and claim to
have ways of predicting probable outcomes based on this behaviour (Anonymous I,
2006)3.
Kendall (1953) asserts that economists assume that time-series data on economic
variables can be analyzed by making adjustment for long-term trends and examining
the residual for short-term movements and random volatilities. He studied series of
data on 22 UK stocks and commodity prices. He concluded that “in series of prices
which are observed at fairly close intervals the random changes from one term to the
next are so large as to swamp any systematic effect which may be present. The data 3 See references for Anonymous I (2006) details.
Chapter 2: Literature Review
17
behave almost like wandering series”. The correlation of price changes was close to
zero (Dimson and Mussavian, 1998). These empirical observations were called the
“random walk model” or even the “random walk theory”. According to this theory,
current price is the best forecast for future price. Therefore, price changes from one
period to the next are independent of past price changes. Future price can be predicted
only once new information arrives and that information is unpredictable. Hence, one
cannot predict the prices of stocks. Olsen, Dacorogna, Muller and Pictet (1992) state
that the empirical studies confirm the efficiency of the major financial markets as
well as the reflection of all information in current prices.
When EMH was first introduced, the theory gained a lot of momentum in the market
and received support from many researchers through their empirical studies
confirming that markets were indeed efficient. Undoubtedly, the studies based on
EMH have made an invaluable contribution to the understanding of the securities
market. However, there is lots of discontentment with the theory. Like all the
theories, the Efficient Markets Hypothesis simplifies a complex reality, an argument
also raised by Stout (2004), which is apparent from the premises it is based on like
the presumptions of homogeneous investor expectations, effective arbitrage, and
investor rationality.
A limited survey of the contemporary literature shows that criticism of EMH has
gained both voice and momentum during recent years (Russel and Torbey, 2002). The
initial euphoria about the EMH has faded and that conflicting opinions on market
Chapter 2: Literature Review
18
behaviour and efficiency have provided the impetus for the current debate that
markets are not efficient.
The furious debate on whether markets are completely informationally efficient has
spanned more than four decades, with some well-known critiques and “anomalies4”
exhaustively researched, rebutted, and researched yet again. For example, Grossman
and Stiglitz (1980) argued that the EMH contained a theoretical contradiction. If all
arbitrage profits were eliminated, and arbitrage is costly, then there would be no
incentive for information search and acquisition; the very activity that made markets
efficient would wither away.
Grossman (1976) and Grossman and Stiglitz (1980) go even farther. They argue that
perfectly informationally efficient markets are impossibility, for if markets are
perfectly efficient, there is no profit to gathering information, in which case there
would be little reason to trade, and markets would eventually collapse. Alternatively,
the degree of market inefficiency determines the effort investors are willing to expend
to gather and trade on information. Hence, non-degenerate market equilibrium will
arise only when there are sufficient profit opportunities, i.e., inefficiencies, to
compensate investors for the costs of trading and information gathering. The profits
earned by attentive investors may be viewed as economic rents that accrue to those
willing to engage in such activities. Who are the providers of these rents? Black
(1986) gave a provocative answer: “noise traders,” individuals who trade on what
they consider to be information that is, in fact, merely noise. The supporters of the 4 An anomaly, in Thomas Kuhn's (1996) elegant phrase, is a “violation of expectations”
Chapter 2: Literature Review
19
EMH have responded to these challenges by arguing that while behavioural biases
and corresponding inefficiencies do arise from time to time, there is a limit to their
prevalence and impact because of opposing forces dedicated to exploiting such
opportunities (Lo, 2004).
In recent years, many studies have demonstrated market inefficiencies by identifying
systematic and permanent variations in stock returns. Some of these systematic
variations, popularly known as anomalies, are small-firm effects, investment
recommendations, and extraordinary returns to the time or the calendar effect5. The
mere existence of investors like Warren Buffett and John Templeton prove that it is
possible to select stocks and earn a higher return than an index fund.
Supporters of the Efficient Market Hypothesis gleefully point out that no investor in
history has ever turned in a statistically significant out-performance of the market
averages over a long period of time. Damodaran (2002) and Clarke, Jandik and
Mandelker (n.d.), amongst many others, assert that the argument that EMH claims
that investors cannot outperform the market is a myth and has been misinterpreted.
And like them, many others sought to clarify this argument saying that - what the
above argument exactly means is, “EMH does not imply that investors are unable to
outperform the market. What EMH does claim, though, is that one should not be
expected to outperform the market predictably or consistently”. However empirical
evidences have proved that there are investors in the market who have been
consistently beating the market. One such well-known and known-to-be world’s 5 Appendix 1 provides a description of all the popular anomalies.
Chapter 2: Literature Review
20
greatest investor (mentioned earlier) is Mr. Warren Buffet, an American investor and
the second richest man in the world6, who made his fortune mainly through
investments in the stock market. Between 1957 and 1969, Warren Buffet beat the
Dow Jones Industrial Average by 22 percentage points (Hangstrom, 1997, p. 4). Bill
Miller (of Legg Mason) is another such example who has beaten the stock market for
14 consecutive years (Heimer, 2005).
If the EMH were literally true, after all, Warren Buffett would not exist. The wizard
of Omaha and a handful of other high-visibility investors, mostly disciples of the late
Benjamin Graham, have outperformed the market averages with EMH-defying
regularity (Hecter, 1988). In recent years scholars have documented a host of other
anomalies - persistent moneymaking opportunities that an unfailingly efficient market
should long ago have arbitraged into oblivion. They have found that small-company
stocks consistently yield higher returns than large ones, even after adjusting for risk.
Year after year, share prices rise in early January. More often than not, they fall on
Mondays (Hecter, 1988).
There have been several studies that suggest that “value” stocks have higher returns
than so-called “growth” stocks. The most common two methods of identifying value
stocks have been price-earnings ratios and price-to-book-value ratios. Stocks with
low price-earnings multiples (often called ‘value’ stocks) appear to provide higher
rates of return than stocks with high price-to-earnings ratios, as first shown by
Nicholson (1960) and later confirmed by Ball (1978) and Basu (1983). This finding is 6 Forbes World Richest People 2006 list
Chapter 2: Literature Review
21
consistent with the views of behavioralists that investors tend to be overconfident of
their ability to project high earnings growth and thus overpay for ‘growth’ stocks (for
example, Kahneman and Riepe, 1998). The finding is also consistent with the views
of Graham and Dodd (1934), first expounded in their classic book on security
analysis and later championed by the legendary U.S. investor Warren Buffett
(Malkiel, 2003).
Proponents of EMH claim that market efficiency implies that given the number of
investors in financial markets, the law of probability would suggest that a fairly large
number are going to beat the market consistently, not because of their investment
strategies but because they are lucky (Damodaran, 2002. p. 114). However, there
exist a number of investors who have outperformed the market over long periods of
time, in a way which it is statistically unreasonable to attribute to good luck,
including Peter Lynch (formerly of Fidelity’s Magellan Fund), Warren Buffett, John
Templeton (of Templeton funds), John Neff (of Vanguard’s Windsor Fund) and Bill
Miller (of Legg Mason) (Paquette et al, n.d.). These investors’ strategies are to a large
extent based on identifying markets where prices do not accurately reflect the
available information, in direct contradiction to the EMH, which explicitly implies
that no such opportunities exist (Anonymous, 2006). This demonstrates that in
addition to ‘luck’, ‘skill’ is a significant input, and it should be no surprise if one
individual systematically beats all others.
Chapter 2: Literature Review
22
Theorists often describe an efficient securities market as one in which prices “fully
reflect” all available relevant information. Yet as Gilson and Kraakman (1984)
pointed out, information is costly to obtain, process, and verify. As a result it is
impossible for every participant in securities markets to actually acquire, understand,
and validate all the available information that might be relevant to valuing securities
(Stout, 2004). Efficient market, as we discussed earlier, implies that the prices fully
reflect available information. In this regard, many critics have raised a doubt and
argued that informational efficiency, alone, does not imply that market prices respond
to new information correctly or even that prices respond at all (Stout, 2004).
Another attack on the proponents of the theory is on their assertion that security
prices reflect all public information. In the years immediately following the
development of the EMH it was subjected to extensive empirical testing as
researchers analyzed how quickly prices responded to public announcements of stock
splits, corporate mergers, and the like. These first studies found that prices seemed to
respond to new information almost immediately, within hours or minutes of an
announcement. But consider the kind of information researchers initially used to test
market efficiency. Merger announcements and stock split reports are widely
disseminated and easy to understand (Stout, 2004). What happens when new
information becomes available but investors must invest substantial time, trouble, or
money to get it? What happens when the information is technical and difficult to
understand? Do prices still change within hours or minutes? As Brealey & Myers
note (2000, p. 363-65), more recent studies suggest the answers to these questions is
no. Many types of information important to valuing securities seem to be
Chapter 2: Literature Review
23
incorporated into prices far more slowly and incompletely than the conventional
account of market efficiency suggests. A good example is the widely-studied
phenomenon of “post-earnings-announcement-drift.” An unanticipated announcement
of increased corporate earnings tends to be followed by abnormal positive returns
over the next several months, while firms that announce unexpectedly poor earnings
see abnormal negative returns over an extended period (this is known as post-
earnings-announcement drift). Researchers have been puzzled over these results.
Bernard & Thomas (1989) suggest drift is evidence that the initial price response to
the new earnings information is incomplete, and that the full implications of the new
earnings information are digested by the market far more slowly than previously
suspected. Information that is easy to understand and that is popularized and iterated
in the media may be incorporated into prices almost instantaneously. Information that
is “public” but difficult to obtain, or information that is complex or requires a
specialist’s knowledge to comprehend, may take weeks or months to be reflected in
price. Indeed, it may never be fully reflected at all (Stout, 2004). Therefore, the
possibility of informationally inefficient markets undermines the most vital
proposition of the EMH that – ‘you can’t “beat the market” by trading on public
information’.
Many economists, mathematicians and market practitioners find it difficult to believe
that man-made markets are strong-form efficient when there are prima facie reasons
for inefficiency including the slow diffusion of information, the relatively great power
of some market participants (e.g. financial institutions), and the existence of
Chapter 2: Literature Review
24
apparently sophisticated professional investors (Anonymous, 2006). The way that
markets react to news surprises is perhaps the most evident flaw in the EMH. HBR
(1964) in its editorial article entitled, “Urgent questions about the stock market”,
indicate that valuation, information, manipulation, fashion and dissatisfaction are the
obstacles in better pricing of equity shares.
Furthermore, as Russel and Torbey (2002) argue that although it is true that the
market responds to new information, it is also clear through many empirical
evidences that information is not the only variable affecting security valuation.
Recent years have witnessed a new wave of researchers who have provided thought
provoking, theoretical arguments and supporting empirical evidence to show that
security prices could deviate from their equilibrium values due to psychological
factors, fads, and noise trading, discussed in the next section.
Another problem with EMH is that it assumes that all investors perceive all available
information in precisely the same manner. The numerous methods for analysing
and valuing stocks pose some problems for the validity of the EMH. If one investor
looks for undervalued market opportunities while another investor evaluates a stock
on the basis of its growth potential, these two investors will already have arrived at a
different assessment of the stock’s fair market value. Therefore, one argument against
the EMH points out that, since the balance of investors value stocks differently, it is
impossible to ascertain what a stock should be worth under an efficient market
(Bergen, 2004).
Chapter 2: Literature Review
25
A considerable body of academic work on asset pricing has stressed that stock
markets are somewhat predictable, and in some circumstances inefficient. Fama and
French (1988) in their paper on permanent and temporary components of stock prices
found returns to possess large predictable components casting doubts about the
efficiency of the stock market. Blanchard and Watson (1982) show that when the
bubble is present, the proportional change in stock prices is an increasing function of
time and therefore predictable; further, as time increases, the bubble starts dominating
fundamentals, which can be tested by regressing the proportional change in stock
prices on time. Lo and Mackinlay demonstrate that there is momentum in the stock
market and that the random walk hypothesis can be rejected (Malkiel, 2003, I, p.9).
Summers (1986) opined that financial markets were not efficient in the sense of
rationally reflecting fundamentals. Several theorists, economists and researchers have
pointed out that the market cannot be perfectly efficient, or there would be no
incentive for professionals to uncover the information that gets so quickly reflected in
market prices, a point stressed by Grossman and Stiglitz (1980). In their survey of the
econometrics of financial markets, Campbell et al (1997), for example conclude that
stock markets are atleast partially predictable. DeBondt and Thaler (1995) survey the
body of work on behavioural finance and suggest that stock prices often deviate
substantially from their fundamental values. In their view, such deviations can be
used by investors to fashion winning investment strategies. Shiller (2000) documents
the behavioural factors that lead to investment bubbles and also argues that future
Chapter 2: Literature Review
26
stock prices are to some extent predictable. Appendix 2 lists the predictions made by
EMH and the empirical evidence on the former.
2.2.3 Behavioural Finance and EMH
Market efficiency has been challenged by behavioural finance, described in a recent
New York Times article as the “brand of economics that tries to explain the market in
terms of the way humans behave - both rationally and not” (Nocera, 2005). Lintner
(1998) defines behavioural finance as being ‘the study of how humans interpret and
act on information to make informed investment decisions’ (p.7).
Many investors have long considered that psychology plays a key role in determining
the behaviour of markets. In the 1990’s, emergence of behavioural finance with its
discovery of systematic biases in human judgment leading to doubts that human
beings can be counted on to take a strictly rational approach to decision making
(Kahneman, Slovic, Tversky, 1982) strongly breached the concept of efficient market
and threw light on many aspects of human behaviour which showed that markets
rather behave inefficiently.
Frankfurter and McGoun (n.d.) illustrate Dreman’s (1979) argument for behavioural
finance. Dreman (1979) builds his argument on psychological factors, proposing that
investors react to events in a fashion that consistently overvalues the prospects of the
“best” investments and undervalues those they consider the “worst”. Dreman and
Berry (1995) summarize the following predictions of the overreaction hypothesis:
Chapter 2: Literature Review
27
1. For long periods “best” stocks underperform while “worst” stocks outperform the
market.
2. Positive surprises boost “worst” stock prices significantly more than they do for
“best” stocks and negative surprises depress “best” stock prices much more than they
do for “worst” stocks.
3. There are two distinct categories of surprises: event triggers (positive surprises on
“worst” stocks, and negative surprises on “best” stocks), and reinforcing events
(negative surprises on “worst” stocks and positive surprises on “best”). Event-triggers
result in much larger price movements than do reinforcing events.
Several event studies have shown evidence of under-reaction in which the market
response to new information appears to be too little or too late. Bernard and Thomas
(1990) and Abarbanell and Bernard (1992) show that financial analysts under react to
earnings announcements, either overestimating or underestimating quarterly earnings
after positive or negative surprises. Michaely, Thaler and Womack (1995), find price
responses to dividend cuts and/or initiations to continue for an excessively and
irrationally long time. Ikenberry, Lakonishok and Vermaelen (1995) contend that
investors under-react to firms’ share repurchases. Investors do not, in fact, discount
information in the rational manner suggested by theory. As a result, it is possible for
the stock market to remain for long periods at levels far removed from intrinsic value
(Frankfurter and McGoun, n.d.).
Chapter 2: Literature Review
28
Other human frailties, like the tendency to place too much weight on the most recent
data, may cause investors, and thus market prices, to overreact to news. Predictable
overreaction allows for a market timing strategy of buying on bad news, or buying
stocks whose prices have recently dropped. On the other hand, another assertion is
that all but a few investors neglect certain obscure stocks. This belief motivates basic
fundamental analysis, as well as technically based momentum strategies; buying
stocks whose prices have started to rise. The point is that if some investors are
irrational, and the irrationality is pervasive enough, some stocks will be mispriced and
the market will be inefficient (Thorley, 1999).
In fact, behavioralists, in consensus, argue that for anyone who’s been through the
Internet bubble and the subsequent crash, the EMH is hard to swallow. They explain
that, rather than being anomalies, irrational behaviour is commonplace. In fact,
researchers have regularly reproduced market behaviour using very simple
experiments. Two other common behaviour outlined by behavioralists are:
The Herd versus the Self: Herd instinct explains why people tend to imitate
others. When a market is moving up or down, investors are subject to a fear
that others know more or have more information. As a consequence, investors
feel a strong impulse to do what others are doing. Here, for example, is a
good description of herding - people suspending their private judgments and
acting on public information.
Chapter 2: Literature Review
29
Two restaurants face one another on the main street of a charming Alsatian
village. There is no menu outside. It is 6:00 PM. Both restaurants are empty.
A tourist comes down the street, looks at each of the restaurants, and goes
into one of them. After a while, another tourist shows up, sees how many
patrons are already inside by looking through the stained glass windows -
these are Alsatian winstube - and chooses one of them. The scene repeats
itself, with new tourists checking on the popularity of each restaurant before
entering one of them. After a while, all newcomers choose the same
restaurant: they choose the more popular one irrespective of their own
information.
- Chamley (2004)
Lamont (2004) seeks to explain herding in a simple model in which
uninformed traders (dumb money) overwhelm informed traders (smart
money) in speculative bubbles. Hoguet (2005) explains as markets rise,
investment managers who underweight a market buy into it, irrespective of
valuation, to reduce their risk of underperforming the benchmark.
Investors tend to place too much worth on judgments derived from small
samples of data or from single sources. For instance, investors are known to
attribute skill rather than luck to an analyst that picks a winning stock
(McClure, 2002).
Chapter 2: Literature Review
30
In fact, the so-called herding behaviour of stock market players has been commonly
found to take place in financial markets. Hoguet (2005) asserts that herding is
particularly common in emerging markets. He alleges that the performance of
Japanese stocks in the 1980s and NASDAQ in the 1990s are two prominent examples
of overshoots. In emerging markets, Taiwanese shares fell 75% in six months in
1990.
Human patterns of less-than-perfectly rational behaviour are central to financial
market behaviour, even among investment professionals. Julius Caesar said “Men
willingly believe what they wish7.” His insight was on target. This statement has
been well elaborated as an explanation for the stock market crashes and bubbles by
the behavioralists. It has been shown in a number of psychological studies that
people suffer a wishful thinking bias, that is, they overestimate the probability of
success of entities that they feel associated with. Wishful thinking bias appears to
play a role in the propagation of a speculative bubble. After a bubble has continued
for a while, there are many people who have committed themselves to the
investments, emotionally as well as financially (Shiller, 2001), which further causes
the prices to deviate unjustifiably from their intrinsic value and causing this process
to continue for a longer time. By the time it is realized that the prices are irrational,
the market has crashed and people have lost significant amount of wealth.
7
Julius Caesar, De Bello Gallico, pp. iii, 18.
Chapter 2: Literature Review
31
Behavioural finance certainly reflects some of the attitudes embedded in the
investment system. Behaviourists will argue that investors often behave irrationally,
producing inefficient markets and mispriced securities - opportunities to make
money. That may be true for an instant. But, consistently uncovering these
inefficiencies is a challenge. Questions remain over whether these behavioural
finance theories can be used to manage money effectively and economically. The
irrationalities present amongst the Indian stock markets participants have been
explored in the findings and analysis sections.
2.2.4 EMH and Investor’s strategy of Investment or Speculation
‘The market is a pendulum that forever swings between unsustainable optimism
(which makes stocks too expensive) and unjustified pessimism (which makes them too
cheap). The intelligent investor is a realist who sells to optimists and buys from
pessimists’.
- Graham (2003)
The EMH and John Maynard Keynes’ (1936) philosophy represent two extreme
views of the stock market. EMH is built on the assumption of investor rationality,
which is in stark contrast to Keynes’ philosophy in which he pictures the stock market
as a ‘casino’ guided by ‘animal spirit’. He argues that investors are guided by short-
run speculative motives. They are not interested in assessing the present value of
future dividends and holding an investment for a significant period, but rather in
estimating the short-run price movements (Russel and Torbey, 2002).
Chapter 2: Literature Review
32
There is a line to be drawn between investment and speculation. Graham (2003), in
his bestseller that made the foundation of many great investors’ investment strategy
of value investing including Warren Buffett, clearly made a distinction between an
investor and a speculator. In his definition, ‘an investment operation is one which,
upon thorough analysis, promises safety of principal and a satisfactory return’.
Operations not meeting these requirements are speculative (p. 29). The thorough
analysis that he insisted upon was explained as ‘the careful study of available facts
with the attempt to draw conclusions therefrom based on established principles and
sound logic’.
Graham says, investors judge ‘the market price by established standards of value’,
while speculators ‘base [their] standards of value upon the market price.’
In 1999, at least 6 million people were trading online and roughly a tenth of them
were ‘day trading’, using the Internet to buy and sell stocks at a lighting speed. It
somehow became an instant way to mint money. By pouring continuous data about
stocks into bars and barbershops, kitchens and cafes, taxicabs and truck stops,
financial websites and financial TV have turned the stock market into a non-stop
videogame. The public felt more knowledgeable about stock markets than ever
before. Unfortunately, while people were drowning in data, knowledge was nowhere
to be found. Stocks had entirely decoupled from the companies that issued them –
pure abstractions, just blips moving across a TV or a computer screen (Zweig, J. in
Graham, 2003, P. 39).
Chapter 2: Literature Review
33
For the capital market comprising for speculators, the theory of EMH would hold to a
great extent, in the sense that they cannot exactly predict the prices. It would be more
a matter of luck rather than skill out of which they can make the money in the market.
Their interest is in the short-term price movements in the market, with majority of
them conducting their trading on a day’s basis, also known as ‘day-trading’ or
‘jobbing’. Buffett also supports this argument and says that he gives zero credence to
market predictions. He cannot predict the short-term market movements and does not
believe that anyone else can. He has long felt that ‘the only value of stock forecasters
is to make fortune tellers look good’ (Hangstrom, 1997, p. 51). Traders make the
short-term market efficient because they trade on rumours and news and are very
close to the source of this information. They move the market rapidly upward or
downward when something is announced. However traders seem to be quite inept at
pricing stocks properly. They move stocks up or down, but they don’t settle on any
correct judgment of intrinsic value. Most traders don’t care about intrinsic value
anyway, seeing ‘truth’ in prices.
Speculators comprise a big chunk in the stock market. They are the people who trade
in the market on the basis of the ‘tips’ or the hot ‘tips’ that is readily available
everywhere. This causes the prices of the stocks to deviate from their fundamental
values and sometimes this deviation is so broad that it may cause a crash in the
market, examples of such behaviour are the so-called Bubbles.
Chapter 2: Literature Review
34
2.3 The Behaviour of Institutional Investors
Proponents of EMH have long been challenging the performance of institutional
investors and have been arguing that if markets are not efficient and there are
opportunities of profiting above the market returns, anomalies exist, and with all the
resources and skills they have, why are the analysts, active managers and other
money managers not able to beat the market. Nearly all mutual and pension funds
also fail to beat the market on a consistent basis. Damodaran (2002) also argues that
there seems to be little evidence of money managers being able to exploit the so-
called profiting opportunities to beat the market.
The recent empirical literature also suggests that institutional or professional investors
have been able to do a little better than the market, and that there is persistence of
performance among investors. One reason that institutional investors may not do
better is that they feel that they are dealing with clients who have expectations of
them that make it difficult to pursue their own best judgment. The clients expect them
to invest in accordance with certain fads. The clients expect them to trade frequently,
or, at least, are not willing to pay high management fees unless they do so. These
effects dilute the advantages that institutional investors naturally have. Another
reason that the differences are so small is that institutional investors do not feel that
they have the authority to make trades in accordance with their own best judgments,
which are often intuitive, that they must have reasons for what they do, reasons that
could be justified to a committee. Their obeisance to conventional wisdom hampers
their investment ability (Shiller, 2001).
Chapter 2: Literature Review
35
Another explanation for the institutional investors not able to beat the market or
atleast not so after considering their research and other expenses, as offered by
Damodaran (2002) and also supported by other researchers, maintains that portfolio
managers do not consistently follow any one strategy for investment. But they rather
jump from one strategy to another, both increasing their expenses and reducing the
likelihood that the strategy can generate excess returns in the long-term.
2.4 EMH in Indian context
2.4.1 Introduction
Despite being a developing economy, India has a mature stock market, established
well over a hundred years ago. The first stock exchange in India, established at
Bombay in 1885, has more than 6200 listed companies (Emerging Stock Markets,
1990, published by IFC). This number is exceeded only by the NYSE and is much
larger than number of listed companies in other stock markets in the world (Barua and
Varma, 2006). However, the Indian stock markets are characterized as the emerging
markets.
India liberalized its financial markets and allowed Foreign Institutional Investors to
participate in their domestic markets in 1992. Ostensibly, this opening up resulted in a
number of positive effects. First, the stock exchanges were forced to improve the
quality of their trading and settlement procedures in accordance with the best
Chapter 2: Literature Review
36
practices of the world. Second, the information environment in India improved with
the advent of major foreign institutional investors (FIIs) in India.
Emerging Markets are typically characterized by low liquidity, thin trading, possibly
less-informed investors with access to unreliable information and considerable
volatility. In addition, emerging markets by their very nature change rapidly through
time. The dismantling of barriers to the flow of capital both within the country and
from external sources will cause changes in the intuitional and regulatory
environments. In turn, this will impact on both the informational and allocational
efficiency of the markets, rather than simply taking a snapshot of the market at a
particular point in time (Tamakloe, 2003).
Although India is an emerging market, the less-informed investor characteristic does
not imply much in Indian case. Investors have availability to all public information,
but whether they use all available information for investment purposes is not known.
2.4.2 Studies on Indian Capital Markets in context of EMH
For emerging Indian stock markets, there have been a number of studies on the
question of efficiency. The results from the studies are mixed. Vaidyanathan and Gali
(1994) in their test for the existence of weak form of efficiency of the Indian capital
market have provided supportive evidence for the weak form of efficiency in the
Stock Exchange, Mumbai (BSE). Mallikarjunappa (2004) examined the efficiency of
the Indian stock market in the semi-strong form using event study. His study was
based on sensitive index (Sensex) based companies of BSE. Returns were computed
Chapter 2: Literature Review
37
using the price data of companies and the Sensex. The results of his studied showed
that the Indian market is not efficient in the semi-strong form.
Studies by Barua (1981), Sharma (1983), Gupta (1985) also indicate weak form of
market efficiency. Ray (1976), Sharma and Kennedy (1977), Barua (1981),
Ramachandran (1984), to name a few, have found the Indian stock market to be
efficient in the weak and the semi-strong form. This conclusion arrived at using the
conventional method of testing market efficiency is in line with similar works in
markets in the developed economies. Poshakwale (2002) examined the random walk
hypothesis in the Indian stock market (i.e. BSE). The broad conclusion of his study
and tests show that the Indian market does not conform to a random walk and hence
rejects the Random Walk Hypothesis. He also asserts that his results are largely
consistent with the previous research in the US and UK.
Sehgaland and Tripathi (2005) have found the evidence of the size based investment
strategy providing statistically significant extra normal returns in Indian stock market.
Their research finds out that a strong size effect exists in the Indian stock market
during the period 1990-2003. They say that such evidence casts serious doubts about
the level of market efficiency (semi-strong form). Patel (2000) also reported the
presence of strong size effect in 9 out of 22 emerging markets including India over
the period 1988-1998. Mohanty (2001) documented the presence of strong size effect
in Indian stock market over the period 1991-2000 using the market capitalization as
the measure of firm’s size.
Chapter 2: Literature Review
38
Behaviour of institutional investors in India can provide an explanation of the cause
of some inefficiency in the Indian stock market. Pitabus (2001) through his research
on ‘Efficiency of the Market for Small Stocks’ found out that in India institutional
investors prefer to invest their money in the liquid stocks. In the case of a liquid
stock, one can easily buy or sell a large number of stocks without affecting the price
much. By investing only in liquid stocks, the large investors are able to reduce certain
transaction costs, like the impact costs. In the study conducted by Pitabus, it was
found that there is a very high correlation between liquidity of the stock and the size
of the company. Hence, the large investors usually invest only in the large stocks. Mr.
U R Bhat, the Chief Investment Officer of Jardine Fleming, once remarked that in
India, for the foreign institutional investors “Big is Beautiful” (Mohanty, 2000). Since
the institutional investors do not pay much attention to small-stocks, there is not much
availability of equity research in such stocks. Hence, if an investor wants to buy
stocks of small companies he has to generate the equity research himself, which
entails costs, which the investor might not be willing to pay. Thus these stocks do not
generate much interest in the market and remain undervalued causing inefficiency
and profit opportunities.
Barman’s (1999) study finds that fundamentals rather than bubbles are more
important in the determination of stock prices in the long run in the Indian market;
however, discerns contribution of bubbles, mild though it is, in stock prices in the
short run. Batra (2003) provides evidence of the herding behaviour in the Indian
markets. Using both daily and monthly data, she finds that FIIs tend to herd in the
Chapter 2: Literature Review
39
Indian market and the herding measure being high for the monthly horizon. Gokaran
(2000) has studied the financing patterns of the corporate for growth in India. The
study indicated that equity markets suffer serious inadequacies as a mechanism for
raising capital. There is more speculation by investors rather than investment
orientation.
Obaidullah (1991) used sensex data from 1979-1991 and found that stock price
adjustment to release of relevant information (fundamentals) is not in the right
direction, implying presence of undervalued and overvalued stocks in the market.
Barman and Madhusoodan (1993) in their RBI Papers found that stock returns do not
exhibit efficiency in the shorter or medium term, though appear to be efficient over a
longer run period.
Like other markets, even in Indian market no consensus has been reached about
whether the markets are efficient or not, as can be seen from the studies above. In
context of behavioural finance, not much research has been conducted on Indian
capital markets.
Chapter 2: Literature Review
40
2.5 Markets are Efficient or Inefficient? Truce between the
two?
“I think that our gurus proved the point without a doubt. The efficient market theory
is flawed. There are simply too many examples of stocks that were discovered by a
great manager before anyone else knew what was going on.”
– Peter Tanous (1997)
“Most of us probably would do better to buy an index fund or throw darts at the Wall
Street Journal. But we also should think twice before assuming markets are even
informationally efficient”. - Stout
(2004)
Market efficiency is always a goal in the marketplace. We all want to get the value
we pay for. However, as mentioned earlier, the market will always overvalue and
undervalue common stocks due to the human emotions that drive it. By assuming
efficient markets, academics can conduct empirical investigations and come to robust
conclusions. As a result, the EMH has literally spawned much recent research and has
become entrenched as a truth in the minds of many academics. But, unfortunately, the
golden goose may not to be so golden (Downe et al, 2004). Even Burton Malkiel, one
of the most lucid proponents of market efficiency, agrees that ‘after the fact, we know
that markets have made egregious mistakes’ (Malkiel 2003, p. 61).
Chapter 2: Literature Review
41
Bergen (2004) argues that although it is relatively easy to pour cold water on the
EMH, its relevance may actually be growing. With the rise of computerized systems
to analyse stock investments, trades and corporations, investments are becoming
increasingly automated on the basis of strict mathematical or fundamental analytical
methods. Given the right power and speed, some computers can immediately process
any and all available information, and even translate such analysis into an immediate
trade execution. However, despite the increasing use of computers, most decision-
making is still done by human beings and is therefore subject to human error. Even at
an institutional level, the use of analytical machines is anything but universal. While
the success of stock market investing is based mostly on the skill of individual or
institutional investors, people will continually search for the sure-fire method of
achieving greater returns than the market averages.
Also, the theory of EMH is not science and researchers have argued that it is not
possible to test the efficiency of a capital market with complete accuracy. Much of
EMH is untestable, unverifiable and non-science and thus cannot be confirmed or
negated through rigorous assessment. This has resulted in protract disputes between
those who supported the EMH and those who did not (McMinn, 2004). According to
Roll (1997), “EMH (is) one of the most controversial and well-studied propositions in
all the social sciences. It is disarmingly simple to state, has far-reaching
consequences for academic pursuits and business practice and yet is surprisingly
resilient to empirical proof or refutation. Even after three decades of research and
literally thousands of journal articles, economists have not yet reached a consensus
Chapter 2: Literature Review
42
about whether markets - particularly financial markets - are efficient or not” (Roll,
1997).
The fury of the market efficiency battle is so great that one can easily miss Fama’s
(1991) statement that “market efficiency per se is not testable” (p. 1575) (in Statman,
1999).
Chapter 3: Methodology
43
CHAPTER 3: METHODOLOGY
3.1 Introduction
Methodology is a framework within which a research is conducted (Remenyi et al,
1995). Methodology and a good structure formulation can ensure a good logical flow
of information and helps reduce complexity within a research.
The aim of this chapter is to illustrate the research approach adopted, including how
data were collected, the rationale of those data collection methods and a discussion of
the validity and reliability of these research methods. It also outlines how the whole
research was carried out.
3.2 Qualitative Research and Quantitative Research
Research is a systematic investigation to find answers to a problem. The two main
broad categories that any research comprises of are Qualitative Method and
Quantitative Method. Considering the broad based nature of the research and the need
to conduct in-depth analysis, the qualitative research technique seemed to be the most
suitable for this research work. More formally, as Fraenkel (1993) puts, ‘no matter
how statistically powerful a nomothetic (quantitative research) finding is, it can never
definitively predict experience and action of the individual person (qualitative
research)’ (quoted in Nau, 1995).
Chapter 3: Methodology
44
The research methods used in this study are mainly qualitative. There are two main
reasons for this. Firstly, research conducted showed that although there has been a lot
of statistical research produced on the validity of EMH in Indian capital markets no
study attempted to find out what market participants believe about the theory. And in
order to find out this, qualitative research was the only method that could be used
effectively.
The aim of the dissertation is to explain the efficiency of Indian stock market and
how can investors beat the market, i.e. if it is possible to beat the market. After
evaluating the topic and aim of research, qualitative research method is most
appropriate for following reasons:
There have been quantitative research and statistical tests conducted on the
Indian stock market to find out if the markets are efficient or not. However, no
study has yet tried to look on the topic area from the qualitative perspective,
which in my opinion is an equally vital area of study. The reason being that
the statistical or the quantitative perspective always looks at the sample and
concludes its results on the basis of what the majority holds. However, in this
research, the aim has been to find out if it is possible to beat the market. The
history and logic suggests that if everyone would have been able to
outperform the market consistently and it would have been an easy job,
everyone in this world would have been rich and all the problems would have
been solved. But this is not the case. Albeit the quantitative studies suggest
Chapter 3: Methodology
45
that markets are efficient, there are people who have proven the theory wrong
by the exceptional returns on their investment. Thus, it is important to study
this subject from a different stance, particularly in the Indian capital markets,
which this research is endeavouring to accomplish.
In order to understand the behavioural factors that affect the capital market
participants and market as a whole, qualitative research methodology is the
most relevant method for data gathering and analysis. The quantitative study
and statistical methods will not be helpful in identifying these factors.
Through this research the researcher aspires to improve her understanding and
broaden her knowledge of the capital markets and the participant’s behaviour
in context of Indian capital markets. With the help of this research, the
researcher also aims to improve the Research Department of the company,
Arihant Capital Markets Limited, which she intends to work with. Thus,
qualitative research would help to meet the objectives as through this research
rather than being an outside-researcher looking in, the researcher is more
likely to be involved with the people, organization - engaging perhaps in
‘participant observation’, which is not possible in a quantitative study.
3.3 Research Map
Figure 1 outlines how the whole research was done and illustrates all the stages of
the research from the beginning, to the conclusion.
Chapter 3: Methodology
46
FIGURE 1
(Source: Author8)
The key research question was selected, then the research process started and
information gathering was done, which began with secondary research and then at a
later stage primary research was conducted. The collected data was then evaluated
and finally the research was concluded on the basis of the research and analysis part.
8 Author indicates the person who carried out this research
Chapter 3: Methodology
47
3.4 Research Methods
The method tools chosen for the research were appropriate as they helped in
obtaining valuable information and knowledge.
3.4.1 Secondary Research
Secondary data is data that has been collected for some other purpose and can be used
to answer research questions (Saunders et al, 2003). In answering the research
questions and meeting the objectives of this dissertation, secondary data has a
restricted application.
The secondary research conducted mainly falls into the heading of the literature
review. However, some articles on Indian capital markets and also the Indian
analysts’ view have been used in the data gathering and analysis stage.
In order to acquire profound knowledge and information of relevant areas of research,
secondary research has assisted in getting information on specific subject problems,
developed theories and research questions. The secondary research also aided in the
creation of questions for interviews.
3.4.2 Primary Research
Primary research is data that is actually collected from the natural world (including
experiments, interviews, case studies, etc.) and is collected specifically for the study
at hand. For data collection, this study has used the qualitative research technique of
Chapter 3: Methodology
48
direct communication with the research participants through interviews, discussed in
detail in next section.
Primary research was pivotal to this research and was the main source of data
gathering. Primary research tools were used because they provide the opportunity to
interact with people and obtain desired information. Interviews were conducted to get
the answers to the research questions and acquire profound information from the
experts and professionals in the investment arena in Indian stock markets.
3.5 Methodology and Data
3.5.1 Methodology Framework
This section outlines the Methodology Framework, i.e. the use of particular strategies
and tools for data gathering and analysis and the rationale for the choice of
methodology for data gathering and for data analysis through a diagram.
Figure 2 basically provides a broad framework of the methodology (taken from
Saunders et al, 2003), that is discussed in the next section.
Chapter 3: Methodology
49
FIGURE 2
(Source: Author)
3.5.2 Research – Setting, Procedures, Participants and Materials
As suggested by Sanger (1996), for qualitative research methods, interviews are the
predominant means of data collection. As defined by Khan and Cannell (1957, pp.
149), interview is “a conversation with purpose”.
In order to get the most valuable information and well-focused comments and advices
on the specific research topics from the experts and professionals, the research
method employed in accessing primary data was semi-structured face-to-face
interviews and telephonic interviews with capital market analysts, mutual fund
managers, individual and other institutional investors (I I’s).
Chapter 3: Methodology
50
An interview is advantageous (Easterby-Smith et al., 2002; Healey, 1991):
Where there are many questions to be answered
When the questions may be open ended
Where the order of questioning may need to be varied
All the above mentioned points justify the selection of interviews for data gathering
in this research project.
The semi-structured interview is one of the most frequently used qualitative methods.
They provide an opportunity to probe answers and the interviewees can be asked to
explain, or build on their responses (Saunders et al, 2003). For example, in order to
understand the psychology of investors and identify the irrationalities on part of the
investors, it was required that the respondents be probed to get answers different from
the past researches and specifically in context of Indian markets, which might not
have been possible without a semi-structured interview. In fact, when the
interviewees were asked to outline some irrational behaviour of investors most of
them initially quoted ‘herding behaviour’ as the answer and provided examples on
that. But only when asked to think of some other such behaviour did they actually
reflect over the question and provided further examples of such behaviour.
Britten (1995) explains that semi-structured interviews are conducted on the basis of a
loose structure consisting of open ended questions that define the area to be explored,
at least initially, and from which the interviewer or interviewee may diverge in order
Chapter 3: Methodology
51
to pursue an idea in more detail. Many questions evolved during the course of the
interview and hence the choice of semi-structured open-ended interview proved quite
beneficial.
Nevertheless, as the aim is to capture as much as possible the subject’s thinking about
a particular topic, interviewer can raise new questions during the interview.
Consequently, at the end, every interview can be different from the other. In fact,
during the interview stage, some new points were discovered, which were later asked
to the other respondents to elaborate and express their view on. The respondents were
informed before the interview that the question sheet is just an outline of the topics to
be covered. For example, in the second interview, the respondent mentioned that
‘discipline is very important when making investment decisions and most of the
investors lose money because they are not disciplined’ which was a new and
interesting point. In subsequent interviews, the author later investigated on the
discipline aspect of investment and found some very interesting results and answers,
discussed in the findings and analysis section on page 96.
Thus, semi-structured interviews were used for collecting data as it was the best
option to get the answers to the research questions and meet the objectives of this
research. And they certainly proved to be a very useful strategy for collecting data.
The interviews were based on a series of open questions, which were used as a
pointer for a wide-ranging discussion on –
Chapter 3: Methodology
52
the efficiency level of Indian stock market,
what irrationalities are investors prone to that affect their performance,
whether I I’s are able to beat the market consistently, the behaviour of various
market participants,
what investment strategy should be adopted by investors, and
how can investors identify good investment opportunities9.
3.5.2.1 Sampling
For some research questions it is possible to survey an entire population if it is of a
manageable size. Sampling (Saunders et al., 2003) is a valid alternative when:
It would be impracticable for you to survey the entire population
Your budget constrains prevent you from surveying the entire population;
Your time constrains prevent you from surveying the entire population;
In this dissertation, sampling is valid for most of the above mentioned reasons. There
were time constraints as well as budget constraints for the researcher. Sampling also
saves time, which was an important consideration for this dissertation. The purposive
sampling technique has been used due to the fact that this sampling technique allows
the researcher to use their personal judgment to select cases that best enables the
researcher to answer the research questions and meet the objectives (Neuman, 2000).
9 Refer to Appendix 5 for interview questionnaire.
Chapter 3: Methodology
53
3.5.2.2 Research setting
The interviews were held in eight different sessions individually with each
interviewee, 5 of them in Mumbai on 09th and 10th November 2006 at the offices of
respective interviewees, 2 interviews in Indore on 11th November 2006 and 1
telephonic interview with an interviewee in Bangalore (all in India).
The seven interviews were conducted at the respective offices of the interviewees
because they preferred the location for their convenience. Telephonic interview was
conducted because the interviewee preferred a telephonic conversation to a face-to-
face interview. Moreover, it was also not possible for the researcher to go to
Bangalore for just one interview.
3.5.2.3 Research Participants and Procedures
Eight interviews were conducted from different analysts and investors, ranging from
institutional to individual investors in Indian stock markets. Collecting data from
fewer subjects means that the information can be more detailed (Saunders et al.,
2003). The Interviewees were selected on the basis of following criteria:
- Experience in Indian stock markets and their knowledge of the research subject.
- Their association with the stock market.
- What sort of portfolio they manage – active or passive; the size of the fund they
manage (in case of institutional investors).
- What companies are they associated with.
- Diversity of background and job situations.
Chapter 3: Methodology
54
All the participants had excellent experience of Indian capital markets and were well
acquainted with the concept of market efficiency, passive and active investment
strategies and behavioural finance, which made the interview-process an enriching
experience. In order to get insight on the subject from different perspectives, it was
made sure that the participants/sample selected was diversified. Therefore, the sample
included participants from mutual fund companies, stock broking companies and
other institutional and individual investors. Participants included fund managers
managing funds between Rs. 600 crores- Rs. 10,000 crores10 of both domestic and
foreign investors. The sample also included both the proponents of active investment
strategy and passive investment strategy.
Table 3 summarises the names and profiles of the interviewees11:
TABLE 3
Interviewee Position ProfileInstitutional Investors
Mr. Ravi Gopalakrishnan Portfolio Advisor to Hudson Fairfax Group (HFG)
Hudson Fairfax Group (HFG) is a US based investment firm focused on sponsoring and promoting India-related investments. Mr. Ravi has 14 years of experience in the Indian capital markets and has a broad and successful background in Indian equities, including value and growth investing in both large and mid capitalization stocks.
Mr. Vishal Jain
Vice President, Investments and Fund Manager to Benchmark Asset Management Company
Benchmark is the only asset management company in India that purely invests through indexing. Mr. Jain has 8 years experience in Indian capital markets.
10 Approximately £71million-£1billion11 Refer Appendix 3 for detailed profiles of the interviewees
Chapter 3: Methodology
55
Mr. B. P. Singh
Managing Director of Atlantis Investment Advisors India Ltd
Mr. Singh is also the Portfolio Adviser to the Atlantis India Opportunities Fund. Atlantis is a leading asset manager, specializing in Asian equities. Mr Singh holds a distinguished reputation in the industry and has more than 15 years experience of Indian capital markets.
Mr. Rajesh Singhal AnonymousMr. Singhal is also associated with the Indian capital markets and is involved in the investment arena.12
Mr. Vinit Sambre
Product Analyst and Assistant Vice President of Global Private Client division of DSP Merrill Lynch.
Mr. Sambre is a Chartered Accountant and offers investment advice to the private client group.
Mr. Ashok Lunawat Research Head of Arihant Capital Markets Ltd.
Mr. Lunawat is the Research Head of Arihant Capital Markets Ltd, which is a leading stock broking firm in India. A Chartered Accountant by profession, he is known for his analytical skills and holds 10 years of experience in Indian capital Markets research.
Individual Investors
Mr. Ramesh DamaniMember of Bombay Stock Exchange
Mr. Ramesh Damani is a well known name among investors in India. A proponent of value investing, Mr. Damani has been tracking the markets for many years now and holds a distinguished investing record.
Mr. Ranjeet HingoraniWealth ResearchManager
Mr. Ranjeet Hingorani is also a value investor, and has a tremendous investing experience. He is a believer of Philip Fisher and Benjamin Graham’s theory on investing.
The names of the interviewees are coded (some respondent’s details are anonymous)
and the codes are listed in Table 4.
12 The company name and profile of the interviewee is anonymous as requested by him.
Chapter 3: Methodology
56
TABLE 4
Keyword Code
Mr Ramesh Damani RD
Mr. Ranjeet Hingorani RH
Mr. Vishal Jain VJ
Interviewee 4 I4 (RS)
Interviewee 5 I5 (RG)
Interviewee 6 I6 (BP)
Interviewee 7 I7 (AL)
Interviewee 8 I8 (VS)
The interviewees were given a questionnaire before the interview to get to know if
they understand the basic terminology and concepts used in the interview. A copy of
the questionnaire is attached in Appendix 4. A sample of the questions was supplied
in advance to all the interviewees but the discussion was open-ended and the
questions were merely indicative of the areas to be covered. A copy of these
questions is attached as Appendix 5 and the summary of the responses is presented in
the ‘Findings and Analysis’ section on page 62. For complete interview transcription,
please refer to Appendix 7.
Table 5 segregates the participants on the basis of different criterion.
Chapter 3: Methodology
57
TABLE 5
Active Managers: 7 (RD, RH, I4, 15, I6, I7, I8) Passive Managers: 1(VJ)
Mutual Fund Managers: 3 (VJ, I5, I6) Stock Broking: 2 (17, 14)
Individual Investors: 2 (RD, RH) Other Institutional Investors: 1 (I8)
Mutual Fund Manager:
Managing fund of – Rs. 600 crores (~ £71m): 1
Rs. 6000 crores (~£710m): 1
Rs. 10,000 crores (~ £1bn): 1
Investing funds for - Indian clients: 1
Foreign clients: 1
Both: 1
Stock Broking company participants:
Small-medium sized company: 1 (I7) Large-sized company: 1 (I4)
Interviews:
Face-to-face: 7 (RD, RH,VJ, I5, I6, I7, I8) Telephonic: 1 (I4)
Tape-recorded: 5 (RD, RH, VJ, I5, I6) Recorded through notes: 3 (I4, I7, I8)
The interview was recorded by the taking of contemporaneous notes and audio-
recording depending on the interviewee’s preference. Writing notes at the time can
interfere with the process of interviewing, and notes written afterwards are likely to
miss out some details (Britten, 1995). Therefore audio-recording was preferred.
However, due to the reluctance of some interviewees, 3 out of 8 interviews were
recorded through contemporaneous notes. Each interview lasted on an average for 60-
minutes with the exception of the telephonic-interview, which lasted for 20-minutes.
This source of primary data was seen as essential in understanding the reasoning
behind the investing behaviour, getting insight of various contradicting views on
Chapter 3: Methodology
58
whether one can outperform the market or not and, if so, how?; identifying what
investment strategy (active or passive) should be pursued by the investors; and other
research questions.
During one of the interviews, for example, the interviewee misunderstood the
meaning of the term ‘passive investment strategy’ while answering, despite
explaining the concepts before the interview was conducted. However, the
interviewer could identify the misunderstanding and clarified the meaning of the term
in reference to this study. Thus interviews also help in clarifying any
misunderstanding on part of the interviewees in regards to the questions, concepts or
theories used in research, which is not possible through a questionnaire. But also the
few questions answered by the interviewee were not reliable as the question was not
understood correctly because of the misunderstanding of the term.
The interviews conducted helped in getting below the surface of the topic being
discussed, and uncovering new areas or ideas that were not anticipated at the outset of
the research, which proved beneficial and added value in the research process. Thus,
using the semi-structured interviews as the tool for getting answers to the research
question proved to be the right choice and all the characteristics of these interviews
discussed above seemed to be applicable in this research as well.
Chapter 3: Methodology
59
3.5.2.4 Data Analysis
Figure 3 outlines the Data Analysis process
FIGURE 3
(Source: Author)
Detailed Explanation of figure 3
Once the interviews were taken they were subsequently transcribed. However, the
interview transcripts produced a large volume of material, which made the data
analysis a complicated process and it also turned out to be a time-consuming activity.
Content analysis was used for analysing the data. It is defined as ‘a set of procedures
for collecting and organizing non-structured information into a standardized format
that allows one to make inferences about the characteristics and meaning of written
Chapter 3: Methodology
60
and otherwise recorded material’ (Anonymous II, n.d.). This technique is popular for
analysing qualitative data.
Once transcriptions were done, the data was subdivided and categories were assigned
to the data. This process is called coding, defined as ‘the process of translating raw
data into meaningful categories for the purpose of data-analysis’ (Anonymous I, n.d.).
The original recording of the interviews was revisited during coding of every
interview to ensure that the true meanings of the participant’s responses are captured,
even if the meaning is not implicit in the transcript of the interviews.
For analysis purposes a tabular format of the commentary made by the interviewee is
also presented that provides answers to some of the research questions. The table,
generated in results section, summarises the key observations arising from the
interviews that have ramifications for the purposes for which the data was generated.
However, in an effort to be holistic and provide a richer understanding of what
emerged from the interviews, the tabular format is adopted but the commentary is
extended to cover all key commentary made rather than excerpts. This will maximise
understanding and minimise misinterpretations. This technique formally proposed by
Locke (2001) has been replicated in other studies (see for example Crossan and
Bedrow, 2003; Noble and Mokwa, 1999).
Chapter 3: Methodology
61
3.5.2.5 Rationale for Interviews for research
Interviews with analysts and investors was considered appropriate given that there
were a lot of issues to be considered, these issues were complex and the logic of the
answers needed to be questioned, enabling the author to “probe” answers (Easterby-
Smith et al., 2002). In addition, a further advantage of conducting interviews was that
it enabled a series of open questions to be put, whereas the questionnaire method
would not have provided for follow up questioning or requests for elaboration.
Moreover, the nature of research also required data gathering through interviews,
reasons have been discussed in the earlier section. Interviews are also a useful way of
attaining large amounts of data quickly. It allows the researcher to understand the
meanings that people hold for their activities (Marshall, 1999), which was crucial for
this research.
3.6 Conclusion
To conclude, in the research the focus was on communication with the participants
with a degree of dynamism. This reflects that there was a constant shifting with the
changing phenomenon and context and this in turn brought about flexibility in
research. In sum, the methodology used in this paper has used a very flexible
approach and adequate care was taken in selecting data sources. Thus the entire
approach and methodology used seeks to provide a comprehensive paper.
Chapter 4: Findings and Analysis of study
62
CHAPTER 4: FINDINGS AND ANALYSIS OF STUDY
4.1 Introduction
As explained in the methodology section, interviews were conducted to find the
answers to the research questions and to test the propositions of this study. In this
chapter, the results of the interviews will be described and will be concurrently
assessed with regard to the relevant literature.
4.2 Findings to the Research Questions and Propositions
The notion that stocks reflect all the available information in the market is supported
by many researchers and academicians (Fama, 1970, 1965; Malkiel, 1973, 1987,
2003; Kendall, 1953). However, others assert that stock markets are not efficient
(Brealey & Myers, 2000; Blanchard and Watson, 1982; Lo and Mackinlay, 1999) and
in fact argue that if markets would be efficient, no market would exist at all. In Indian
markets also, several studies have demonstrated that markets are efficient in weak and
semi-strong form and few of them showed that they are even strong form efficient. In
Table 6 below, the findings to the first research question - ‘Are Indian markets as
efficient as other developed markets like US and UK? Why?’, is presented using the
commentary made by the interviewees. The interpretations of the commentary and
findings are clearly highlighted in the table.
Chapter 4: Findings and Analysis of study
63
TABLE 6
How valid is the theory of efficient markets? Are Indian markets as efficient as other developed markets like US and UK?
Key Commentary made
RD: “My understanding is that while markets are roughly efficient but
they are not perfectly efficient and investors can take advantage of this
gap between perfectly efficient and roughly efficient markets in order to
maximise their returns. Indian markets are probably less efficient than
other developed markets and that is because the equity cult has just now
begun to take place, since mid-1990. It’s an emerging market and in
emerging markets typically the values are unknown, fund flow is not
predictable. But as India is liberalising, the financial sector has also
been liberalised, we are having lots of western influences. Indian
markets are getting to a more efficient level.”
I6: “EMH assumes that two people think alike. It is good in theory but in
practice it does not hold true. In real world information is analysed by
people, who interpret it differently. Had computers carried out the
analysis, the theory might have been true. The mere presence of brain in
humans deviates markets from reaching an efficiency level because
market comprises of people and people make the markets and each
person interprets or views things differently.
EMH is helpful in understanding markets and it can serve as a
benchmark from where to start.”
I4: “India is a developing economy and for high growth markets like
India, EMH does not hold true. India is not as efficient as the developed
markets because it is an emerging economy. Markets of countries like
UK and USA are saturated; the growth rates of companies are stagnant.
However, in India, every now and then the returns of some sector
suddenly grow at high rates and people who are able to identify them
beforehand can outperform the market. Therefore, Indian markets are
Chapter 4: Findings and Analysis of study
64
not as efficient as the developed markets. In fact, efficient markets are
only possible in an ideal world, but not in reality. Reason being that
there is always mismatch in expectations and this mismatch causes
inefficiency in markets.”
RH: “I do not agree with the EMH. Market is a reflection of many
people taking decision at the same time and they make those decisions on
the basis of the information they hold, their interpretation of the
information, their psychology, etc., which differs from person to person
and hence all these factors together makes the market inefficient.
However to some extent the markets are efficient because everyone has
access to same information. So on the face of it you’ll find that the
valuations are fair. Also there is no difference in the efficiency level of
the stock markets in India and other developed markets because the
people and their behaviour is the same and the greed exists everywhere.
They have also gone through the dot.com boom and bust like India.”
I5: “Firstly about EMH, in theory it holds true, yes. But in terms of
practicality, it is efficient over a longer period of time but in shorter
term, say 3-6 months over even a year sometimes, market may not be
efficient. India is a volatile market, and often times what happens is like
there is not proper dissemination of information, it takes time for the
market to understand that information.
I think Indian markets will still take time to reach the level of developed
markets like US or UK market. They are not as efficient as the markets of
developed economies.”
VJ: “I agree with EMH to some extent. However complete efficiency is a
utopian idea. In my view, Indian markets were not efficient 4-5 years
back because the information was not disseminated properly. But today
the regulations in the Indian markets have improved, information is
disseminated as soon as it is available and the dissemination is also
Chapter 4: Findings and Analysis of study
65
higher leading to markets becoming more efficient. The research on the
markets has improved manifolds. Now, there are more researchers,
analysts, and much more technically qualified people than earlier.
Therefore the markets are much more efficient than they were few years
back. And over a period of time, Indian markets would become more
efficient.”
I8: “Indian markets are not efficient, in fact I think if efficient markets
theory would have been true, no market would have existed. EMH is a
reflection of an ideal world and ideal world does not exist.”
Interpretations Indian markets, in fact, no stock markets are completely efficient. The
theory of complete market efficiency is only possible in an ideal world.
Reasons for market inefficiency are – mismatch of expectations,
behavioural patterns, information not always fathomed correctly and
above all the way information is being interpreted, in the sense that not
all information is interpreted by computers, people are involved in
assessing the information and people holding different perceptions assess
information differently.
There is clear indication of difference in the efficiency level of
developed and Indian stock markets. The main reason for this difference
is that India is an emerging economy. Other reasons for the difference
include Indian stock markets are not as well-researched as of developed
economies, there is improper dissemination of information, it is a volatile
market, fund flows are not predictable, the Indian economy is growing
exponentially and there are many high growth-rate companies that are
not present in developed markets.
The findings also indicate that as Indian markets are getting attention
Chapter 4: Findings and Analysis of study
66
from foreign markets, the regulations are becoming restrictive,
liberalisation is taking place in financial sector and markets are
becoming well researched, the efficiency level is gradually integrating
with the developed markets. But for this process to materialise fully, it
would take some time.
The findings are in line with many studies that confirm that Indian stock markets are
efficient in weak and sometimes semi-strong form, discussed in literature view. But
they are not completely efficient. Findings also confirm that Indian stock markets are
not as efficient as the other developed stock markets (like US or UK).
Krishnaswami13 also agrees that ‘the Indian stock markets lack liquidity and many
Indian companies are thinly traded in markets controlled by powerful local
brokerages’ (Knowledge@Wharton, 2006).
The answer to the first research question in Table 6 and the findings of the study
yield an apparently significant result to the first research proposition that says:
‘Complete market efficiency is a utopian idea. Markets cannot be completely
efficient nor are they completely inefficient’. The results indicate that no stock
market can be completely efficient or completely inefficient. As Warren Buffett once
commented, “I’d be a bum on the street with a tin cup if the markets were always
efficient”. The first proposition is therefore correct in context of this study.
13
Mukund Krishnaswami is managing director of Krilacon Group, an investment firm based in New York and Philadelphia.
Chapter 4: Findings and Analysis of study
67
Empirical evidences have suggested that market participants do not comprehend and
interpret information correctly that causes inefficiency in the market (for examples
see Jegadeesh and Titman 1993, Rajgopal et al, 2003). This study confirms this
statement. Therefore, this discrepancy provides opportunity for smart investors to
profit from and to understand that short-term price deviations should not cause panic
or they should not make hasty decisions.
In the literature review it was indicated that several event studies have shown
evidence of under-reaction in which the market response to new information appears
to be too little or too late. The results from this study concur to this evidence. In
context of global stock markets (including India) Mr. Damani quotes, ‘information
disseminates and there is immediate reaction but the final conclusion of that may
sometimes take even years before the market understands what it holds’.
Table 7 further summarises the findings along with the response of the interviewees
on information dissemination and its interpretation.
Chapter 4: Findings and Analysis of study
68
TABLE 7
Is the information that is disseminated in the market interpreted correctly by the investors? Does the market price the securities correctly in short-term, medium term or long-term?
Key Commentary made
RD: “Beauty is in the eyes of the beholder. Understanding the value of
particular information and its implication on a company is an art, and
not everybody can understand it atleast in the short-term. Market
sometimes takes time to grasp the reality of particular information.
Markets price the securities correctly in the long-run, it takes time for
people to understand the full implication of the information”
I4: “Market prices the securities in a longer period. Inefficiencies would
go away in a longer-term and there are no surprises in long-term which
would deviate the market price from the intrinsic value.”
VJ: “I think information is interpreted correctly and its meaning
immediately reflects in the prices. Even if the general public does not
understand what lies behind, there are smart analysts sitting in the
market who correct the price of the security if people misprice it.
Market prices the securities correctly in medium-short term, because in
short-term many factors causes deviations”
RH: “Information in the short-run and sometimes even in a longer
period is not interpreted correctly. For e.g. sometimes the expectations
of the market are so high that people actually misprice the securities,
that is what I would call as overreaction bias. On the basis of just one
piece of information people under-react or overreact and ignore the
other factors that may be equally important in price determination. The
market prices the security correctly only in the longer-run.”
Chapter 4: Findings and Analysis of study
69
I6: “Over longer-term markets prices the securities correctly”
I5: “Markets price the securities correctly in Medium-long term. In
short-term there might be fluctuations, there might be discrepancies in
terms of pricing but in a long-run definitely markets price the securities
correctly. Reason being that the information might not have been
incorporated completely; there might be disbelief in terms of what is
going on. There may be other external or international factors
(psychological) like if there is a war going on somewhere and their
markets and other markets are not doing well, people might expect
companies and markets in India not to do well. In short-term there is
discrepancy in pricing but in longer run it is corrected because the
information sort of populates down (people understand the information
and what lies behind it), other factors also settle down”.
I8: “There is a discrepancy. For example, the information that is
disseminated may not be comprehended in the same manner as the
company wanted to show. Each individual will understand and
henceforth react in a different manner. In fact, existence of both the
buyers and sellers in the market prove that same information is
interpreted differently and there is rational and irrational action on the
basis of that information.
Markets price the securities in a longer-term. Short-term markets are
driven by irrational investors. For example, external events like a
bombing in UK will result in crash of Indian markets despite the fact
that such an event actually has not affected the Indian economy or its
industries and companies. It is just panic from investors or an
opportunity for speculators to make profits by driving the market away
from its fundamentals. However, in a longer-term the true picture will
show and prices will reach their intrinsic value, their efficiency.”
Chapter 4: Findings and Analysis of study
70
I7: “In short-term prices often deviates from their intrinsic value.
However over a long-run the true picture is identified and hence
markets price the security correctly.”
Interpretations Generally believed that market participants take time to grasp the reality
of the information, sometimes it takes a long time to understand the full-
implications of the information. Information may not be comprehended
in the same manner as the information-provider wanted it to,
expectations formed before the information is disseminated causes
distortion of true picture. In sum, information that is disseminated in the
market is not always interpreted correctly by the investors. Its
implication can be that it can provide opportunities for smart investors
and analysts to profit from.
On the other hand, VJ’s statement about the information dissemination
varied from all the other respondents. He said that information is indeed
interpreted correctly and even if some people do not fathom it correctly
and misprice the stocks, smart arbitrageurs exist who bring the
securities to their correct prices. Further research on the area is needed
to find the validity of this argument in Indian markets.
Answer to the first question broadly answers the second part. General
consensus is that markets prices the securities correctly in the long-run.
In the short run, markets are sometimes driven by irrational investors
who cause prices to deviate from their intrinsic values. External factors
which actually do not have any effect on the companies may cause these
deviations. Investors panic if information is not what they expected. All
such factors lead the prices of stocks, in the short-term, away from their
intrinsic value.
Chapter 4: Findings and Analysis of study
71
Results from Table 7 confirm the argument of Brian (1994) – ‘At any time there will
be two sorts of operators in the stock market, one bull and the other bear, but they
will rarely be in balance. When bulls predominate the market will go up, and when
bears predominate the market will go down. The ratio of these two sets of people will
vary according to their interpretation of various news items, both political and
business, upon other investors, as well as their overall feeling about the economy in
general and the stock market in particular’.
The results from Table 7 also clearly substantiate the findings of Barman and
Madhusoodan (1993) who found that stock returns do not exhibit efficiency in the
shorter-to-medium-term though appear to be efficient over a longer run period. When
the interviewees were asked, ‘does the market price the securities correctly in short-
term, medium term or long-term’, all of them answered that it does it in a long-run or
medium-to-long run and that markets are not efficient in the shorter term. In the
short-term many macro-factors like war in some part of the world or a terrorist attack
in another country, which do not have much affect on the economy and stock
markets, also affect the prices of the securities. There is a tendency to over-react to
some piece of information amongst the investors and under-react to others. DeBondt
and Thaler (1985, 1987) argued that investors tend to overreact to extreme price
changes due to the human tendency to overweigh current information and underweigh
prior data. I7 says ‘people generally tend to forget the past and other factors that
have an effect on the company and give so much weight to the current information
that it leads the price deviation from its intrinsic value’. The results from this study
Chapter 4: Findings and Analysis of study
72
concur DeBondt and Thaler findings, and this provides another reason for why
markets are not efficient in short-term.
Benjamin Graham (1965) was therefore correct in suggesting that
‘While the stock market in the short run may be a voting mechanism, in the long
run it is a weighing mechanism. True value will win out in the end’.
The results clearly indicate that in the short term several factors causes prices to
deviate from their intrinsic value, however in a longer period all the shocks and
surprises vanish and the price of a security reflects its true value. These findings
generate important results for proposition 2 of this research that says: ‘Stock markets
price the securities correctly in long term. In other words, over a long-term the
price of a company’s shares reflects its intrinsic value’. Proposition 2 has been
tested and verified and the finding from this study shows that it is correct.
Table 8, below, seeks to provide an answer to the third research question.
TABLE 8
What investment strategy should be adopted by individual investors? Does their risk profile affect their choice of investment strategy?
Key Commentary made
RD: “I believe in active strategy for investment. Passive investment
strategy is good for people who actually don’t have time to follow the
Chapter 4: Findings and Analysis of study
73
financial markets, don’t have time to think or read the Balance sheets,
and meet and talk to the management of the companies. So it is a low
cost way to take the advantage of the economic growth of a country, just
buy the index and get market returns. And yes, the risk profile of an
investor will also affect what investment strategy he wishes to adopt. A
risk-averse person would prefer indexing, while someone who is less
risk averse will go for active strategy”.
I4: “What investment opportunity should be adopted by investors
actually depends on their risk profile. If you are a more risk-averse
individual, you should go for passive investment strategy, while a risk-
neutral or less risk-averse person should go for active strategy.
However, in a country like India, I think, they should go for active
investment strategy because Indian stock markets are developing and in
Indian markets abnormalities often occur which causes inefficiency and
thus opportunities for active managers to profit from them.”
RH: “Individual investors who do not have expertise and understanding
of analysing companies, markets and sectors can straight away go for
indexing, because the expenses and cost to the investor is less and they
will be much better off than many active investors. When market falls,
active investors may lose much significant amount than passive
investors.
Risk profile of an investor may not necessarily affect his choice of
investment strategy. A person who is risk averse, because he has made
one correct decision in investing his risk taking capacity increases. He
becomes intelligent and brave in his own eyes. And then he takes that
additional risk that is disastrous. So risk profile for me is a relative
term. When an investor is making money, for him risk becomes
irrelevant and when he loses money he realises what he has done and
becomes risk averse but then it is too late”.
Chapter 4: Findings and Analysis of study
74
I5: “Active will generate better returns. Even a passive investor, when
sees his returns are lower than markets, will eventually divert to active
because of the nature of Indian markets, they are very volatile.”
I8: “I think that individual investors should adopt an active investment
strategy broadly, but if they want stable returns and are risk-averse they
should adopt passive strategy. Moreover, since the investors do not
have access to information and resources to analyse and understand
that information as well as the fund managers do, they should invest in
the market through professional investors, rather than doing it
themselves.”
I7: “There is low risk in passive investing, but not necessarily true in
volatile markets like India. I would recommend active strategy because
that is what investment is all about.”
VJ: “I think it should be a combination of active as well as passive
strategy. Simply because there are periods when active fund managers
outperform the market and indexing doesn’t generate returns. And
obviously the skill is there and that skill of active guys should be valued.
However, because an active manager has outperformed the market this
year doesn’t guarantee that he will be able to outperform in the coming
time. I don’t want to take this risk. I might as well put my funds in an
Index for 4-5 years and I believe in it because if our economy is going
to grow, which it will, so obviously the large companies are going to
benefit the most. I want to be invested in the best companies and that is
reflected in the Index. I don’t want to put my money with some fund
manager who might be there today but might not be there tomorrow,
who is performing today but might not be performing tomorrow. I don’t
want to make that call.
Yes, definitely the risk profile of an investor makes a difference in his
investment strategy. If the investor is risk-averse, he would probably
Chapter 4: Findings and Analysis of study
75
prefer being with the index. He would not want 30-40% return that may
not be stable; he is content even if he is just getting the market returns
of say 20-25%.”
InterpretationsThere are divergent opinions on what investment strategy should be
adopted by individuals; some suggest active strategy, some advice going
through mutual fund channels only but through active managers. One
interesting response was a combination of both active and passive. No
one advised a pure passive investment strategy.
Clear indication of risk profile affecting choice of investment strategy.
A more risk-averse person would pursue a passive strategy and a less
risk averse will follow active strategy. Two interesting perspective also
arose. First is that risk profile affects the choice of strategy but a passive
strategy may be more risky in volatile markets like India and second is
that risk is a relative term, the more one earns the more risk taking he
becomes.
Malkiel (2005) argues that - ‘In recent years financial economists have increasingly
questioned EMH. But surely if market prices were often irrational and if market
returns were as predictable as some critics have claimed, then professionally
managed investment funds should easily be able to outdistance a passive index fund’
and shows in his paper that professional investment managers, both in the U.S. and
abroad, do not outperform their index benchmarks and provides evidence that by and
large market prices do seem to reflect all available information’.
To the extent of Indian markets, the above statement and finding provided by Malkiel
does not hold true. The results from this study show that passive (or index) funds are
Chapter 4: Findings and Analysis of study
76
not very popular in India and in fact there are examples of active funds that have
beaten the market consistently. As Dey (2006) points out, ‘there are not too many
takers for such funds (passive) in India, even though the asset management company
in question may be backed by the mighty HDFC (a leading and renowned asset
management company in India)’.
Thus the findings from this study contradict the assertion of many researchers who
agree with efficient market theory’s implication that it is not possible to beat the
market. ‘In India, there are actively managed funds that comfortably outperform the
index over longer time frames (over 3 years). This is because unlike the United States
(or UK), India is a developing economy and many stocks are still under-researched.
This gives fund managers several investment opportunities to outperform the index.
So investors chasing performance still have a good reason to invest in active funds’14.
All the mutual fund managers in this study have agreed to this that in India, there are
ample opportunities for active managers to outperform the index and they have been
consistently doing it. Even other investors have confirmed this view.
Another reason for the unpopularity of index funds in India is costs. Although index
funds in India have a lower expense ratio vis-à-vis their actively managed peers, they
are not as cost-effective as their US counterparts when it is compared to their actively
14 This evidence is provided by Personalfn (a investment advisory company in India) in their article Index funds: Too expensive, published in 2005.
Chapter 4: Findings and Analysis of study
77
managed counterparts from the same fund house (Personalfn, 2005)15. Thus, the costs
associated with passive funds are not low enough in India to get investors interested.
These findings provide an indication to the passive fund managers to develop their
products in ways that will be attractive to customers. The findings from this study
also shows that there is a need for awareness of indexing strategy amongst individual
investors. Results also indicate that in the coming time, in India, passive strategy will
gain popularity, as the markets will reach a more efficient level.
Table 9 provides evidence on whether overvalued/undervalued stocks exist or not.
TABLE 9
Do overvalued and undervalued stocks exist?
Key Commentary made
RD: “Yes they exist and because they exist I am able to make
money otherwise I would have been a poor guy, I would have
been out of the market.”
I4: “Yes overvalued and undervalued stocks do exist. In fact it is
corollary of the fact that markets are inefficient. Expectations
differ in the market, which results in undervaluation and
sometimes overvaluation of the stocks.”
Motilal Oswal when asked in an interview if the market is reasonable
valued answered, ‘The market is never reasonably valued; it is either
underpriced or overpriced’16.
15 Refer Appendix 6 for the expense ratio of active and passive funds in India and in US.
Chapter 4: Findings and Analysis of study
78
I7: “Markets are often driven by greed and fear of the people,
which causes stock prices to move beyond their intrinsic value
causing overvaluation of stocks, as has been seen in 2000-2001
Internet bubble. Similarly when people suffer losses because of
the mistakes they commit of buying stocks in highly overpriced
market without understanding fundamentals, they are so scared of
the market that it causes companies selling sometimes below their
cash value. In 2002-2004, I have actually seen that the offices
which used to be packed with traders and investors 2-3 years back
had no one except the operators. Stockbrokers used to telephone
their clients and convince them to come to the market atleast for a
few hours. Being an analyst, I found some very good companies
during that phase whose stocks were selling in the markets at
unbelievably low prices and no one wanted to buy them. While 3
years back, people actually were paying up to say 50x the price to
get the same company. Nothing went wrong with the company; it
was still selling its products, generating profits and running its
business. But it was the fear and over-pessimism that was guiding
them. This is a clear indication of existence of overvalued and
undervalued stocks.”
I5: “Yes overvalued and undervalued stocks exist all the time”
I8: “Yes, definitely overvalued and undervalued stocks exist in the
market. Markets are like a pendulum which swing between the
phase of overvaluation and undervaluation”.
16 Motilal Oswal is the Chairman and Managing Director of Motilal Oswal Securities, which is amongst the top 5 broking houses in India. This comment is taken from a Newspaper article by Bhagat (2006)
Chapter 4: Findings and Analysis of study
79
InterpretationsCommon belief among participants that overvalued and undervalued
stocks exist in the market. Difference in expectations, over-optimism
and over-pessimism and fear and greed amongst investors and the recent
Internet Bubble confirm that overvalued and undervalued stocks exist.
Finding from Table 9 and verdicts of interviewees show that it is possible to
outperform the market, especially in India. Identifying undervalued and overvalued
stocks can provide opportunities for investors to outperform the market. It requires
skill and investment acumen to identify these opportunities, which is not possessed by
everyone. But nevertheless, people who have that acumen can outperform others in
Indian stock markets. RD remarked, ‘People say that since nobody can beat the
market why should I try. So the question is not this. Let me give you an example, in
Mumbai say 3000 people play tennis everyday. Half of them lose and half win, so that
doesn’t mean that people who lose will give up trying. They have to get back and get
their credit’. I6 comments: ‘not everyone can continue to outperform the benchmarks
all the time. Even Warren Buffett underperformed for the brief period of technology
boom. But then over a longer run, it is possible to beat the market consistently’.
I5 also commented ‘I am admitting that it is not easy to beat the market especially
with the changing scenario of Indian stock markets as they are being well-
researched, but the fact is it is not impossible either’. The how part, i.e. how to beat
the market, is discussed on page 94.
Chapter 4: Findings and Analysis of study
80
I5 quoted: Skill is an important factor that distinguishes an outperformer from
others’. VJ also commented on the presence of skill in Table 8 that implies that skill
helps in selecting good investment opportunities. I8 quoted: ‘your skills and ability to
identify good opportunities are important in making investment-decisions’. I7 stated
that, ‘If we actually contain to stick to our basics then only we will be able to beat the
market through our skill through our vision’. RH also agreed that ‘vision and
analytical skills’ of an individual that others do not have, distinct him/her from the
average people and using this he/she can outperform the others. He further adds that
‘To outperform the market a good judgement is required and that is matter of skill,
which everyone does not possess. Skill plays an important role’.
The above discussion and results from Table 6, 7, 8 and 9 and the subsequent
discussion clearly demonstrate that it is indeed possible to outperform the market
consistently but it requires distinct skill and investment acumen. These results verify
proposition 3 that says: ‘It is possible to outperform the market on a consistent basis
and skill plays an important role in such performance. The chances of consistently
outperforming the market are low, albeit possible’. Thus the findings of this research
confirm and verify the above proposition. Shiller (2001) also says that ‘Success in
investing usually involves some acquired skills in understanding the particular
category of investment and in the strategy of dealing with it’.
Chapter 4: Findings and Analysis of study
81
Table 10 provides results on whether the majority of markets participants in India are
driven by short-term speculative motives or not? And also attempts to test the
Research Proposition 4.
Table 10
‘Keynes’ pictures the stock market as a ‘casino’ guided by ‘animal spirit’. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements’. Is this statement correct in context of Indian markets?
Key Commentary made
RD: “I think he is right. So I agree that stock markets act like a casino
where people are looking for short-term fluctuations and not long-term
value and it is there for their detriment. Globally investors behave the
same way, when they come to the stock market they look at price and
not value”.
I4: “I don’t think it is completely true. Speculators do exist, but then
there are people who want to stick to their decisions and are not
speculating. People do take a longer term view. But like I said, traders
also exist who carry out speculation.”
I5: “I think it is a fair comment and I don’t dispute that. Very few people
in the Indian markets are there for a long-run. Nobody wants to wait for
their returns. People don’t picture their stocks as investment.
People don’t want to invest money but play with the market.”
I6: “Keynes’ picture of the market is absolutely correct, bulk of the
investments that is done in the market is done with the mindset of
Chapter 4: Findings and Analysis of study
82
making short term profits and that is why people don’t make money.
People actually think it is a casino where cheap money can be made but
believe me there is no cheap money in this world.”
I7: “Keynes made a fairly correct statement. In fact, this problem is
more severe in Indian markets; everyone is here to make cheap money.
Especially when the markets are on a bull run, you will find housewives,
doctors, software professionals, bank clerks, credit managers investing
in the stock market. In fact even my cook wanted me to recommend him
stocks to put his money in. And believe me they don’t understand a bit
about the company they are putting their money in. It is actually like a
casino for them. However, actual investors do exist, though sometimes
even they are driven by this animal spirit.”
I8: “In regards to Keynes’ picture of the market, I think his explanation
is correct and this happens in the market. But is this not what markets
are for?”
Interpretations General consensus that most of the market participants are driven by
short-term speculative motives in the Indian stock markets. Most of the
people in India invest for the short-term; very few people actually are
long-term investors. In fact even they are sometimes driven by the
markets and indulge in speculation.
When the interviewees were asked to present their opinion on Keynes’ view of the
stock market (see Table 10) all of them supported Keynes’ picture of stock market.
Results from Table 10 verify the proposition 4 that states: ‘Most of the people
putting-in money in the stock markets in India are guided by the short-term
speculative motives. Therefore, prices of securities often deviate from their intrinsic
Chapter 4: Findings and Analysis of study
83
value’. However, findings also indicate that long-term investors do exist who pass the
definition of investors provided by Graham that says, ‘An investment operation is one
which, upon thorough analysis, promises safety of principal and a satisfactory return
and people indulging in the investment operation are investors. Operations not
meeting these requirements are speculative’ (Graham, 2003; Graham and Dodd,
1934). Though such investors are very rare in the market and even they sometimes
are sometimes susceptible to speculation.
RD gives a very interesting statement, ‘Stock markets are vehicle of producing only
long-term wealth. But people speculate and get in for adventure, but that is not the
purpose of the market. You might be using it for different purposes and that is why
you end up with bad returns and hard luck stories’.
Table 11 generates the results on behavioural finance and irrational behaviour of the
investors.
TABLE 11
Is Behavioral Finance (BF) important in making investment decisions? What irrational behaviour or emotional biases investors capitulate to, in India, that affects their investment decisions and also market prices and returns?
Key Commentary made
VJ: “I think people have run out of ideas to beat the market and
that is why things like BF are coming up. It is a fuzzy logic.
There is a tip-behaviour in India. Without using their judgment
Chapter 4: Findings and Analysis of study
84
and research people invest on the basis of tips from the market.
Everyone in the market wants to make quick money, no one looks
at it as investment. Greed drives people. All this is irrational
behaviour.”
RD: “I think understanding behaviour is important in
understanding markets and in making investment decisions.
If you go to a store in sale and two shirts are selling for the price
of one, you will buy more shirts because it is cheaper. But in stock
market the reverse happens, when the market goes down people
run away instead of buying more they buy less. While when prices
go up all of them want to buy shares. At the bottom of the market
when they should be buying they are too scared to buy while in
bull markets people will pay any price to get stocks of the
company that are hot/popular. Now that is irrational behaviour.”
I5: “It is fairly important because a lot of time what happens is
that there generally is consensus in the market and the consensus
normally is wrong”.
“Examples - There is herd mentality on the streets. Suddenly
when you see something doing well, everyone wants to pile on it.
Then over-speculation, chasing stocks with no fundamentals at all
just because someone on the street or your stock-broker has
recommended you. Greed, ‘I should not be left-out’ attitude.
People don’t have time to analyse and get the information on the stock,
because they have their own work and business to manage, so they just
buy whatever is recommended to them. The attractiveness of the stock
market is so overbearing that they can’t afford to miss anything like
that. And mind you ‘losing an opportunity hurts you more than having
actually lost money’.
Chapter 4: Findings and Analysis of study
85
I7: “BF provides a platform to learn from people’s mistakes, to
modify and improve their overall investment strategies and
actually profit from identifying these mistakes. It is very helpful.
People show problems of self-control, and know that they may be
unable to control themselves in the future. Investors get optimistic when
the market goes up, assuming it will continue to do so. Conversely,
investors become extremely pessimistic amid downturns. Putting-in
money on tips, overconfidence, greed and getting emotionally
attached to the shares are other examples of irrational behaviour
seen in Indian markets.”
I8: “BF is indeed very important in making investment decisions.
One of the examples is herding behaviour, herding without
understanding why they are getting into a particular sector and
without understanding why they are buying stock of so and so
company. Even rational investors and professional managers
follow the crowd.”
RH: “BF is very important while making investment decisions.
Since everyone is investing in the market and making money then
why should I be left-out attitude exists. There is a tip-behaviour in
the market, because no one wants to do the hard-work and still
want to make money”.
I4: “Yes BF is actually very important and understanding
behaviour can actually help us in not making the errors people
generally commit in the market”.
Interpretations Generally believed that behavioural finance is very important in making
Chapter 4: Findings and Analysis of study
86
investment decisions. However, one respondent presented a contrarian
view that it is a fuzzy logic and can cause trouble if decisions are based
on it. To sum up the comments, behavioural finance is actually
important and can provide a means for understanding what errors should
not be perpetrated. The irrational behaviour of Indian investors outlined
include herding, greed, investing on tips available in market without
evaluating it, buying when markets are up and running away when
markets are down without understanding the logic, over-speculation,
overconfidence, lack of self-control and emotional attachment to the
shares invested in.
In explaining the importance of behavioural finance Mayer (2001) argues that ‘Many
psychological biases are so persistent in so many individuals that it seems difficult
that anyone could deny their existence’.
The findings of this research agree with the statement that ‘Behavioural finance
essentially says that people are not the rational participants EMH makes them out to
be. The study shows that market participants can and do act irrationally’ (Anonymous
I, 2006) and supports Mayer’s statement. The explanations provided by behavioural
finance theory and the involvement of psychological factors in stock markets cannot
be ignored. Most of the respondents agree that understanding people’s behaviour and
learning from their mistakes can actually assist investors in their investment decisions
and help them in improving returns from their investments. However, one of the
respondents comments that ‘The explanation provided by the behavioural finance
Chapter 4: Findings and Analysis of study
87
theory is correct and one should try to avoid the general errors’ but further argues
that ‘I might invest according to behavioural patterns and some day it might bomb on
my face. I don’t know to what extent it would work, whether it is stable, whether it
works in different scenario. Even if you try to understand people all the time, you are
not always be able to outperform & outsmart them’.
Mr. Parag Parikh17 agrees that behavioural finance is very important in making
investment decisions and with its use once can get good returns from the market –
‘After an extensive study of the literature on behavioural finance, I believe that its
perfect application could make you a successful investor making fewer mistakes’ (in
Verma, 2004). He further adds, ‘Simply put, standard economic theory starts with a
flawed basic premise that the investor is a rational being who will always act to
maximise his financial gain. Yet, we are not rational beings; we are human beings.
Frequently emotions prompt us to make decisions that may not be in our rational
financial interest. Behavioural finance is the study of how emotions and cognitive
errors can cause disasters in our financial affairs. In stock markets, behavioural
finance can help explain situations such as why we hold on to stocks that are
crashing, ridiculously overvalue stocks, jump in late and buy stocks that have peaked
in a rally just before the price declines, take desperate risks and gamble wildly when
our stocks descend’ (in Lohande, 2004).
17 Mr Parag Parikh has studied behavioural finance at Harvard University and is the Chairman of Parag Parikh Financial Advisory Financial Services, India has been applying the concept of behavioural finance while investing in the stock market.
Chapter 4: Findings and Analysis of study
88
In regards to the proposition 5, the tests and results confirm that ‘Behavioural
finance plays a vital role in understanding investor behaviour and making
investment decisions’. But the second part of the proposition that states - ‘With the
use of explanations on investor behaviour propounded by BF theory, investors can
improve their returns in the market’ – does not generate consistent result. There are
mixed views on whether behavioural finance theory can help the investors in
improving their returns and outperforming the market.
4.2.1 Why are IIs not able to beat the market
Billions of dollars worth stocks are traded on Indian stock exchange18 every day. This
is supported by a massive investment in research, trading infrastructure,
communications and so forth. Analysts, money managers, fund managers use their
expertise and spend a lot of time analyzing a stock, its industry and peer group to
provide earnings and valuation estimates. In India, the opportunities for active
managers to outperform the market are greater than the developed markets, as
discussed earlier. But despite all this, only a handful of the IIs in India are actually
able to beat the market consistently. The results and findings have generated reasons
for this underperformance discussed below.
The results indicate that pressure from investors to give quick returns is the main
reason why Mutual Fund Managers (henceforth FMs) and other IIs underperform. All
the interviewees agree that the fund managers have to report daily Net Asset Value
18 National Stock Exchange of India (NSE) and The Stock Exchange, Mumbai (BSE) website
Chapter 4: Findings and Analysis of study
89
(NAV)19 of their funds, which causes pressure on them and they start investing in the
momentum stocks or the so-called current hot sectors in the market.
Figure 4 gives a model of how the pressure is created on FMs.
Figure 4
(Source: Author)
There are various funds available in the market and investors (clients) have many
options to choose from. In the mutual fund industry in India, FMs have to report the
NAV of their fund everyday as seen in Figure 4. Now due to this, a pressure is
created on FMs to show performance everyday, otherwise their clients shift to other
funds. This pressure causes them to invest in momentum stocks, which may even be
19 The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV) (source: www.sebi.com)
Chapter 4: Findings and Analysis of study
90
against their own judgement. I6 explains, ‘Investors create pressure on fund
managers and that is why they get into momentum stocks’. RD comments, ‘There is a
funny business going on in the mutual fund industry. It’s a very NAV driven industry
and everyday the NAV is reported. Now stock market is not conducive to printing a
NAV everyday, you have to look at this over a period of time not everyday. Now if you
force yourself to look at NAV everyday, you are going to end up not making any
money because you then tend to go with the stocks that are moving up. So the whole
Mutual Fund business is structured, in my opinion, in a wrong fashion. Suppose if we
buy a house, we don’t check its value everyday although it may go up and down. You
don’t need to check your investment’s value everyday. Businesses perform and keep
doing their work irrespective of what is happening on the Dalal Street20. They create
new products, launch their marketing campaigns, and enter new markets and all this
has nothing to do with the stock exchange’.
I6 also remarks ‘The manner in which the money is invested is wrong. People
investing money in stock markets want to generate short-term profits. But they will
have to take long-term perspective. And I think this phenomenon is worldwide,
however it is more prominent in emerging economies like India and less in developed
economies. If in the short run a fund does not perform, investors withdraw their
money from it and invest in other funds and so FMs are also pressurized to select
sectors and stocks which will generate short-term returns and so they fail to show
their performance. People will have to take a long-term perspective in stock markets’.
He further adds that, ‘If the fund manager is not investing in the ‘hot’ sector because
his logic and judgement says not to and he underperforms compared to others, people 20 Dalal Street in India is analogous to Wall Street of USA
Chapter 4: Findings and Analysis of study
91
will think ‘oh he has lost his touch’ and they withdraw money from his fund and
invest in other funds. That FM might then think that my business is suffering, if I don’t
invest in the ‘hot’ sector I will be losing customers and I will be losing money. So let
me also participate in the sector. When this bubble will burst I will walk out. But no
one knows when this bubble will burst otherwise no one will invest in the bubble’.
Thus results show that FMs are more short-sighted under stronger pressures from
their customers concerned with short-term performance. In fact one of the
respondents even commented that ‘I often trade too much because my clients demand
short-term performance’. Moreover the frequent trading that they indulge in increases
their expenses as RD mentioned, ‘people who frequently trade, every time they
buy/sell they have to pay the brokerage, they have to pay extra for difference between
bid-ask price, they have to pay transaction costs. Over time all these costs add up to
huge amount, so the compounded return of the person who engages in one time
buy/sell is much higher than who actively buys and sells’. This frequent trading is
also a result of sometimes pressure from the investors.
Another reason for their underperformance can be attributed to the fact that generally
IIs do not have the authority to make trades in accordance with their own best
judgments, which are often intuitive, that they must have reasons for what they do,
reasons that could be justified to a committee. Their obeisance to conventional
wisdom hampers their investment ability. But in making investment decisions, using
one’s own judgment can actually help investors to outperform others as has been
Chapter 4: Findings and Analysis of study
92
discussed earlier. IIs are not allowed to use their judgment and they therefore are not
able to work to their best ability and not give performance. VJ commented: ‘It is like
the ‘chicken and the egg problem’. I mean even if the FM has guts to sit in the market
with his portfolio even when it is underperforming and still believe in his philosophy,
the thing is people should also have faith in his philosophy and judgement. But it does
not happen. If his fund is underperforming his clients will shift to other FM and then
he will not have the money to manage. At the end of the day, it is business. I might
have a philosophy but I got to survive in the market’.
The findings also show that IIs try to be jack of all trades, i.e. they try to be an expert
in all the sectors and do not concentrate on areas that they understand. As I6
comments, ‘Investors put pressure on FMs to perform every quarter and the FM
actually comes under pressure to retain the market share and they start looking at
everything and basically become jack of all trades and master of none. And in the
process they become average people and an average person will give you average
returns. So they need to focus on their strengths. This is the biggest problem in MF
industry’.
Findings also indicate that Institutional investors are not able to outperform the
market also because:
- many schemes they put the money into are designed in a way that they are not
supposed to beat the market. Their motive is to generate safe returns.
Chapter 4: Findings and Analysis of study
93
- Out-performance is not the motive of many schemes. (This was highlighted by
I8 and agreed by other interviewees.)
Herding behaviour amongst the IIs is another explanation to their underperformance.
As I8 comments ‘If a well-known FM has identified something, the others get into it,
stories are built, hype is created and that sector becomes hot. This is a common
mistake. In fact, at this point in time, smart FMs exist and make good returns while
others just pile on into that stock and most of them end up losing money’. VJ also
agrees that herding behaviour exists and that is why IIs are not able to beat the
market. Everyone is having almost same portfolio. VJ further adds, ‘It is a business
and at the end of the day I have to survive in the market. I have to get the money, pay
salaries & bonuses. So it’s like flavour of the month like today, in India, the whole
flurry of investors is into mid-caps stocks & funds’.
The findings also show that most of the FMs and other IIs concentrate on mainly
large-cap stocks. Some firms are more heavily followed by the analysts than others.
The result is that they end up having similar portfolio, as VJ mentioned earlier. In
fact, most of the interviewees agreed that most of the portfolios of IIs are replication
of Index, only a small chunk holds different stocks. VJ also commented ‘If you look
at the portfolio of active FMs, 80% stocks they have in their portfolio are there in the
Index. This would mean that he is just going to play around with 20-30% of the stocks
in his portfolio to generate returns higher than the market-returns, which again is a
big call he is taking. So eventually he is also going to give you index returns. Simply
Chapter 4: Findings and Analysis of study
94
because the psyche is that he also cannot deviate much from the index because of the
risk that he might underperform. Everyone is looking at the Nifty21, so they have to
hold the Nifty stocks also. If he is completely off the Nifty and his selection goes
wrong he would be in trouble and he would not want to take that risk. So indirectly he
is also tracking the index’.
RH quoted ‘IIs are only comfortable with buying large cap stocks that is why they
are over-researched. So rather than venturing into something that is unknown or less
popular, they pile on large-cap stocks, and they do this because if they don’t get good
returns they can say that they bought a good company. So their returns are ultimately
market returns as they concentrate on Index stocks’. Thus, herding and concentrating
on just segment of the market causes IIs to not generate returns higher than the
market.
4.2.2 How can investors identify good investment opportunities
The findings provide very interesting and valuable advice on how to identify good
investment opportunities and what errors not to commit to improve the performance
in the stock market.
Firstly, in order to identify good investments it is important to start with one’s own
‘circle of competency’, which means only invest in companies that you can really
21 Nifty is an index of prices of a group of fifty stocks listed on the National Stock Exchange of India.
Chapter 4: Findings and Analysis of study
95
understand and can evaluate with confidence. This idea was introduced by Philip
Fisher22 and later championed by Warren Buffett (Hangstrom, 1997).
RD says, ‘The market specialises in 6000 stocks, and you can narrow it down to 50-
60 stocks that you understand and pick from them. So the odds of beating the market
improve dramatically because you are already within the industry. So, for e.g., if you
are a doctor, pick a pharmaceutical stock, you will be much better able to understand
say this is the medicine that will be given to all the diabetic patients and has a huge
potential. You understand which the best medicine is and which company makes the
best medicines amongst all. So you should build circle of competency in order to
outperform the market, and you should look within that circle of competency. You
should not try to be ‘jack of all trades and master of none’. You should be focused to
the area and sectors you have understanding and knowledge about’.
I6 commented: ‘Only focus on companies and stocks which you understand, whose
business, markets, products, and management you can understand. An example for
this can be given of Warren Buffett, he is an activist, in 2000 he made a statement
that ‘I don’t understand IT industry and therefore I don’t invest in it’. For a brief
period his performance was down as compared to other active managers who
invested in IT companies. But his performance again soared and the other managers
actually lost tremendous amount of money. In those brief periods of excess, one has to
be focused on his basics and only concentrate on what he understands rather than
getting driven or tempted by others. Very few money managers, fund managers and
other investors actually follow what Warren Buffett said. I don’t understand IT, so I
22 Philip Fisher was a very successful stock investor, best known as the author of Common Stocks and Uncommon Profits.
Chapter 4: Findings and Analysis of study
96
won’t invest in it. Very simple. I will only invest my money in what I understand,
because if you continue to put your money in what you know better, you will do better
than the others’.
One of the most important aspects highlighted by all the respondents was that getting
good returns from the market would require a disciplined approach, i.e. not to be
driven by markets and sustaining from the short-term luring opportunities. All the
interviewees stressed the importance of being disciplined in the market and also
taking all investment decision with a disciplined approach. RD commented:
‘Discipline is extremely important, not only in terms of price but also in terms of
understanding valuations. People base their decisions on price and even
professionals make that mistake. If the prices go up it is good and if it goes down it is
bad, they don’t understand valuations of a company’. I6 quoted: ‘Discipline has an
important part in making investment decisions. You have to be disciplined while
making investment in the stock market; you should not get carried away by the
market. You have to know your limitations and work on those limitations’.
I8 commented: ‘It is the ability that will always keep you ahead of the market. And
you need to have a disciplined approach of investing. This discipline means not
getting carried away by the market, resisting the temptation of generating high-
returns in short-term, which is an important cause of all the FMs to underperform.
Not following the herd mentality – ‘Just because everyone is doing it I should also
follow the herd’. They should only be venturing into industries and stocks which they
understand’.
Chapter 4: Findings and Analysis of study
97
Strong fundamental research is important to evaluate an investment, disciplined
investment approach is required, ability to identify excesses is also needed both when
the markets are up and down.
Another point highlighted is to time the market correctly, in other words when
making purchase or sale decisions in the stock market, it is important to identify the
right time to buy the stock and also to sell the stock. This would come with
experience and also with understanding the valuations of the security. I5 commented:
‘Timing is extremely important in making entry to and exit from the market. Many
people say that we don’t time the market it’s not possible to time the market. But in
my view, it is difficult but you got to get it right. Otherwise what is the point in
identifying something which everyone has got into. You got to get in early and be at
the lead rather than a laggard because then you will only make index returns and not
extraordinary returns. The idea is not only to get the sector right, but to get it at the
right time because it is not easy to determine the turnaround’.
Three of the interviewees remarked that their experience says technical analysis can
sometimes help in identifying the entry and exit time in the market. I5 commented:
‘From stock entry and exit point of view technical analysis is important. It does help
you in selecting your entry and exit points. You can’t go and select stocks on the basis
of technical analysis. But having selected a particular company, you should go back
and look at the charts and you can check if there is volume happening in that stock, is
there some accumulation going on and such factors, what are the range in which you
Chapter 4: Findings and Analysis of study
98
can typically buy and if breaks a particular level then you need to be a little careful.
So you can go back and check your fundamentals, if it still holds or not. So it is a
good guiding tool but not from stock selection perspective’. I8 also pointed out that:
‘Technical analysis is a useful tool and can aid to time your entry and exit from the
market. It has been seen that stocks follow a particular pattern. And once you have
identified that you want to invest in X company, then with the help of technical
analysis, you can decide when should you buy stock of X company and when should
you sell it off’.
VJ remarked: ‘Fundamental also works at the end of the day you have to look at
numbers. Similarly in order to time the market you also might need technical
analysis. You might even need behavioural finance. So you need inputs from
everything, and use those and the make your decisions. I don’t think one thing works
all the time. Don’t base your decisions on just one thing. So you got to take inputs
from everything, inputs from fundamental analysis, technical analysis, behavioural
finance and your own judgment to identify good opportunity and evaluate it’. RH
commented: ‘Nature of the business, capability of management, quality of the
management, such factors should be taken into account while selecting stocks for
investment’. It is, therefore, important to understand fundamentals, technicals,
behavioural patterns and other important factors when making investment decisions
and also while identifying investment opportunities. It is also important to understand
that when you are making an investment, you are buying a business, i.e. you are
investing in a business not in the stock market.
Chapter 4: Findings and Analysis of study
99
A lot of reading is required to get the information and knowledge about the
companies, sectors and other macro scenario that will help in selecting sectors and
companies. RH remarks: ‘You will have to read a lot, go through annual reports, find
out companies which have consistently made profits and will be able to do so by
looking how their management is, finding out what are their plans for the next 10
years. You need to envisage whether this business is going to be there in the next 10
years, what will future hold for this company. From these aspects you have to refine
your research and select stocks of good companies. You have to get into the nitty-
gritty of the balance sheet of past few years, understand the company and the sector it
is in, understand its competitive position in the market, how good the product or
service it is selling is, how good its research and development department is. And
then finally you have to make the judgement whether the company is good or not and
its product will remain in the market in the coming 10 years. There is no short-cut in
life and you have to be patient to be able to consistently beat the market. You can
create wealth only through taking a long-term perspective’.
4.3 Findings in context with Literature
Malkiel (2005) argues that markets are indeed efficient and provides evidence that by
and large market prices do seem to reflect all the available information. Fama et al
(1969), assert that stock prices respond quickly to new information, and subsequently
display no apparent strong trends following major events such as mergers, stock-splits
or changes in firms’ dividend policies. The market appears to anticipate the
Chapter 4: Findings and Analysis of study
100
information, and most of the price adjustment is complete before the event is revealed
to the market.
However, the results present a divergent view. Security prices in Indian markets do
not always reflect all the available information. In fact claims have been made that
since markets consists of human and their emotions are associated with market
movements, no security price can all the time reflect all the available information.
This result is supported by Stout (2003) who asserts that ‘Information that is easy to
understand and that is trumpeted in the business media may be incorporated into
market prices almost instantaneously. But information that is public but difficult to
get hold of, or information that is complex or requires a specialist's knowledge to
comprehend, may take weeks or months to be fully incorporated into prices’.
A review of the literature and an overwhelming body of empirical evidences shows
that it is not possible to beat the market, especially not so after considering the
expenses incurred on the research and analysis. This argument is supported by many
researchers and scholars (Malkiel, 2003, 2005; Damodaran, 2002). However, the
results of this study appear to contradict this allegation. Results from Table 6, 7, 8 and
9 and the subsequent discussion clearly demonstrate that it is indeed possible to
outperform the market and that too consistently. There have been instances of funds
and even individual investors who have been consistently beating the market on an
average. They may not to for a temporary period, but on an average they do
outperform the market, both in India and other stock markets. Ippolito (1993, p.42)
and Brealey & Myers (2000, p. 361) also note that some recent studies have found
Chapter 4: Findings and Analysis of study
101
that mutual funds outperform market indexes enough to offset their research and
trading expenses.
Chapter 5: Conclusions and Limitations of the study
102
CHAPTER 5: CONCLUSIONS AND LIMITATIONS
5.1 Conclusion
A lot of body of evidences have shown that stock markets are efficient and it is not
possible to beat the stock markets consistently both in India and other global stock
markets. Critics have however argued that markets are not completely efficient and
there are examples of out-performance that cannot be ignored as mere chance. This
study examined the market participant’s view on the efficiency level of Indian stock
markets and the behavioural patterns of investors in India.
The study shows that Indian stock markets are neither completely efficient nor
completely inefficient, as Higgins (1999) puts it, “rather than being an issue of black
or white, market efficiency is more a matter of shades of grey”. In Indian stock
markets, that have substantial impairments of efficiency, more knowledgeable and
skilled investors can strive to outperform less-knowledgeable and less-skilled ones.
Apart from skill and investment acumen, a disciplined approach in the market and
self-control is also essential to be able to beat the market. As Blaise Pascal puts it, ‘all
of human unhappiness comes from one single thing: not knowing how to remain at
rest in a room’.
Chapter 5: Conclusions and Limitations of the study
103
Existence of overvalued and undervalued stocks is also found in the Indian stock
markets along with presence of active funds that have consistently beaten the Indian
stock market.
A preliminary objective of the study was to find out the importance of behavioural
finance and whether its application can help investors in India to improve their
returns from the market. A review of the literature showed divergent opinions on the
importance of behavioural finance in making investment decisions. However, the
results show that behavioural finance is important and behavioural pattern of the
market participants should be examined when making investment decisions. But its
usefulness in improving market returns was questioned by one of the respondents but
others consented to its usefulness.
The study documents the reasons for the underperformance of the institutional
investors. The empirical results indicate that pressure from clients to give short-term
performance causes an increase in the expenses of the IIs and is also the reason why
they are not able to outperform the markets. Consistent with the theory, herding
behaviour and emphasis on large-cap stocks are also the factors that contribute to
their underperformance.
Finally, the study also gives insight on how to identify good investment opportunities
in the market and what strategies should be followed by the investors. Insights
derived from this study can help the investors improving their performance in the
stock markets.
Chapter 5: Conclusions and Limitations of the study
104
Although the results and findings of this dissertation are encouraging, they should be
viewed in the context of the limitations discussed in the following section.
5.2 Limitations of the study and future research
“Finality is death. Perfection is finality. Nothing is perfect. There are lumps in it”
(James Stephens)
Nothing is perfect in this world and although the results and findings of this
dissertation are encouraging, they should be viewed in the context of the following
limitations.
An observed limitation of this study is that the area of study is very subjective. It is
difficult, for example, to test the behavioural patterns of investors in stock market, to
test the reasons for - why the Indian stock markets are inefficient, or to test how
investors can identify good investment opportunities. It is therefore recommended for
future researchers to find out the ways to test and investigate the findings generated in
this research. For example, I4 suggested that ‘to find out the correct picture of ratio
of speculators versus investors look at the statistics or delivery volumes in stock
markets. Also, I think a data research and survey would be more appropriate to find
the answer to this question and I am sure you can easily find this data.’
Chapter 5: Conclusions and Limitations of the study
105
This study used Qualitative research technique that has its own disadvantages. Firstly,
the word qualitative implies an emphasis on the processes and meanings that are not
rigorously measured in terms of quantity. This creates problems of reliability as it is
difficult to categorize descriptions into codes and themes (Silverman, 2001). As a
consequence, the researcher might have found it difficult to link the specific questions
to larger theoretical constructs to illuminate the bigger picture. There are chances of
researcher getting lost in the line of exploration as she might have failed to see
patterns or skewed the analysis in one direction or another. More formally, there is a
probability of elements of researcher bias found in this dissertation.
Another limitation is the inaccuracy and unreliability of the comments of the
interviewee as analysts try to defend themselves and present a rosy picture about the
investment strategies they adopt. Since the discussion was subjective, the respondents
might have answered whatever they thought at that time but they might not have had
the knowledge about the subject. Some of the interviewees didn’t know the answers
to certain questions asked during the interview and speculated their response, which
can be a question-mark on the validity of the data. In one of the interviews, when the
question ‘are Indian markets as efficient as other developed markets’ was asked, the
interviewee answered ‘I don’t know much about the US and UK markets, but I think
that Indian markets are not as efficient as the developed markets’, which was actually
speculation of the answer and may not be reliable.
Chapter 5: Conclusions and Limitations of the study
106
The researcher may misperceive what the researched wants to communicate. As a
result, the information gathered may not be reliable. The possibilities like the
respondent didn’t tell the truth or uncovered few facts or the absence of complete set
of recorded data may create a question-mark on the reliability of this study. Even
when people’s activities are tape recorded and transcribed, the reliability of the
interpretation of transcripts may be weakened by a failure to record apparently trivial,
but often crucial, pauses and overlaps (Silverman, 2000).
The reliability of the results cannot be taken as concrete outcome since only eight
interviews were conducted, as the study was to be completed during a specific time
frame. A small sample is therefore another projected limitation of this study.
Moreover, out of 8 people interviewed, only one of them was pursuer of passive
investment strategy, rest others were all active managers. Therefore, answers may be
biased and may not have presented the true/complete picture. However, the reason for
such bias in sample selection was that, in India there is only one asset management
company that invests only through passive strategy. Other Fund Managers who
managed passive funds are sometimes also in-charge of active funds and identifying
and accessing them had not been possible. Future research should consider multiple
informants or multiple members of the research team at each business unit; more
analysts, investors and researchers from different companies and adopting different
investment strategies (active and passive) to offset single informant’s bias as well bias
arising due to concentration on only active managers.
Chapter 5: Conclusions and Limitations of the study
107
In qualitative studies, one important way of verifying findings or establishing validity
is to actually take transcripts or analysed results back to some of the interview
participants, and ask them if this is really what they meant. However due to time
constraints and reluctance of the interviewee for validating their answers, this
approach for validating the answers could not be carried out. Thus, for future research
it is recommended that the researcher validates the data collected in order to improve
the validity of the research.
Another limitation of the study was that interview results required lots of
interpretation from the comments made as it was not possible to frame direct
questions on the topic in hand, moreover the limitations of taking an interview will
also be present.
The study and results were based solely on interviews. The use of quantitative
research methods and techniques may well improve the validity of the findings and
are essential to avoid purely empirical exercises. For example to examine whether IIs
trade frequently and actually take short-term perspective in the market, use of
quantitative study would be helpful.
But as Leonard Cohen quoted:
“There is a crack in everything, that's how the light gets in”
Chapter 5: Conclusions and Limitations of the study
108
This research may have shortcomings, but it can provide a platform for other
researchers to find out the causes of inefficiency arising in the Indian stock markets,
identify the behavioural aspects of market participant’s that can be used to correct the
mistakes investors commit in the market, provide guidelines for investors on the
investment techniques that should be adopted by them. Moreover, this research has
made an attempt to uncover the above subject areas and can therefore help the
investors (both individual and institutional) in their investment decisions. The
outcome in the results and findings section can help them to identify the mistakes and
irrationalities committed by them and the market, and how can they improve it.
References
109
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Appendices
123
LIST OF APPENDICES
APPENDIX 1 LIST OF ANOMALIES IN EMH (pp. 124)
APPENDIX 2 PREDICTIONS OF EMH AND EMPIRICAL EVIDENCE
(pp. 124)
APPENDIX 3 PROFILES OF INTERVIEWEES (pp. 130)
APPENDIX 4 QUESTIONNAIRE BEFORE THE INTERVIEW (pp. 134)
APPENDIX 5 PROPOSED INTERVIEW QUESTIONS (pp. 135)
APPENDIX 6 COMPARISON OF EXPENSE RATIO OF ACTIVE
FUNDS AND PASSIVE (OR INDEX) FUNDS (PP. 140)
APPENDIX 7 INTERVIEW TRANSCRIPTS (pp. 141)
Appendices
124
APPENDIX 1
Anomalies in EMH:
A. Fundamental Anomalies
Value Effect: Value investing is probably the most publicized anomaly and is
frequently touted as the best strategy for investing. There is a large body of
evidence documenting the fact that historically, investors mistakenly overestimate
the prospects of growth companies and underestimate value companies
(Anonymous, 1999).
Basu (1977, 1983) noted that firms with high price-to-earnings (P/E) ratios earn
positive abnormal returns relative to the CAPM. He shows that stocks of
companies with low P/E ratios earned a premium for investors during the period
1957-1971. An investor who held the low P/E ratio portfolio earned higher returns
than an investor who held the entire sample of stocks.
Many subsequent papers have noted that positive abnormal returns seem to accrue
to portfolios of stocks with high dividend yields (D/P) or to stocks with high
book-to-market (B/M) values (Schwert, 2001). Capaul, Rowley and Sharpe
studied six countries from January 1981 through June 1992 and found that Value
Stocks outperformed growth stocks on average in each country (Anonymous,
1999).
Appendices
125
Small Firm Effect: Some studies have shown that small firms (capitalization or
assets) tend to outperform. Banz (1981) published one of the earliest articles on
the ‘small-firm effect’ which is also known as the ‘size-effect’. His analysis of the
period 1936-1975 reveals that excess returns would have been earned by holding
stocks of low capitalization companies. Supporting evidence is provided by
Reinganum (1981) who reports that the risk adjusted annual return of small firms
was greater than 20 percent (Russel and Torbey, 2002). Others have argued that
its not size that matters, its attention and number of analysts that follow the stock
(Anonymous, 1999).
B. Calendar Anomalies
January Effect: Stocks in general and small stocks in particular have historically
generated abnormally high returns during the month of January. Rozeff and
Kinney (1976) were the first to document evidence of higher mean returns in
January as compared to other months. Using NYSE stocks for the period 1904-
1974, they find that the average return for the month of January was 3.48 percent
as compared to only .42 percent for the other months. Later studies document the
effect persists in more recent years: Bhardwaj and Brooks (1992) for 1977-1986
and Eleswarapu and Reinganum (1993) for 1961-1990. The effect has been found
to be present in other countries as well (Gultekin and Gultekin, 1983) (Russel and
Torbey, 2002). Keim (1983) and Reinganum (1983) showed that much of the
abnormal return to small firms occurs during the first two weeks in January
(Schwert, 2001).
Appendices
126
Turn of the month effect: Stocks consistently show higher returns on the last day
and first four days of the month. Frank Russell Company examined returns of the
S&P 500 over a 65 year period and found that U.S. large-cap stocks consistently
show higher returns at the turn of the month (Anonymous, 1999). Hensel and
Ziemba (1996) presented the theory that the effect results from cash flows at the
end of the month (salaries, interest payments, etc.). Ziemba (1991) finds evidence
of a turn of month effect for Japan when turn of month is defined as the last five
and first two trading days of the month. Hensel and Ziemba (1996) and Kunkel
and Compton (1998) show how abnormal returns can be earned by exploiting this
anomaly.
The Weekend effect or Monday Effect: Monday tends to be the worst day to be
invested in stocks. Average return on Mondays is very small, in contrast with that
average return on Fridays (or Saturdays). Prices tend to rise on the last day in a
week. The Price of the smaller firms shows greater changes in the weekend effect
(Sato et al, n.d.). French (1980) analyzes daily returns of stocks for the period
1953-1977 and finds that there is a tendency for returns to be negative on
Mondays whereas they are positive on the other days of the week. He notes that
these negative returns are "caused only by the weekend effect and not by a
general closed-market effect". A trading strategy, which would be profitable in
this case, would be to buy stocks on Monday and sell them on Friday (Russel and
Torbey, 2002). Several other studies confirmed this anomaly.
Appendices
127
C. Other Anomalies
Intraday Effects: On all days without Monday, prices rise during first 45
minutes. Returns are high near the end of the day, particularly on the last trade of
the day. The day-end price changes are greatest during last five minutes, have
been observer in experimental markets. Thaler (1992) also said a part of these
phenomena can be explained by the structural and institutional reasons such as 1)
the difference of duration when a market is closed and 2) the special duration
related to a settling day.
The Weather: Few would argue that sunshine puts people in a good mood.
People in good moods make more optimistic choices and judgments. Saunders
(1993) shows that the New York Stock Exchange index tends to be negative when
it is cloudy. More recently, Hirshleifer and Shumway (2001) analyze data for 26
countries from 1982-1997 and find that stock market returns are positively
correlated with sunshine in almost all of the countries studied (Russel and Torbey,
2002).
Announcement Based Effects: Price changes tend to persist after initial
announcements. Stocks with positive surprises tend to drift upward, those with
negative surprises tend to drift downward. Some refer to the likelihood of positive
earnings surprises to be followed by several more earnings surprises as the
"cockroach" theory because when you find one, there are likely to be more in
hiding (Anonymous, 1999). Haugen (1999) argues that the evidence implies that
Appendices
128
investors initially underestimate firms showing strong performance and then
overreact. DeBondt and Thaler (1985, 1987) present evidence that is consistent
with stock prices overreacting to current changes in earnings. They report positive
(negative) estimated abnormal stock returns for portfolios that previously
generated inferior (superior) stock price and earning performance (Russel and
Torbey, 2002).
Appendices
129
APPENDIX 2
(Source: Breechey et al, 2000)
Appendices
130
APPENDIX 3
Interviewee’s Profiles
Mr. Ramesh Damani – A member of Bombay Stock Exchange, Mr. Ramesh
Damani is a well known name among investors in India. An MBA from California
State University, Mr. Damani is also a frequent commentator on financial issues on
CNBC and Star News. A proponent of value investing, Mr. Damani has been tracking
the markets for many years now, has tremendous investing experience and holds a
distinguished investing record.
Email: [email protected]
Mr. Ranjeet Hingorani – A Wealth Research Manager, Mr. Ranjeet Hingorani
is also a value investor, and has a tremendous investing experience. He is a believer
of Philip Fisher and Benjamin Graham’s theory on investing. Mr. Hingorani’s value
investing has generated him good returns from the market over the years.
Email: [email protected]
Mr. Ravi Gopalakrishnan – Mr. Gopalakrishnan is Portfolio Advisor to
Hudson Fairfax Group (HFG), a US based investment firm focused on sponsoring
and promoting India-related investments. He has 14 years of experience in the Indian
capital markets. He provides exclusive non-discretionary investment advisory
Appendices
131
services to HFG. Mr. Gopalakrishnan has a broad and successful background in India
equities, including value and growth investing in both large and mid capitalization
stocks. His experience includes:
- Formerly Portfolio Manager at Principal PNB Asset Management
Company and Sun F&C Asset Management, where he ran the Sun F&C Value Fund
and the Resurgent India Fund;
- Eight years of experience in market strategy and research for UBS and
Unit Trust of India
Email: [email protected]
Mr. Vishal Jain - Mr. Jain is Vice President – Investments and Fund Manager
to Benchmark Asset Management Company, India, the only asset management
company that purely invests through indexing. He holds a B.Sc. in Statistics and a
MBA and has 8 years experience in Indian capital markets. He was previously with
the Credit Rating Information Services of India Ltd. (CRISIL), India's premier rating
agency, where he was part of the Capital Market group. He was then involved in
setting up India Index Services & Products Ltd (IISL), a joint venture of CRISIL and
NSE At IISL, he was also involved in promoting indices for the use of higher
applications like Index Funds, Futures and Options.
Email: [email protected]
B. P. Singh – Mr. Singh is the Managing Director of Atlantis Investment
Advisors India Ltd and the Portfolio Adviser to the Atlantis India Opportunities Fund.
Appendices
132
Atlantis is a leading asset manager, specialising in Asian equities. Mr. Singh joined
Atlantis from Deutsche Asset Management. He was Fund Manager of the Deutsche
Alpha Equity Fund and the Deutsche Investment Opportunities Fund. Prior to this, BP
Singh was Head - Equity Research at SSKI Securities, a premier brokerage house in
India. He was directly responsible for India strategy and the Pharmaceuticals, Media
and Biotechnology sectors. Before joining SSKI, BP Singh was Director - Research at
UBS Warburg. He earned his MBA from SP Jain Institute of Management &
Research at Mumbai and Bachelor of Technology (Chemicals) from University
Department of Chemical Technology (UDCT) at Mumbai.
Email: [email protected]
Mr. Rajesh Singhal – Mr. Singhal the Investment Advisor and Portfolio
Manager of a distinguished company.
Mr. Vinit Sambre - Mr. Sambre is the Product Analyst and Assistant Vice
President of Global Private Client division of DSP Merrill Lynch. He is a Chartered
Accountant and offers investment advice to the private client group.
Email: [email protected]
Mr. Ashok Lunawat - Mr. Lunawat is the Research Head of Arihant Capital
Markets Ltd, a leading stock broking firm in India. A Chartered Accountant by
profession, he is known for his analytical skills and holds 10 years of experience in
Indian capital Markets research. He has been continuously searching for fundamental
Appendices
133
stocks with low valuations, quality management and excellent business model and has
provided with some very good investment advice over the years.
Appendices
134
APPENDIX 4
Questionnaire:
FOR RESEARCH PURPOSES ONLY
Please answer the following:
YES NO
Do you know what is Passive Investment Strategy (or Indexing)?
Do you know what Active Management Strategy is?
Do you what is does the term ‘efficient capital markets’ or ‘Efficient Market Hypothesis’ means?
Do you know what Behavioural Finance is?
Appendices
135
APPENDIX 5
Proposed Interview Questions:
1. (i) Do you agree with the EMH?
(ii) To what extent do you think the theory holds true?
(iii) Do you think that it is possible to “beat the market”?
If yes then can you please explain how it is possible? (despite so many research
confirming that except a very few people, most of the analysts and investors have not
been able to beat the market).
(iv) Empirical evidences prove that passive investment strategy are better and more
beneficial than active investment strategies because as the markets reach efficiency
the cost incurred (time and money) in discovering the strategies to outperform the
index outweighs the benefits received from them.
Is this true?
(v) Do you think that Indian stock market is as efficient as the capital markets of other
developed countries like US or UK?
Why?
2. “What investment strategy do you think investors should follow? Active or
passive?” (considering the evidence that cost involved (both time and money) in
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pursuing an active management strategy outweighs the benefits and Money Managers
are not able to beat the market)
Why? What factors do you think should be taken into account? Does the risk profile
of an investor make a difference?
3. Institutional Investors:
- Many researchers have proven that nearly all mutual funds and other institutional
investors fail to beat the market on a consistent basis and that they underperform the
market. In most of the instances, when they actually are able to beat the market, the
costs incurred in their research and other expenses wipe-off the benefits.
Can you explain the reasons for this? Or provide evidence when a fund or a company
has been able to outperform the market over a consistent basis?
- Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional
Investors concentrate on? Why is that?
4. ‘Investing for the long term means judging the distant future, judging how history
will be made, how society will change, how the world economy will change. Reaching
decisions about such issues cannot proceed from analytical models alone; there has
to be a major input of judgment that is essentially personal and intellectual in origin.
That is to say that long-term investment involves making one’s own judgement about
the future state of economy, company and the industry for prospective investment.
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Technical models, financial statements and other analytical statements do not suffice
in making investment decision’
Do you think this statement is correct? Are subjective issues important in evaluating
investments? Can you further elaborate this point from your perspective and give an
example, from your own experience, when you identified a particular investment
opportunity, long before it was ‘popular’ in market and also detail on that.
5. How important is Behavioral Finance in making investment decisions?
(i) Can you provide some examples of investor behaviour (irrationality per se –
like herding behaviour, over-pessimism or over-optimism) that causes inefficiency in
the market from the Indian stock market perspective? And it’s Cause and effects?
(ii) Are the explanations provided by the theory of behavioural finance regarding
the efficiency of markets and behaviour of investors realistic?
Examples of some of the argument and investor behaviour asserted by Behavioralists:
When a market is moving up or down, investors are subject to a fear that
others know more or have more information. As a consequence, investors feel a
strong impulse to do what others are doing. Here, for example, is a good description
of herding - Two restaurants face one another on the main street of a charming
Alsatian village. There is no menu outside. It is 6:00 PM. Both restaurants are empty.
A tourist comes down the street, looks at each of the restaurants, and goes into one of
them. After a while, another tourist shows up, sees how many patrons are already
inside by looking through the stained glass windows - these are Alsatian winstube -
and chooses one of them. The scene repeats itself, with new tourists checking on the
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popularity of each restaurant before entering one of them. After a while, all
newcomers choose the same restaurant: they choose the more popular one
irrespective of their own information
(iii) Are they correct from the perspective of Indian stock market? Can you
further provide some examples of Investor’s behaviour that may be categorized as
‘irrational’ or that causes the market to deviate from being efficient?
(iv) Keynes’ pictures the stock market as a ‘casino’ guided by ‘animal spirit’. He
argues that investors are guided by short-run speculative motives. They are not
interested in assessing the present value of future dividends and holding an
investment for a significant period, but rather in estimating the short-run price
movements.
What is your view about the Keyne’ philosophy and why?
6. Do you think that markets price the securities correctly:
- in short-term?
- in medium-term?
- in long-term?
Why?
7. Do you think that as soon as some information regarding a security is disseminated
in the market, it is reflected in the price? Do stock market participants fathom the
information correctly and act rationally or there is a discrepancy?
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8. Do you believe in the existence of overvalued and undervalued stocks as against
the many researchers and investors who think that there is no such thing in the
market, and it is just a way of fooling investors?
9. How do you think should investors identify good investment opportunities?
-----------------------------Thank you for your time and patience----------------------------
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APPENDIX 6
Comparison of Expense ratio of active funds and passive (or index) funds:
Expense ratio of Funds in United States of America
Fund name Management style
Benchmark index
Expense ratio
FIDELITY SPARTAN 500 INDEX
Index S&P 500 0.10%
VANGUARD 500 INDEX FUND Index S&P 500 0.18%
FIDELITY CAPITAL APPRECIATION
Active S&P 500 0.94%
VANGUARD GROWTH & INCOME
Active S&P 500 0.42%
(Data sourced from fund house websites)
Expense ratio of Funds in India
Fund name Management style
Benchmark index
Expense ratio
FT INDIA INDEX NIFTY Index S&P Nifty 1.00
FT INDIA INDEX SENSEX Index BSE Sensex 1.00
HDFC INDEX FUND (NIFTY)
Index S&P Nifty 1.50
HDFC INDEX (SENSEX) Index BSE Sensex 1.50
HDFC INDEX (SENSEX PLUS)
Index BSE Sensex 1.50
FRANKLIN BLUECHIP Active BSE Sensex 1.90
HDFC EQUITY FUND Active S&P CNX 500 2.02
(Source: Personalfn, 2005)
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APPENDIX 7
Interviewee Page NumberMr. Ramesh Damani 14114 149Mr. Ranjeet Hingorani 152I5 158I6 167I7 172I8 174Mr. Vishal Jain 179
Interview Transcripts:
1. Mr. Ramesh Damani
Do you think markets are efficient? What is your view on EMH in context of Indian markets? Do you believe in active investment strategy or passive investment strategy?
“My understanding is that while markets are roughly efficient but they are not perfectly efficient and investors can take advantage of the gap between perfectly efficient and roughly efficient in order to maximise their returns. Indian markets are probably less efficient than other developed markets and that is because the equity cult has just now begun to take place, since mid-1990’s. It’s an emerging market and in emerging markets typically the values are unknown, fund flow is not predictable. But as India is liberalising the financial sector has also been liberalised, we are having lots of western influences and western brokerage houses coming here telling us how to understand the markets, so we are getting to a more efficient level. But as this bull market will demonstrate to you that while the Index is up three times from bottom to top individual stocks are 15x or 20x, which clearly is not possible in an efficient market. So yes there are stock picking opportunities for investors in India, which would not be possible in a completely efficient market.Broadly I do not think perfectly efficient markets exist. Investors in market swing between fear and greed, there is a kind of herd mentality going on, everyone wants to pile on to the most popular stocks, stocks that are ‘hot’ are in conversation in parties. So there will be opportunities for savvy investors to outperform the market because of such behaviour. Obviously it is not possible that they buy and immediately sell and get good returns. But for patient investors, for value investors, almost in every stock
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market in the world over periods of time you’ll find stocks that are irrationally priced, either undervalued or overvalued.”
People have different reasons to come to the market. And my theory is that market gives them exactly what they want in life. A lot of people want excitement in life. So they want something to do everyday.
In most professions, activity is a positive and inactivity is a negative in terms of value. In stock market it is actually reverse. Inactivity generates value and activity does not conduce to better returns. Someone who bought Coke 10 years ago didn’t really have to do much; the value compounded through that holding gave him humongous returns. So people think that the more active they are, i.e. the more trading they do, the better the returns will be. But history has shown that activity is actually negatively related to returns. People who frequently buy and sell, every time they buy/sell they have to pay the brokerage, they have to pay extra for difference between bid-ask price, they have to pay transaction costs. However, a person who invests for long-term, value investor, he has to pay all the costs only once, no capital gains tax and dividends accrue. Over time all these costs add up to huge amount, so the compounded return of the person who engages in one time buy/sell is much higher than who actively buys and sells. And for the person who engages in frequent trading needs a new idea every week, while people who invest for a longer periodneed only one great idea when they buy a stock. So over a long-run, long-term investment is better approach and also the costs are lower in it.Why do people do that? Because they enjoy going to the parties and saying that we bought the most popular stock or they enjoy saying that we are in the sensex stocks, that has gone up that day. And so they mess up.One should go to the financial market for long-term investment, should go for long-term wealth making and buy infrequently and with lot of conviction. Just as Rome was not built in a day, great stocks do not give returns in a quarter or a year. It takes time for the business to unfold, to get mature and to build the proverbial mode for the competition. And the thing is people don’t understand these basic dynamics. They approach the market from various different points of view, not just from the point of generating wealth and the market then gives them just that. That’s the reason why so many people loose money in the market, and that’s why they make such hard luck stories. They would say, ‘I made so much money but I lost it all and I will never go back to the market’. All this is because they don’t understand the fundamental dynamics on which the markets operate.”
What we look when making investment decisions or buying a stock, what we call as value-investing, is we tend to look at the absolute market caps or see what a private party would pay to purchase the business or the company. Would it pay more than the market capitalisation of the stock or less than the market-cap. As long as we understand that the market is treating the stock relatively low compared to its private market value, we are happy to own the stock, despite the fact that the stock has doubled or quadrupled, or the PE may have exploded to 50 or other such arbitrary factors. So the approach to investing should be buy and hold and do a careful analysis
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before purchasing the company, which involves holding a vision and trying to look at the future and also requires skills.
If you put it in the context of active and passive investment strategies you are saying, I believe in active strategy for investment. It is my job as an investor to allocate my capital and I take it very seriously. Passive investment strategy is good for people who actually don’t have time to follow the financial markets, don’t have time to think or read the Balance sheets, and meet and talk to the management of the companies. So it is a low cost way to take the advantage of the economic growth of a country, just buy the index and get market returns. But there are classic examples where I can tell you when passive investment got people in trouble is, for example when the Dow Jones Index hit 1000 for the first time in 1962 or 64 and it didn’t come back to 1000 Index level until 1982, so for the period of almost 20 yrs if you were a passive investor in Dow you got no returns, but even during that period there were stocks and companies which did well in the stock markets. Take our own Indian markets, in 1992 the Sensex hit 4500 level for the first time, it did not cross that level decisively until 2004, so for the period of 12 years, a passive investor basically did not get any returns from his investment.So the trick in the stock market, whether it is passive investing or active investing is to buy value, is to buy things when they are cheap. The sensex at 4500 level in 1992 was not cheap, but in 2004 4500-level was cheap. So the trick in the stock market is to buy 1Rs for 50paise.
How would you find out whether a stock is cheap or not?
I think it comes from years of experience in the market; the key factor is to look at how the market is valuing the stock and what in your estimation is the value of that business or the company you are buying. There are more than 6000 stocks traded on the exchange everyday and clearly no one can be an expert in all the stocks. But if you segment the market and if you say, for example, that I am a banker and I am going to look at the banking stocks because I understand that sector or I am in the construction business so I am going to focus on construction-related business. Certainly then the playing field is levelled to your advantage. Most famous question is that how can you beat Sachin Tendulkar23 and the obvious answer is that that you play nothing else but cricket. So should therefore play to your speciality. The market specialises in 6000 stocks, and you can narrow it down to 50-60 stocks that you understand and pick from them. So the odds improve dramatically because you are already within the industry. So if a doctor picks a pharmaceutical stock, he will be much better able to understand that oh this is the medicine that will be given to say all the diabetic patients and has a huge potential. He is already a doctor and he understands which the best medicine is and which company makes the best medicines amongst all.
23 Sachin Tendulkar is one of the famous cricket players in the world.
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So you should build circle of competency in order to outperform the market, and you should look within that circle of competency. You should not try to be ‘jack of all trades and master of none’. You should try to look at a very well-defined specialised area of the stocks you want. You should be focused to the area and sectors you have understanding and knowledge about.
Institutional Investors and MF Industry‘So much research conducted in the market by so many analysts, so price already reflects about the present and even what is going to happen in the future about the company’. What is your view on this statement?
See there are two questions, people say that since nobody can beat the market why should I try. So the question is not this.May be in Mumbai 3000 people play tennis half of them loose and half win, so that doesn’t mean that people who lose will give up trying. They have to get back and get their credit. A lot of value investors follow Graham and Buffett’s school of investing and a lot of them have beaten the market consistently over time. The MF industry is very strange animal. It’s a very NAV driven industry and everyday the NAV is reported. Now stock market is not conducive to printing a NAV everyday, you have to look at this over a period of every bull market cycle or every bear market cycle from 2-3 years perspective. Now if you force yourself to look at NAV everyday, you are going to end up not making any money because you then tend to go with the stocks that are moving up. So the whole Mutual Fund business is structured, in my opinion, in a wrong fashion. That is why you see that over a 14 years period no one has beaten the S&P (Standard and Poor’s). There was one person, who could do it for 13-14 years, but he also fell flat, that is Bill Miller in America. So it is very hard to beat the market because of the way MF industry is structured. But individual investors don’t face that problem. They can be inaudibly patient; they don’t have to match their returns to say S&P or the Dow all the time. (12:30) I think the MF industry has to come up with a different way to benchmark their returns. It may be different with a closed-end fund, but any open-end fund, which is NAV driven has to face this problem because the MF manager is almost compelled to buy the bad stocks but only because they are performing. If you don’t increase the NAV money doesn’t come to you and if money doesn’t come to you, your returns go down. So it’s a vicious cycle that is going on. The NAV goes up you will be buying bad stocks, more money comes in because people are attracted by the percentage of appreciation 13:10.
And in the long run it is the single most detrimental factor for the financial market, but they haven’t learned that yet.
Do MF managers concentrate on only a particular kind of stock, say large-cap or mid-cap and completely ignore one side of the market?
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Again it is a peculiarity problem. But it’s not completely true because now, for example, there are small-cap funds, sector funds and other funds concentrating on mid and small-cap stocks. But generally the sheer size of the money they have make them put the money in the large cap funds because they cannot get a meaningful quantity of a small cap stock. So yes they want liquidity and they want inhibitions. So there is this funny business going on in the MF industry.Individual investors don’t have that problem because they are investing their own money. If the stock performs well liquidity will automatically appear in that stock and individual investors can wait for that. So the trick is to get the stock right. What I believe in, like many other value researchers is, we test that if we buy a stock today and the markets close for 10 years would we still be willing to hold that stock? If the answer is yes then only we decide to buy a particular stock. Because good businesses create value over time. Suppose if we buy a house, we don’t check its value everyday although it may go up and down. Similarly for five ten years it is ok, you don’t need stock quotation everyday. But this business is created in such a way that people think that unless the stock is not quoted well in the Evening Press the company is not performing well or is not doing anything. But this is wrong. Businesses perform and keep doing their work irrespective of what is happening on the Dalal Street (it is analogous to Wall Street of USA). They create new products, launch their marketing campaigns, and enter new markets and all this has nothing to do with the stock exchange.Over time the yes markets prices the securities correctly, as Warren Buffett once quoted, ‘in the short run the market is a popularity machine but in the long run it is a weighing machine’. As it is generally said that ‘it is not always the most popular girl who ends up getting married to a smart guy’. Look for different things at different stages in life. In the short-run market goes haywire and there is a bunch of other things going on which causes prices to deviate from their fundamental value. So in the long run market will reflect the true value of the businesses.
How would you be able to outperform the market when the information is available to everyone and they might have acted upon it?
Markets work on difference of opinion, for every buyer there is a seller and vice-versa. In fact most of the people start investing in the markets when the markets are up and there is a popular saying in the Wall Street that ‘when the public gets smart, the smart get out’.In the bear market, when markets are at bottom no one is talking about stocks and when markets are high everyone is in the stock market. When markets are up the stock market investors are the most popular people and when markets are down everyone talks about Bollywood in India. Despite knowing this, for some strange reason it always happens the same way. In fact the stock market would not exist if everyone behaves rationally; the fact is we know people behave irrationally. We may tell them in lectures, give them presentations, tell them through books, explain to them the mistakes they are making, but unfortunately the stock market is a place where people don’t use their
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rational senses. Say for example if you go to a store in sale and two shirts are selling for the price of one, you will buy more shirts because it is cheaper. But in stock market the reverse happens, when the market goes down people run away instead of buying more they buy less. While when prices go up all of them want to buy shares. To perform well, people will have to break that psychological mind-set they are in but history shows that it will not happen.
How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior that causes inefficiency in the market from the Indian stock market perspective? And it’s Cause and effects?
I think understanding behaviour and psychology is important in understanding markets and in making investment decisions. People repeat the same mistakes and if I can profit from it then I will do it.
At the bottom of the market when they should be buying they are too scared to buy because previously when markets were up they bought stocks at crazy prices and lost money. So now they are too scared too buy. There are companies in the bear markets that trade below their cash value and yet people won’t buy that stock while in bull markets people will pay any price to get stocks of the company that are hot or are the next big thing in the market. Now that is irrational behaviour. This is the classic mistake people make, not doing their home-work, not understanding the nature of the market, getting into areas out of their circle of competency like doctors buying technology stocks when they don’t understand the ABC of the sector or the company they are buying shares of. Stock markets are vehicle of producing only long-term wealth. But people speculate and get in for adventure, but that is not the purpose of the market. You might be using it for different purposes and that is why you end up with bad returns and hard luck stories. But if you come with the purpose of generating long-term wealth and make long-term investments then only you will generate favourable returns and will be able to beat the market.
So you think discipline is important factor when you are in the stock markets?
Yes it is extremely important, not only in terms of price but also in terms of understanding valuations. People base their decisions on price and even professionals make that mistake. If the prices go up it is good and if it goes down it is bad, they don’t understand valuations of a company. But the thing is sometimes when the stock price goes down for some reason, it becomes more attractive but people don’t understand that.
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Keynes’ pictures the stock market as a ‘casino’ guided by ‘animal spirit’. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.What is your view on Keynes’ picture of the stock market?
I think he is right. And it is really important to understand. But the problem is stock market will always work like it. As long as the markets functions in the same fashion there will be booms and busts, fear and greed and people will do the opposite of what they are supposed to do. But investors who understand history, past and logic would not be tempted to make the same mistake. In fact they would be able to profit from that.So I agree that stock markets act like a casino where people are looking for short-term fluctuations and not long-term value and it is there for their detriment. That is why we stress investor education, but if it is told to ten people only one person understands it.
Globally investors behave the same way, when they come to the stock market they look at price and not value.
Do you think that as soon as some information regarding a security is disseminated in the market, it is reflected in the price? Do stock market participants fathom the information correctly and act rationally or there is a discrepancy? Beauty is in the eyes of the beholder, similarly market sometimes takes time to grasp the reality of particular information. So the immediate reaction is sometimes not correct but in a longer term it can have a huge impact on a stock price. Understanding the value of particular information and its implication on a company is an art, and not everybody can understand it atleast in the short-term.Yes information disseminates and there is immediate reaction but the final conclusion of that may sometimes take even years before the market understand what it holds. For example, in 1989 when Berlin wall fell and entire world changed. But the correct conclusion to that was the triumph of capitalism over communism and the icon of capitalism is free markets. So that time you would have seen a global bull run in the markets. And yes the Sensex for example went up 50 points and the Dow Jones Index went up 100 points, but over a period of time Dow went up from 1000 to 10000 points and that was when the ultimate effect of the triumph of capitalism was understood. So yes in the short run markets may have gone up 50-100 points but the full impact was seen and implemented till 1999.
So definitely markets do not understand and fathom the information correctly, if markets would have been efficient I would not have been in business, I would have been a poor guy.
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How do you think should investors identify good investment opportunities?
The first thing is you should always look at your circle of competency. The second thing is always you should always buy value, because even if you look at your circle of competency and buy expensive stocks, it will not generate returns. And so the trick to all investing is to buy assets when they are cheap. You should buy it when you think the company is worth a buck when it is selling in the market at 25 cents. Have patience. You only need compounded return of say 20% every year and that would work, that is what Warren Buffett has done and that is what makes him the second richest guy in just 40 years. If someone comes to you and say that buy this stock and it will generate 30% returns in three-months you don’t want to believe him. Because the man who is richest in the world generated only 22.5% return every year, so the idea of someone giving you the tip of doubling your money in 2-months is playing stupid and that is when you will fall flat. It may work once but it will not work always.
Be stock specific you are not investing in the stock market you are investing in the business.
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2. I4 (Interviewee 4)
Are Indian stock markets efficient?
“India is a developing economy and for high growth markets like India, EMH does not hold true. In fact, efficient markets are only possible in an ideal world, but not in reality. Perhaps developed markets like US may be more efficient than Indian stock markets, but even those markets are not completely efficient. India is not as efficient as the developed markets because it is an emerging economy. Markets of countries like UK and USA are saturated, the growth rates of companies are stagnant. However, in India, every now and then there is some sector that suddenly grows at high rates and people who are able to identify them beforehand can outperform the market. In fact there are many Fund managers and investors who have consistently beaten by identifying such sectors before the whole market have got into it. Therefore, Indian markets are not as efficient as the developed markets.”
What investment strategy do you think investors should follow? Active or passive?” (considering the evidence that cost involved (both time and money) in pursuing an active management strategy outweighs the benefits and Money Managers are not able to beat the market) Why? Does the risk profile of an investor make a difference?
What investment opportunity should be adopted by investors actually depends on their risk profile. If you are a more risk-averse individual, you should go for active investment strategy, while a risk-neutral or less risk-averse person should go for passive strategy. Even in active strategy, risk level of person will determine what funds he is putting his money in. A more risk loving person might put his money in say mid-cap fund while a risk-averse individual will prefer more conservative funds.I think that the risk profile of investors determines their choice of investment strategy. Risk is low in pursuing passive investment strategy. But mainly, in a country like India, they should go for active investment strategy because in a market like India abnormalities often occur which causes inefficiency and opportunities for active managers to profit from them. As I mentioned, mismatch in expectations also causes inefficiency and managers who are able to identify these mismatch can make returns greater than the market returns. For example real estate sector is hot today and there are many companies which are overvalued, but because of the overconfidence in the market, people are not able to match the intrinsic value and the market value of the sector.
Why are Institutional Investors not able to beat the market consistently despite all the efforts and costs they indulge in?Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional Investors concentrate on? Why is that?
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Huge costs are associated with the research they conduct and that is why they are not able to outperform as you rightly mentioned that the costs incurred in their research and other expenses wipe-off the benefits. Not much idea.
‘Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. Reaching decisions about such issues cannot proceed from analytical models alone; there has to be a major input of judgment that is essentially personal and intellectual in origin’. Do you think this statement is correct? Are subjective issues important in evaluating investments?
Yes this statement is correct. Some factors that may be true and applicable in one market may not be applicable in India, say certain behavioural factors application for US investors may not apply on Indian investors. The difference in culture and society, like how people perceive things, may be different and how would they act upon it will also be different. There always exists some difference of opinion amongst people for same thing. Difference in view and perspective exists like people may view the growth prospects of a company or a industry differently. Such mismatch in judgement and opinion creates opportunities to get returns more than the market. There is contrarian opinion that is why buyers and sellers exist at the same time. There may be situation in the stock market when there is a upper circuit or lower circuit, i.e. when there are no buyers or no sellers for a particular stock. But such situation is rare and does not prolong.
How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior (irrationality per se – like herding behavior, over-pessimism or over-optimism) that causes inefficiency in the market from the Indian stock market perspective?
Yes Behavioural finance is actually very important and understanding behaviour can actually help us in not making the errors people generally commit in the market.
The example of irrational behaviour that I can think of in context to Indian markets is that people don’t want to be left out when everyone is investing in the market or investing in a particular stock. And they do this even if they are not convinced to invest, it is out of the mentality that everyone is making money and I will be left-out, so without understanding also they take a bet in the market. Even though their instincts are against it.
Certainly the explanations provided by the behavioural theories are correct, we see the herd mentality everywhere, over-optimism always exists when the markets are bullish and there is over-pessimism when the bear market is in phase.
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What is your view about the Keynes’ philosophy and why?
As for the Keynes’ statement on stock market, I don’t think it is completely true. Speculators do exist, but then there are people who want to stick to their decisions and are not speculating. That is why systematic investment plans are popular in Indian markets. People do take a longer term view. But like I said, traders also exist who carry out speculation. I would suggest that to find out the correct picture of ratio of speculators versus investors look at the statistics or delivery volumes in stock markets. Also, I think a data research and survey would be more appropriate to find the answer to this question, you can easily find this data.
Do you think that markets price the securities correctly: - in short-term? - in medium-term? Or - in long-term?Why?
Market prices the securities in a longer period. Inefficiencies would go away in a longer-term and there are no surprises in long-term which would deviate the market price from the intrinsic value.
Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors?
Yes overvalued and undervalued stocks do exist. In fact it is corollary of the fact that markets are inefficient. Expectations differ in the market, which results in undervaluation and sometimes overvaluation of the stocks.
How do you think should investors identify good investment opportunities? Individuals do not have access to information and it is not feasible for them to carry out the expenses for collection this information. It is therefore advisable that they should search for good money managers in the market and invest through professionals via the mutual fund channel.
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3. Mr. Ranjeet Hingorani
Do you agree with the EMH? To what extent do you think the theory holds true?Do you think that it is possible to “beat the market”? If yes then can you please explain how it is possible? Empirical evidences prove that passive investment strategy are better and more beneficial than active investment strategies, as the markets reach efficiency and the cost incurred in discovering the strategies to outperform the index outweighs the benefits received from them. Is this true?
“I do not agree with the efficient markets theory. Market is a reflection of so many people taking decision at the same time and they make those decisions on the basis of the information they hold, their interpretation of the information, out of some idea they hold, their psychology, etc., which differs from person to person and hence all these factors together makes the market inefficient. The decision they are making may be based on people’s fear or greed. Stock prices may not reflect the intrinsic value of the company because of the use of these factors in decision-making. However to some extent the markets are efficient, everyone has access to same information – everyone reads the same reports, newspapers, evaluates EPS and other accountancy tools for analysis. So on the face of it you’ll find that the valuations are fair.
But there is something going inside the company, which is intangible that no other person can see but you can see. That might be due to the nature of the business, you have edge over the others, or it might be because of your vision and analytical skills which others do not have. So to some extent the theory works, you cannot outperform the market with the help of the past information. But using the public information and the insight and through your skills, it is possible to beat the market. Skill plays an important role.
Nature of the business, capability of management, quality of the management, such factors should be taken into account while selecting stocks for investment.
In MF industry, Institutional imperative that we call it, everybody has to perform because there is a pressure from the unit holder that your fund is not performing, so they have to go for momentum stocks that are hot in the market, stocks on which there is lot of news going around in the market because the bonuses of the FM is also linked to the returns. So therefore they commit mistakes and are not even able to meet the index returns. They falter in between. But for individual investors like us there is no such pressure. We can take our own time, and we don’t have a concept of sticking to say large-cap, mid-cap or small-cap stocks, we can find any company wherein we believe in and then can wait for that company for a long time to start giving us returns. We don’t have that compulsion.
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There are 6000 companies listed on exchange and certainly all the analysts are not tracking all those companies. They are generally tracking the companies of the sectors which are hot, companies which are in the Index, they are over-researched. But certainly there are industries, sectors, which are dull. But it doesn’t appeal to the institutional investors, because those companies don’t give returns in shorter term. So they ignore such companies or sectors.
Do you think that Indian stock market is as efficient as the capital markets of other developed countries like US or UK? Why?
Also there is no difference in the efficiency level of the stock markets in India and other developed markets because the people are the same, behaviour is the same, and the greed exists everywhere. They have also gone through the dot.com boom and bust like India and India is also now witnessing the real-estate boom.”
What investment strategy do you think investors should follow? Active or passive?” (considering the evidence that cost involved (both time and money) in pursuing an active management strategy outweighs the benefits and Money Managers are not able to beat the market) Why?Does the risk profile of an investor make a difference?
Individuals investors who do not have expertise and understanding of analysing companies, markets and sectors can straight away go for indexing, because the expenses of later and cost to the investor is less. So he can go for index stocks or index funds and he will be much better off than many active investors. When market falls, active investors loose much significant amount than passive investors.Investors should have a much unrelated portfolio and reduce the risk of the portfolio. So for example I hold 4 stocks, those stocks should not be related to each other.
Risk profile of an investor may not necessarily affect his choice of investment strategy. A person who is risk averse, because he has made one correct decision in investing his risk taking capacity increases as he becomes intelligent and brave in his own eyes. And then he takes that additional risk and that is disastrous. So risk profile for me is a relative term. When an investor is making money, for him risk becomes irrelevant and once he loses money he realises what he has done and becomes risk-averse but then it is too late.
Institutional Investors: - Many researchers have proven that nearly all mutual funds and other institutional investors fail to beat the market on a consistent basis and that they underperform the market. In most of the instances, when they actually are able to beat the market, the costs incurred in their research and other expenses wipe-off the benefits.
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Can you explain the reasons for this? Or provide evidence when a fund or a company has been able to outperform the market over a consistent basis? Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional Investors concentrate on? Why is that?
They are on interest, their bonuses are linked to their performance and so they start taking higher risk without understanding returns will come or not. And another thing is that they are only comfortable with buying large cap stocks that’s why they are over-researched. I think they do this because if they don’t get good returns they can say that they bought a good company. So rather than venturing into something that is unknown or less popular, they pile on large-cap stocks, and they don’t want to take that risk. So their returns are ultimately market returns as they concentrate on Index stocks.
Do you think this happens because of other factors also, say liquidity. Small and mid-cap stocks do not have liquidity and these managers cannot easily exit when they want.
See, liquidity is again a function of demand and supply. Now if I buy a good company and eventually its stock price increases, its market capitalisation will also increase and the same market cap comes into buying criteria. So finally that is the question of belief. So maybe today the liquidity is not so high but if you think that this is a good company and in few years it will grow and give good returns then automatically the liquidity will come in that stock because of increase in the market-cap.Institutional investors generally concentrate on large cap stocks.
‘Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. Reaching decisions about such issues cannot proceed from analytical models alone; there has to be a major input of judgment that is essentially personal and intellectual in origin’. Do you think this statement is correct? Are subjective issues important in evaluating investments?
Stock market is a game of probability, i.e. how good you are at projecting the future. And that projection doesn’t come so easily. You have to be sure about what are venturing in to and that comes with thorough research and analysis. That requires a lot of skill and it doesn’t come overnight, it comes with a lot of experience and understanding of the market and businesses. Essentially you need that intellectual, foresight and judgement to decide whether to be there with the company for 5 years and make money. Once the opportunity is lost, those 5 years will not come back and also you have many companies to choose from. So that judgement is required and that is matter of skill, which everyone does not possess. There also lies the allocation of capital concept, which is the most difficult
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part to me, i.e. I should be able to decide how much capital I should allocate to a particular company, can I allocate a percentage of my capital to that company for 5 years without making much difference to my portfolio. I certainly agree that you should be confident and very sure about your decision and there lies the concept of Warren Buffett’s circle of competency that says you should know and understand what you are doing and investing into.I agree that that judgement is relative and you might go wrong but then again there comes the skill into picture. Through understanding of the business you are sure that this business is going to quadruple in next 4 years, although this surety is again relative. But that is what the skill is all about that you are different from others.
There is again a philosophy into investing, that I am not going to buy business which can loose money and exit from the market. So I have to be sure that the business I am getting into never loses money. Temporary setbacks are possible, but there is an Economic goodwill of that business that can again generate that kind of money in short period of time. I am ready to say no to 99% of business which this philosophy says that have the chance to loose money, though you know they are going to do well right now.
Like Bank, a good bank, whose management doesn’t do bad loans and it is careful about the cost. The bank’s services are always desired, everyone needs a bank account and the bank is nimble enough to come out with fantastic products. Another example is of a company in the paint industry, Asian paints, the company is there since last 40 years and it has been market leader, it is number 10 in the world. The company has not lost money. Paint is always needed and desired and now the margins are improving, the company has pricing power in the industry and they are coming with higher-end products where margins are huge. Also, what I am trying to say is that people might have identified such companies, but these companies don’t get overvalued. Their intrinsic value and market value go together; such companies don’t fluctuate too much in their market value. There is not much volatility in their prices. They have stable growth and because of this stability most of the people stay away because there is not much short-term movement in the price. But over a long run, these companies generate returns higher than the market. The management of such companies don’t want speculators to come in their shareholding and make their prices volatile. So they deliberately keep the prices stable. And there is so much greed in the market that people are not interested in such stocks because they don’t have much short-term movement. So today by investing-in in such companies I might not be able to beat the market, but when the market will fall, my companies will not loose their value in the market or very nominal decline. Identifying such companies is the key to investment decision-making.
How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior (irrationality per se – like herding behavior, over-pessimism or over-optimism) that causes inefficiency in
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the market from the Indian stock market perspective? And it’s Cause and effects?
Behavioural finance is very important while making investment decision. Everyone is investing in the market and making money then why should I be left-out. So without knowing ABC of investing or the company, people also start investing because everyone else is doing it. There is a tip-behaviour in the market, because no one wants to do the hard-work and still want to make money.
What is the role of discipline in stock markets?
Discipline is also the most important part in making investment decisions. You have to be disciplined while making investment in the stock market; you should not get carried away by the market. You have to know your limitations and work on those limitations. You should get things done in simple ways. Most of the people try to complicate things and then solve it and then get things done.
Do you think that markets price the securities correctly: - in short-term? - in medium-term? Or - in long-term?
The market prices the security correctly only in the longer-run, in short-term it is only a voting mechanism
Do you think that as soon as some information regarding a security is disseminated in the market, it is reflected in the price? Do stock market participants fathom the information correctly and act rationally or there is a discrepancy?
The expectations sometimes of the market or company are so high that people actually misprice the securities, that is what I would call as overreaction bias and as a result no one gets any returns. People overreact to the good news and pay higher price for the securities. So finally it will average out somewhere down the line. So higher expectations exist in the bull market and people are overoptimistic, without understanding that there are other factors which will de-accelerate the growth. On the basis of just one piece of information people under-react or overreact and ignore the other factors that may be equally important in price determination.Bottom-line is, you need skill to identify good investment opportunities, which comes through experience and also you should always select good businesses.
Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors?
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Yes, overvalued and undervalued stocks do exist in the market.
How do you think should investors identify good investment opportunities?
For investment opportunities, investors should look for such companies, whose products are desired and will always be needed in the market, which have market leadership and edge over others in the market, who make constant innovations, where there are not much of government regulations. For e.g. the paint industry in India, the product is desired and it has no alternative, in that sector there are companies which have sort of monopoly, they have pricing power and margins are huge. But that sector has not been paid attention by institutional investors.You will have to read a lot, go through annual reports, find out companies which have consistently made profits and will be able to do so by looking how their management is, finding out what are their plans for the next 10 years. You need to envisage whether this business is going to be there in the next 10 years, what will future hold for this company. From these aspects you have to refine your research and select stocks of good companies. You have to get into the nitty-gritty of the balance sheet of past few years, understand the company and the sector it is in, understand its competitive position in the market, how good the product or service it is selling is, how good its research and development department is. And then finally you have to make the judgement whether the company is good or not and its product will remain in the market in the coming 10 years.
Also, you should only get into the industry or business which you understand. And there comes your circle of competency, you should be able to understand everything about the company or business you are intending to invest in. Moreover, you should not be guided by short-term motives. There is no short-cut in life and you have to be patient to be able to consistently beat the market. You can create wealth only through long-term wealth.
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4. I5 (Interviewee 5)
What is your view on EMH?
Firstly about EMH, in theory it holds true, yes. But frankly in terms of practicality, it’s efficient over a longer period of time but in shorter term say 3-6 months over even a year sometimes market may not be efficient.
Do you think markets price the securities correctly? Over a longer period yes.
Is it possible to beat the market consistently?
It is possible, over a longer period of time, to consistently beat the market. At times you might underperform maybe for a quarter or two, but then by and large it is possible in India to outperform the market consistently, mainly through specific stock selection and sector selection. At given points in time you will find certain sectors doing exceptionally well so if your weightage in those sectors is good, higher than the index weightage, then you can outperform the market. And that is not difficult in a country like India, to find 2-3 stocks from a longer perspective, which will do better than the market. And a lot of funds actually have beaten the market consistently over the past several years.
India is a volatile market, it is not a very stable market and often times what happens is like there is not proper dissemination of information, it takes time for the market to understand that information. The no. of participants is not completely broad based, of course now things are changing as India is getting integrated with the other global markets. But I think Indian markets will still take time to reach the level of developed markets like US or UK market. Indian stock markets are not as efficient as the markets of developed economies.
In volatile markets like India, passive investment strategy will not work, will not generate good returns. But if in 2003 you would have expected the Index to go to 13000 from a level of 4000 in 2-3 years time, then passive investment strategy would have been awesome, and you would have made much more money than through active strategy. But having said that, because you don’t know what’s going to happen in say next 6-months or further ahead, whether the markets will go up or down, its always better to pursue the active management strategy.
Identifying the fundamental factors of a sector in terms of turnaround of the sector, the valuation of the sector, i.e. is it undervalued or overvalued, the growth prospects of the sector and other such factors is the starting point for investors to identify good investment opportunities. Now obviously if a company is within that sector, say for example sector like cement now when you know that infrastructure of the company is
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improving and a lot of investments going-in in infrastructure. Obviously there is going to be demand for cement and you should try to gauge the demand supply equation in that sector and identify if the supply is more than demand or vice-versa because that will be the determinant of the actual price of the cement in the market. So these are kind of ideas that you can get, and if you keep monitoring these through reading, meeting management, meeting industry associations then you can identify good investment opportunities and its not very difficult.
So many researchers and analysts exist in the market, that they might have identified the sectors or companies that are doing well now or those which have a good outlook for the future. So it is not possible to outperform the market as the price already reflects all available information
When you start off, that’s the reason it is important to be ahead on the curve. After some time everybody will be starting to talk about it and that’s when you see the performance of that sector tends to be muted despite all the fundamentals still holding true. At this point in time a lot of smart money gets out of that sector and then looks for something else. Timing is therefore extremely important in making entry to and exit from the market. Many people say that we don’t time the market it’s not possible to time the market. But in my view, it is difficult you got to get it right. Otherwise what is the point in identifying something which everyone has got into. You got to get in early and be at the lead rather than a laggard because then you will only make index returns and not extraordinary returns. The idea is not only to get the sector right, but to get it at the right time because it is not easy to determine the turnaround.
Shruti: You should be first-mover in the market?Yes.
Empirical evidences prove that passive investment strategy are better and more beneficial than active investment strategies, as the markets reach efficiency and the cost incurred in discovering the strategies to outperform the index outweighs the benefits received from them. Is this true?
You are right in a way that majority of the people are not able to beat the market and the reason is precisely this that they do not get in early in the market. You need to be early and everybody can’t be early.Today the market is very-well researched, there is a huge amount of tracking going on the media is all over the place so finding those opportunities are getting difficult by the day. 2-3 years ago it was easy in India to identify such opportunities, but things are getting difficult in the sense that you pick up any mutual fund review and you will find most of the people are invested in similar sectors or stocks by and large and there
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is hardly any differentiation. And I am admitting that it is not easy but the fact is it is not impossible either.
It is not possible to beat the market consistently. Today you might outperform but cannot guarantee for tomorrow. Is it correct?
It is quite possibleThe way industry is getting so much attention and so many people are involved in tracking that, managements are coming out and talking about their performance, a lot of information is getting disseminated on websites and through news so really I mean that differentiating factor is really diminishing. And maybe in the next 5 years even Indian markets will be like other developed markets in terms of efficiency level. Wherein beating the index will be a real challenge.
You do you think at the bottom of the day it is not skill that will play role but luck. The skill is there but then so many people have it
It is skill in a way because everything is not company researched, everything is not company fundamentals, a lot of it is got to do with the flows in the market, what is happening internationally and lot of other factors, also how successful the person is in terms of managing the money. How quickly and what your access to that channel is that will determine whether you having cutting edge over others.
Apart from the quantitative aspects of the companies there are many other factors like government policies, price of crude, commodities, how is the global interest rates cycle, etc. which determines how the company or the market will perform. In fact interest rate is one of the most important determinants in terms of flows into the emerging markets, which greatly affects the whole economy. For example if the interest rates are rising, then obviously the money will not flow into equity and it will go out from the emerging markets (India) to more developed markets. So interest rates is very important in determining in which phase the market will go because flows from FIIs affects the emerging stock markets to a great extent.
What investment strategy do you think investors should follow? Active or passive? Why? What factors do you think should be taken into account?Does the risk profile of an investor make a difference?
In a country like India where people look at the Index on a daily basis, and you might find a client who says that I am risk averse and I am happy with a 10-15% return so you might structure a portfolio which is relatively safe for him. The index would give a 20% return but you structured the portfolio such that the returns generated were 15%, the client might come back to you after 6 months and say that look buddy the index has given 25% return and you have given me a 15% return then why should I pay you anything. So people don’t understand that risk, atleast in India, that high
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returns come with high risk. And that is why in India the MFs are not allowed to promise any particular return in equity markets.
Do you think investors in India are not very well-educated in comparison to investors of developed markets?
That would be a fair statement to some extent, which is why the regulator encourages everyone to go into the equity markets through MF, because they do not understand themselves their risk profile, what is diversification. Emerging markets are generally volatile.
In context of Institutional Investors: Many researchers have proven that nearly all mutual funds and other institutional investors fail to beat the market on a consistent basis and that they underperform the market. In most of the instances, when they actually are able to beat the market, the costs incurred in their research and other expenses wipe-off the benefits. Can you explain the reasons for this? Or provide evidence when a fund or a company has been able to outperform the market over a consistent basis?
Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional Investors concentrate on? Why is that?
There is herd mentality on the streets. Suddenly when you see something doing well, everyone wants to pile on it. That is why you got to be early in the game. When you missed first 20-25% of the rally then you should not get into it, because then the whole world has got into it and the smart money has actually gone out. That is the fact, most MFs do not beat the market, but there are some MF that have consistently beaten the market, E.g. of a newspaper article.
It all depends on a mandate, if it is a diversified fund, 80-85% of the stocks would be mid-cap, if it is a mid-cap fund obviously it will be a mid-cap focus. But if there is a flexibility then most people will focus on the large-caps given the facts that liquidity is important from fund management perspective. What happened in the mid-June (2006), when the markets fell, mid-caps plummeted 40-50% when the large caps were down 20%. There is a bit of comfort and much more transparency in the large-caps. The comfort-level in investing in large-caps is much higher than the mid-caps so generally people tend to stick to large-caps.
Does such behaviour causes undervaluation of mid and small-cap stocks and therefore inefficiency in the market?
It does, it certainly does, which is why large-caps are always traded at a premium compared to mid-cap stock.
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Liquidity is one of the main reasons why this happens. Also, large-caps are generally well-researched, well-covered. There are a lot of fund managers sitting abroad and for them it is easier to get information on large companies that will not be necessarily true for some of the mid-cap companies. Comfort level for large-cap is certainly higher.
Do you think that if someone takes that risk and identify good opportunities in mid and small-cap segment then he can outperform the market?
I wouldn’t go that far. Over a period of time market recognises all of this. And if there is some gap between mid-cap and small-cap stocks then it becomes apparent. For example a month and a half ago (September 2006), it became quite evident that mid-cap stocks were not moving and a lot of momentum was going on in large-cap stocks. And typically after a sometime large cap need a particular rally or a decline and when large-caps tend to become overvalued, then at that point in time people take their money out of large-cap and invest it in relatively liquid mid-caps. And those companies start going up in terms of share prices and that segment start picking up until it is overvalued and the shift occurs back towards large-cap stocks. And that’s the cycle and it’s a very typical pattern. You may term it inefficiency. But it is a known inefficiency in the market.
It is not that people don’t know about it, everyone knows about it. When the rally is starting it is better to be in the large-cap stocks because if you are wrong it is easy to get out of the large-cap stocks. But if you are wrong and you select mid-cap and if the markets start to go down then you might have difficult in exiting, that’s precisely the reason.
The cost of getting-in in the small-cap stocks is high, difficult is in the entry and exit cost because of the illiquid nature of the stock.
Behavioural Finance
It is fairly imp because a lot of time what happens is that there is generally consensus in the market and the consensus normally is wrong. When the whole world becomes pessimistic, when there is a herd mentality, generally it is time to go reverse. It is not easy to kind of anticipate and determine but it is important.
People don’t want to invest money but play with the market.
In 2000, everybody was in the equity markets and everyone was buying technology stocks. Even the diversified Mutual Funds had 30-40% exposure in technology stocks, i.e. diversified funds we are talking about. This was because of the performance, the technology sector was performing so well that they increased their exposure in it. May be that initially they held 10-15% position in tech stocks but that
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must have grown to 30% because the other sectors was going down. There was so much concentration on tech sector. People were justifying stocks trading at P/E multiples of 100 and 80, people were looking at 10 years story of technology companies’ performance in India. I mean it is still true, its not that the tech story has completely gone from India, it is still a great sector. But what had happened was that the entire ten year story was priced in a period of 6 months time of timeframe that was the problem. Talk about the reverse, in 2002-2003 when the markets reversed you could buy the technology stocks at 10-20% of their values in 2000. Even in down-cycle none of the technology companies in India were making losses, but despite that people were not buying the companies that earlier they were ready to buy at 80 P/E. I am talking about large-cap companies. So that’s the other extreme, people don’t want to get in the stock market.
Can you outline some other irrationality of investors apart from what you just mentioned?
Over speculation, chasing stocks with no fundamentals at all just because someone on the street or your stock-broker has recommended you. Many people do that, even after burning their hands many a times they still do that and end up buying things because someone else has recommended you. People don’t have time to analyse and get the information on the stock, because they have their own work and business to manage, so they just buy whatever is recommended to them. But the attractiveness of the stock market is so overbearing that they can’t afford to miss anything like that.And mind you ‘losing an opportunity hurts you more than having actually lost money’ (42:40). Suppose I have bought some shares and I told you to buy and you happen to miss that opportunity and I made a profit from it then you’ll feel so bad having missed it. On the other hand if I bought something and lost money and you bought something and lost money, you would not feel so bad because I have lost money too. So that is the human nature and this sort of behaviour is often seen amongst Indian investors. Seeing that your neighbour is making money and you are left out hurts more than when you actually loose money in the market.This is why there is so much tendency of over-speculating that you go beyond your mean. Typically when the markets are plummeting and are at their bottoms, you play within your mean because you are scared of losing money. So your size of investment at that point of time is also very low, say you invested only Rs. 100. But as the market goes up and as you make money, you increase your Rs100 investment to Rs1000 and 1000 climbs to Rs5000 and 10,000 and 15,000.
So what you mean is that the risk taking capacity of people increases as they make money?
It’s not the risk capacity; they very well know that if this Rs15000 halves or even goes down 30%, it will wipe out everything they have. Because you have gradually
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built it up in lots and your Rs 100 investment has actually climbed to the multiples of that. It is therefore the psychology. Nobody thinks of their capacity. In fact it should be the other way round, but quite frankly it never happens.
This kind of behaviour is actually driven by the greed. Greed is therefore one of the irrational behaviour that investors succumb to which affects their returns in the markets.
Keynes’ pictures the stock market as a ‘casino’ guided by ‘animal spirit’. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.What is your view about the Keyne’s philosophy and why?
I think it is a fair comment and I don’t dispute that. Very few people in the Indian markets are there for a long-run.
Out of 40 years in the stock markets in USA (the numbers and details is given in Peter Lynch’s book), the annualised returns are better in the stock markets than in bank deposits and fixed income market. But out of those 40 years, the profits were actually made in 4-5 years, the real money that is. And that is the reason for this kind of behaviour as described by Keynes. Nobody wants to wait for 40 years, for that matter no one wants to wait for 5 years. They will rather put money in stocks or funds where they’ll get say 20% returns in 6 months or 1 year. It is a fact and it is not going to change as long as the markets exist.
Does this behaviour exist even in developed economies?
Yes, this behaviour exists even in the developed economies, no question about that.
Do you think that markets price the securities correctly: - in short-term? - in medium-term? or - in long-term?Why?
Medium-long term. In short-term there might be fluctuations, there might be discrepancies in terms of pricing but in a long-run definitely markets prices the securities correctly.Reason being that the information might not have been incorporated completely; there might be disbelief in terms of what is going on. There may be other external or international factors (psychological) like if there is a war going on somewhere and their markets and other markets are not doing well, people might expect companies and markets in India to do well. There are so many things influencing your mind
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when you are buying or selling that in short-term there is discrepancy in pricing but in longer run it is corrected because the information sort of populates down (people understand the information and what lies behind it), other factors also settle down and this particular factor gains priority and people understand their former mistake.
In short-term reactions occur. There is immediate reaction to say earnings expectations, and the moment the expectations doesn’t match, the stock prices crashes or rises depending on what was the expectation and what was declared. However in long-run people find out – there are analysts meet, questions asked from company’s management, they confirm whether this is a one-off thing, find out the reason for the numbers declared and depending on that assessment the stock price will correct.
Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors?
Yes overvalued and undervalued stocks exist all the time
How do you think should investors identify good investment opportunities?
Let us talk about undervalued stocks. There could be undervalued stocks because:- There is not much of coverage in that sector or company,- No one is looking at it- It is in a sector which everyone hates, no one likes that particular sector
So the whole idea is to find out why is this company standing out, why has the market not recognized it. There is a reason and it is not that it can remain undervalued for a very long time because the market remains inefficient only for a very short time. The moment the management gives some indication markets starts to price that in. When you are scanning the universe, a lot of time you will find undervalued stocks. For e.g. in 2004 everyone knew that the market is undervalued, but no one had the courage to put-in in equity having seen what happened in 2000. They were all waiting for companies to start performing well. Even in bullish markets you will find companies which are undervalued because they are ignored by the analysts.
‘The best way is to do it yourself; in this market you are all alone’.
It is a lot of hard work, you need to study about the company and the industry it is in.
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But how does an individual identify the company or the industry?
There are different approaches for it. You can either go for a top-down kind of approach wherein you look at the macro scenario and narrow your selectionOr you look at within the sectors that are doing well. There are lot of databases available and you can find out that in a particular sector the 3 companies are going extremely well n stock market and there are 2 companies which are actually languishing, nobody wants to touch them. So start from there. You should do a lot of reading and you can identify sectors and company from there.Suppose there is a new technology coming-in that you have heard about, and a particular company is getting into it maybe through designing, engineering or anything. Then your due diligence starts and you identify the growth opportunities of this company, you might be ahead of the market, but you should be patient. But look for growth prospects of the company and profits that is the only tool you have to see if the company will do well. ‘Market likes growth and it is willing to pay premium for that growth.’
Never look at past and base your judgment because it is history. The future is completely different. The company might have changed its technology, changed the way it does business, it might have moved to international shores, it might be tapping new markets, might be acquiring some company. A lot of things would have changed. Lot of qualitative factors would have come in. So the point is, P/E would not determine the outlook, you got to adjust that P/E to growth, the expected growth. Through PEG. That puts things into perspective. Even today India is one of the most expensive markets in this region in terms of P/E multiples. That is the general perception internationally. The fact of the matter is Indian earnings are growing @ 25% p.a. So if they are trading at 16-20 times it might be justifiable. There would be other markets trading at 12 P/E multiples, but their corporate earnings’ growth is 5-10%. So would you go and buy that?So if you adjust the P/E ratio to growth and look at PEG instead of P/E you might find an answer there for identifying good investment opportunities.
Do you believe in technical analysis?
Not from stock selection perspective but from stock entry and exit point of view. It does help you in selecting your entry and exit points. So I wouldn’t ignore it completely. You can’t go and select stocks on the basis of technical analysis. But having selected a particular company, you should go back and look at the charts and you can check if there is volume happening in that stock, is there some accumulation going on and such factors, what are the range in which you can typically buy and if breaks a particular level then you need to be a little careful. So you can go back and check your fundamentals, if it still holds or not. So it is a good guiding tool but not from stock selection perspective.
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5. I6 (Interviewee 6)
“Efficient capital markets theory assumes that two people think alike. It is good in theory but in practise it does not hold true. In real world information is analysed by people, who interpret it differently. Had the analysis been carried out by computers, the theory might have been true. But every individual has brain and using his/her brain each one interprets or views things differently. The mere presence of brain in humans deviates markets from efficiency level as a market comprises of people and people make the markets.Efficient market theory is helpful in understanding markets and it can serve as a benchmark from where to start, but if we will think that markets are going to completely efficient then markets will cease to exist”.EMH is correct in theory but if it will be implemented in real life then no market will exist.
There are cycles in the market. Let us say for example, there are two vegetable vendors and you decide to purchase vegetable from one of them because he is selling cheaper than the other. Now, you think that he is selling cheap and he thinks he is making a profit and so the deal takes place and you buy from him everyday. Now a behavioural part will come in this deal and that vendor will start thinking that ;oh this lady buys from me everyday and I think I am selling too cheap’ and so he starts to increase the price of his vegetables. You will realise that this vendor is now cheating and you decide to try someone else. And so a cycle forms. And this cycle brings things to the equilibrium. So sometimes there are excesses in the market which brings things to the equilibrium.And anything that becomes excessive starts devaluing something. Take an example of your personal life, if you devote too much time and energy on academics, then you will start ignoring your health, your extra-curricular activities and you might even start devoting less time to your family. But you are expected to balance-out everything and this balance is nothing but bringing equilibrium to your life.
Innovations keep happening, this how this world grows. Excess keep happening, people overvalue or overestimate the power of new innovations. That is what happened in 1929 about the steel, people overestimated its potential and there was overcapacity of steel and the World War happened. Similarly when the semi-conductor chips came in people overestimated its potential too, there were books in that era written that in 5 years all the work will be done by Robots, domestic, etc. And it was overvalued. But that is not the case, we don’t have robots doing our household work.
Empirical evidences prove that passive investment strategy are better and more beneficial than active investment strategies because as the markets reach efficiency the cost incurred (time and money) in discovering the strategies to outperform the index outweighs the benefits received from them.
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Is this true?
A passive manager says that markets are going to go and down and up and down then why should I waste my efforts in predicting these ups and downs. Let me be in this market and invest in Index, so I will get the average and I am happy with the average, it is fantastic.
But an Active manager thinks that because God has given me brains so I should use it. Because people behave differently and there is excessive for somebody then I will have the opportunity to make money out of this excessive by taking a reverse position from what others are doing.
Why are fund managers not able to outperform consistently?(Irrational behaviour also highlighted)
Active managers are not able to perform consistently because they try to be jack of all trades, but they can’t be an expert of everything. They got to understand this and only focus on companies and stocks which they understand, whose business, markets, products, management they can understand. An example for this can be given of Warren Buffett, he is an activist, in 2000 he made a statement that ‘I don’t understand IT industry and therefore I don’t invest in it’. For a brief period his performance was down as compared to other active managers who invested in IT companies. But his performance again soared and the other managers actually lost tremendous amount of money. In those brief periods of excess, one has to be focused on his basics and only concentrate on what he understands rather than getting driven or tempted by others.We as human beings consider ourselves as super efficient, we think that we know more than anyone else and that is where problem arises and that is why we underperform. If we actually contain to stick to our basics then only we will be able to beat the market through our skill through our vision. But it is easier said than done.Very few money managers, fund managers and other investors actually follow what Warren Buffett said. I don’t understand IT, so I won’t invest in it, Very simple. I will only invest my money in what I understand. Because if you continue to put your money in what you know better, you will do better than the others.
Investors create pressure on fund managers and that is why they get into momentum stocks. When they generally evaluate the FMs performance they look at 3-6 months or a year record and then pick up the fund. Moreover, if the fund manager is not investing in the ‘hot’ sector because his logic and judgement says not to and he underperforms compared to others, people will think ‘oh he has lost his touch’ and they withdraw money from his fund and invest in other funds. That FM might then think that my business is suffering, if I don’t invest in the ‘hot’ sector I will be losing customers and I will be losing money. So let me also participate in the sector. When this bubble will burst I will walk out. But no one knows when this bubble will burst otherwise no one will invest in the bubble. So fund managers are making these mistakes because investors are forcing them to make this mistake.
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Investors put pressure on FMs to perform every quarter and the FM actually comes under pressure to retain the market share and they start looking at everything and basically become jack of all trades and master of none. And in the process they become average people and an average person will give you average returns. So they need to focus on their strengths. This is the biggest problem in MF industry.
Another irrational behaviour on part of FM is that if they start to outperform market and make profits, they start thinking that they drive the markets. But they don’t understand that they are part of the market and they cannot drive the market. A smart investor will never drive the market. He will actually take opportunistic advantage of the market. That is why he is a smart investor. It is all human nature.
Glamour is also coming in this industry. They come on television channel and give advice on which sectors to invest in, which company to invest in. Today they recommend something and tomorrow that stock will move up. This is all glamour and they become overconfident about their performance.
Also, there has to be equilibrium, so if I am making more money, someone will have to loose it. So I got to be smarter than others to make money.
People have actually lost focus on their strength, the problem doesn’t lie in the theory be it behavioural finance or be it value investing, problem lies with the implementation.You will see people all over the world investing in India. How can you know about India sitting in United States when you hardly visit India? What is on the Internet, newspapers, magazines and TV will not give the complete picture of India. You got to live here to understand the complete scenario economic, social and other. Everyone says India is a big story. But if India is a big story why are farmers in India committing suicides? This is something which they cannot monitor from United States. The point is, the problem is not with the theory, the problem is the way that theory is implemented. Just because the implementation is wrong, theory cannot be wrong.
So active managers can make money and beat the market because there are cycles and there is nothing in this world, I stress, there is nothing in this world that is not cyclical. And if there are cycles you will always make money if you predict the cycles. However, no human being can predict all the cycles right at the right time. But problem lies, everyone tries to predict all the cycles. So you need to focus on few cycles in order to get returns higher than the average. Those who did it they are successful and we have examples of such people. However, not everyone can continue to outperform the benchmarks all the time like Warren Buffett underperformed for the brief period of technology boom. But then over a longer run, it is possible to beat the market consistently.
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Is there a difference in developed markets and emerging markets in terms of the irrational behaviour outlined above?
The human psychology remains the same everywhere. And today the world is integrated. Therefore the nature remains the same, the mistakes remain the same, only the impact of the mistake has a different intensity. Once probably reason for this is that Emerging economies have are smaller markets compared to the developed economies. Other reason why the impact is severe is because the volatility is quite high, the liquidity is low but in developed economies the impact of such behaviour is less severe. Otherwise both the markets are similar.
Is technical analysis helpful in making investment decisions?
I think it is a very good tool but only for the people who understand it. Equipments of a brain surgeon will only be useful in his hands, if a heart surgeon will use it, it will result in a fiasco.Technical analysis is helpful because it predicts the behavioural patterns of the investors. If people have behaved in a manner in past it is very likely they will do it in the future because humans have the tendency to repeat their mistakes or behave in a similar fashion.
Can you provide some examples of investor behavior (irrationality per se – like herding behavior, over-pessimism or over-optimism) that causes inefficiency in the market from the Indian stock market perspective?
The manner in which the money is invested is wrong. People are investing money in stock markets to generate short-term returns. But they will have to take long-term calls. And I think this phenomenon is worldwide, however it is more prominent in emerging economies like India and less in developed economies.
If in the short run a fund does not perform, investors withdraw their money from it and invest in other funds and so FMs are also pressurized to select sectors and stocks which will generate short-term returns and so they fail to show their performance. People will have to take a long-term perspective in stock markets.
What is your view on the Keynes’ pricture of stock market?
Keynes’ picture of the market is absolutely correct, bulk of the investments that is done in the market is done with the mind set of making short term profits and that is why people don’t make money. People actually think it is a casino where cheap money can be made but believe me there is no cheap money in this world.Do you think that markets price the securities correctly:- in short-term?, - in medium-term? Or - in long-term?
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Over longer-term markets prices the securities correctly.
How do you think should investors identify good investment opportunities?
An individual should never invest on his own. Fund managers exist for that purpose. But if you invest through passive managers, then you will only get average returns. Invest through active managers and for funds which are for long-run investment. Check the track record of the manager who is managing that fund and check not just 1-2 year track record but a longer record.
You should have a business owner perspective when you are deciding to buy the stocks of a company. You should never invest in a company with the intention to sell it tomorrow if you want good returns in the market. Always buy stock with the mindset of owning that particular business then only can you make money from that investment.
When you invest you should always evaluate the company in the sense that is it sustainable for a longer period and can it sustain the same growth level of its cash flow to generate returns for you. Always buy a business which in your mind is sustainable.
You need to continue to focus on your strength and identify your strength. Likewise you will find 4-5 areas or industries which you understand. You should then predict the cycle of that industry, how is the future of the industry and the growth in it. Pick a company and see where it stands in that cycle. Then you meet the management and understand what their vision is, and their management style is. Evaluate the company using the Porter’s five factor model and then come to conclusion whether you should own it or not and accordingly make your decision.
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6. I7 (Interviewee 7)
What is your view on EMH, is the theory valid in Indian stock markets?
EMH does not picture the true world. In real world there are many factors like irrational behaviour of people, unavailability of some information that affects valuation of the company, misunderstanding, etc. that contains the markets from becoming efficient. In India also stock markets are not completely efficient, though they are efficient to some extent. Mature markets of US and UK may be more efficient than India, but even they are not completely efficient.
What is the role of Behavioral Finance in making investment decisions? Can you outline some examples of irrationalities on part of investors in the market?
Behavioral Finance provides a platform to learn from people’s mistakes, to modify and improve their overall investment strategies and actually profit from identifying these mistakes. It is indeed very helpful in investment decisions”.
Putting-in money on tips, overconfidence, and getting emotionally attached to the shares are all examples of irrational behavior seen in Indian markets. People are driven by greed, when they see prices of stocks climbing, without understanding the valuations they purchase those stocks and when it busts they all curse the stock markets. People show problems of self-control, and know that they may be unable to control themselves in the future. Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic amid downturns.
Keynes’ pictures the stock market as a ‘casino’ guided by ‘animal spirit’. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.What is your view on this statement?
Keynes made a fairly correct statement. In fact, this problem is more severe in Indian markets, everyone is here to make cheap money. Especially when the markets are on a bull run, you will find housewives, doctors, software professionals, bank clerks, credit managers investing in the stock market. In fact even my cook wanted me to recommend him stocks to put his money in. And believe me they don’t understand a bit about the company they are putting their money in. It is actually like a casino for them. However, actual investors do exist, though sometimes even they are driven by this ‘animal spirit’.
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Do you think that markets price the securities correctly: - in short-term? - in medium-term? or - in long-term?Why?
“In short-term prices often deviates from their intrinsic value as it takes time for people to understand what lies behind the information. People also generally tend to forget the past and other factors that have an effect on the company and give so much weight to the current information that it leads the price deviation from its intrinsic value. However over a long-run the true picture is identified and hence markets price the security correctly.”
Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors?
Markets are often driven by greed and fear of the people, which causes stock prices to move beyond their intrinsic value causing overvaluation of stocks, as has been seen in 2000-2001 Internet bubble. Similarly when people suffer losses because of the mistakes they commit of buying stocks when market is highly overpriced without understanding fundamentals, they are so scared of the market that it causes companies selling sometimes below their cash value. In 2002-2004, I have actually seen that the offices which used to be packed with traders and investors 2-3 years back had no one except the operators. Stock brokers actually used to telephone their clients and convince them to come to the market atleast for a few hours. Being an analyst, I myself found some very good companies during that phase whose stocks were selling in the markets at unbelievably low prices and no one wanted to buy them. While 3 years back, people actually were paying 50x the price to get the same company. Nothing went wrong with the company, it was still selling its products, generating profits and running its business. But it was the fear and over-pessimism that was guiding them. This is a clear indication of existence of overvalued and undervalued stocks.
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7. I8 ((Interviewee 8)
Indian markets are not efficient and certainly not as efficient as developed markets of US and UK.
Fundamental research gives returns better than the market. Capability and credibility of a company plays an important role in generating returns.Although I agree that majority of the mutual funds are not able to beat the market, but then everyone cannot be a winner.
Explanation of why fund managers are not able to beat the market:
- Varied schemes for varied objectives- Fund managers have to report day-to-day Net Asset Value (NAV). - above causes pressure on fund managers
Because of the pressure, so many FMs just play the momentum. So in the bullish markets they outperform but in the bearish market they do not. In order to solve this problem, fund managers need to be disciplined and they should not hold very risky portfolio because everyone else is doing so, out of short-term motives of getting high returns.
‘It is the ability that will always keep you ahead of the market. And you need to have a disciplined approach of investing’.
This discipline means not getting carried away by the market, resisting the temptation of generating high-returns in short-term, which is an important cause of all the FMs to underperform. Not following the herd mentality – ‘Just because everyone is doing it I should also follow the herd’. They should only be venturing into industries and stocks which they understand.
It is difficult to beat the market on a consistent basis, nevertheless it is not impossible. Intellectual capital, out-smartness and diligence can help you to outperform the market along with the points discussed above.
Is technical analysis important in making investment decisions? Is it helpful in selection of good investment opportunities and outperforming the market?
Technical analysis cannot help you in outperforming the market, nor can it help in identifying good investment opportunities. However, it is a useful tool and can aid to time your entry and exit from the market. It has been seen that stocks follow a particular pattern. And once you have identified that you want to invest in X company, then with the help of technical analysis, you can decide when should you buy stock of X company and when should you sell it off.
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What investment strategy do you think investors should follow? Individuals should also adopt active management strategy. And also, risk profile will affect the choice of the strategy adopted by them. If investors want stable returns and are risk-averse they should adopt passive strategy. Moreover, since the investors do not have access to information and resources to analyse and understand that information as well as the fund managers do, they should invest in the market through professional investors, rather than doing it themselves.
Many researchers have proven that nearly all mutual funds and other institutional investors fail to beat the market on a consistent basis and that they underperform the market. In most of the instances, when they actually are able to beat the market, the costs incurred in their research and other expenses wipe-off the benefits.
Can you explain the reasons for this? Or provide evidence when a fund or a company has been able to outperform the market over a consistent basis?
Irrationalities and reasons why FMs underperform:
- Thrill of out-performance that makes you take riskier option. When you start doing well, you start to increase your exposure in the market and put-in more money in the market, which is disastrous.- If a well-known FM has identified something, the others get into it, stories are built, hype is created and that sector becomes hot. This is a common mistake. In fact, at this point in time, smart FMs exist and make good returns while others just pile on into that stock and most of them end up losing money.
Funds that have outperformed consistently: HDFC mututal Fund’s scheme called ‘HDFC Euity’, Sundaram’s mid-cap fund, Reliance’s growth fund, DSP Merrill Lynch’s opportunity fund, DSP Merrill Lynch’s Equity fund, Templeton’s Prima fund.
Institutional investors are not able to outperform the market also because:- so many schemes they put the money into are designed in a way that they are
not supposed to beat the market. Their motive is to generate safe returns for their investors.
- Outperformance is not the motive of many schemes.
‘Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. Reaching decisions about such issues cannot proceed from analytical
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models alone; there has to be a major input of judgment that is essentially personal and intellectual in origin’.
Do you think this statement is correct? Are subjective issues important in evaluating investments?Can you further elaborate this point from your perspective and give an example, from your own experience, when you identified a particular investment opportunity, long before it was ‘popular’ in market and also detail on that.
Yes I strongly believe that this statement is correct. Subjective issues lies in your judgment power, your skills and ability to identify good opportunities and analyse companies and stocks, how discipline you are in the market, capability and credibility of the management of the company you intend to invest in, etc are some examples of subjective issues that are important in decision-making.Own example is of Pantaloons Retail India Ltd.. I identified this company 5 years back when it was trading at Rs 30. My rationale was that there were very few big retailers in Indian markets into apparels and supermarket and only 2-3 of them had national presence and outlook of increasing their stores in India. Pantaloons was one of those three stores. The company’s products and services were appreciated in the market, it was a new concept otherwise earlier people used to buy only through individual small retailers.I always try to map the US and UL markets and try to identify and watch what changes these economies had 50 years back and relate that to India, since it is an emerging market. So retail boom was what I envisaged and I was confident about it. It was a right decision and like I envisaged within 5 years the company’s stocks are trading at Rs. 1600 from Rs. 30 in 2001-2002. 5 years back everyone was sceptic about Pantaloon’s performance and its retail concept. They were not ready to accept the change that will take place in the retailing market. But then this change was bound to happen because the Indian market is changing and consumer’s tastes and preferences are also changing. To some extent this change is aligned to the market patterns of other developed economies.
How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior (irrationality per se – like herding behavior, over-pessimism or over-optimism) that causes inefficiency in the market from the Indian stock market perspective? And it’s Cause and effects?
Behavioral Finance is indeed very important in making investment decisions.
One of the examples is herding behaviour, herding without understanding why they are getting into a particular sector and without understanding why they are buying stock of so and so company. I will explain this through an example. It is 5.30pm, peak hours of local trains in Bombay (Mumbai). The train platform and train is very crowded. Someone was talking to his companion in a loud voice and was using the
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word Bombay and someone pushed him and he could only utter Bomb.. Few people heard his utterance and started shouting BOMB, BOMB, BOMB, and a rush of panic occurred in the station, everyone started running-off and started acting irrationally. No one even once tried to understand what happened and caused this irrational behaviour causing trouble.
Exactly this is how the stock market participants behave in the market. If someone recommended buy, everyone will follow the advice without using their logic and so happens for the selling advice. Without understanding and knowing people just do as others do and even rational investors and professional managers follow the crowd.
Keynes’ pictures the stock market as a ‘casino’ guided by ‘animal spirit’. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements.What is your view about the Keyne’ philosophy and why?
In regards to Keynes’ picture of the market, I think his explanation is correct and this happens in the market. But is this not what markets are for?
Do you think that markets price the securities correctly: - in short-term? - in medium-term? or - in long-term?Why?
In a longer-term. Short-term markets are driven by irrational investors. For example, external events like a bombing in UK will result in crash of Indian markets despite the fact that such an event actually has not affected the Indian economy or its industries and companies. It is just panic from investors or an opportunity for speculators to make profits by driving the market away from its fundamentals. However, in a longer-term the true picture will show and prices will reach their intrinsic value, their efficiency.
Do you think that as soon as some information regarding a security is disseminated in the market, it is reflected in the price? Do stock market participants fathom the information correctly and act rationally or there is a discrepancy?
No, there is a discrepancy. For example, the information that is disseminated may not be apprehended in the same manner as the company wanted to show. Each individual will understand and henceforth react in a different manner. In fact, existence of both
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the buyers and sellers in the market prove that same information is interpreted differently and there is rational and irrational action on the basis of that information.
Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors?
Yes, definitely overvalued and undervalued stocks exist in the market. Markets are like a pendulum which swing between the phase of overvaluation and undervaluation.
How do you think should investors identify good investment opportunities? Through-- Strong fundamental research- Disciplined investment methodology- Ability to identify excesses on both the sides up and down.
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8. Mr. Vishal Jain
Shruti: Do you agree with the EMH? To what extent do you think the theory holds true? Do you think that it is possible to “beat the market”?Do you think that Indian stock market is as efficient as the capital markets of other developed countries like US or UK? Why?
Vishal: Agree with it.In my view, in India markets were not efficient 4-5 years back because the information was hotchpotch. But today the regulations in the Indian markets have improved from the stock markets and also the regulator.Information disseminates at the same time as soon as it is available and the dissemination is also higher leading to markets becoming more efficient.
Besides, 3-4 years back there were only a few players in the market, mostly domestic institutions. But today even domestic institutions have become large, retail investors are becoming more educated, lot of foreign institutions and hedge funds have come into the market. So the competition level has increased. The research on the markets has improved manifolds. Now, there are more researchers, analysts, much more technically qualified people in finance than earlier. Therefore the markets are much more efficient than they were few years back. And over a period of time, Indian markets would become more efficient.
Shruti: Do you think that the markets always price the securities correctly?
Vishal: Yes markets price the securities correctly. But claiming that it always does is a utopian idea. However, even today, if you have information that other people in the market do not hold, then you can make money out of the market and outperform others. Say insider information. But such chances are rare.But through public information and historical prices it is difficult to outperform the market.
Shruti: Is there a discrepancy between what the information holds and how people interpret it?
Vishal: Yes and no. For example, a person may interpret a particular piece of information to be great but the other may not. For this reason only buyers and sellers both exist in the market. There will always be contrarian views. If everyone will view the information and interpret it in the same fashion then no market will exist.
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Shruti: What do you think about the argument that if everyone will pursue passive investment strategy then the amount of research carried out will diminish resulting in markets becoming inefficient?
Vishal: In market there have to be active managers. Because the active managers are taking call on the market, the passive fund managers are there and exist. If whole market is passive there will be no market.India is developing market, therefore there would always be some sectors ‘popping-up’, which will give above-average returns and add value. For eg. Few years back no one talking about telecom sector. Suddenly it has popped-up and it’s a big story. And people have been able to get excellent returns through investing in this sector. Hence active managers can make money. When economy develops/grows, sectors and companies grow. They become large and competitive, so it becomes difficult for even one company to out-beat the others because mergers and acquisitions occurs, companies start consolidating and growth rate comes to average levels like what has happened in the developed markets like US, where a company growing @ 10% is considered big and good. But in India, if a company is not growing atleast @20-25%, it is not considered good because of the nature of our economy.
So say in 5-10 years down the line India will also reach that stage and the growth level will reach average and companies will have growth level of say 8-10 % as against the 2—25% they have now. If you are a 100 million company you can grow @15-20% but when you become 10 billion then you can’t sustain the same growth level. Indian companies are also reaching economies of scale and they are becoming big. Companies in India are now having 20k-40k employees which wasn’t seen 4-5 years back. Having a year-on-year growth of 20% is not possible all the time. So in a few years time they will also come down to average and then it will be difficult for active fund managers to beat the market, as they are able to do now.
Shruti: In 2003 no one knew that market will reach from 4000 index-level to 13000 in 3 year’s time. In this period, investors who might have pursued indexing earned well. But before that period 1992-2003 the market did not do well. In fact it was stumbling down in that duration. So a person who pursued passive strategy in that period was actually worse-off for 13 years.
Vishal: Obviously there will be periods when Passive fund managers will underperform compared to active managers but then even the vice-versa happens.Looking at this point of time, it is not necessary that active fund managers will outperform the market as they grossly did in the past.
In developed markets like US and UK passive investment strategy is ingrained in people. $4-5 trillion is floating in index funds. There the index managers review the index on an active basis, there are constant changes happening to index. Companies which do not fulfil the criteria move out of the index. In India, companies are getting
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into the index on the basis of valuation and that valuation is on the basis of which the active fund managers are playing on.
What is gradually happening now and will continue to happen is that Indices in India are getting reviewed much more often. And the criteria for Index companies being a part of index is also changing ad Index providers are also learning. But now gradually even the indices are going to get all the more efficient and they are going to select better stocks. Due to this, the instances of active managers outperforming the market are going to reduce.
Shruti: Research has shown that Active Fund Managers are not able to beat the market on a consistent basis. However, despite that there are people like Peter Lynch, Bill Giller who have done so.Do you think skill plays an important role and people with certain skills will always outperform the market?
Vishal: Ya it does. Active fund managers have to be there otherwise passive guys will not survive. There has to be a guy who has to go wrong for some other guy to go right and vice-versa. There has to be research done on stock and there has to be a contrarian view in the market, in fact everywhere. Then only will both the philosophies will survive. So there is a role for active fund manager as well.When a client approaches us, we never say that put all your funds in indexing, even though we are purely a passive fund company. We always suggest them that a part of your portfolio should always be in active funds. Say if he has Rs. 100, put 25-30 purely in indexing, another 30-35 in active funds and the rest can probably be put in debt. Active funds also have value.
Shruti: What investing strategy should an investor follow? Passive or active?
Vishal: I think it should be a combination of both.
Shruti: Why is that?
Vishal: Simply because there are periods when active fund managers outperform the market and indexing doesn’t generate returns. And obviously the skill is there and that skill of active guys should be valued. However, because an active manager has outperformerd the market this year doesn’t guarantee that he will be able to outperform in the coming time. I don’t want to take this risk. I might as well put my funds in an Index for 4-5 years and I believe in it because if our economy is going to grow, which it will, so obviously the large companies are going to benefit the most. I want to be invested in the best companies and that is reflected in the Index. I don’t want to put my money with some Fund manager who might be there today but might not be there tomorrow, who is
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performing today but might not be performing tomorrow. I don’t want to make that call.
Shruti: Do you think that the risk profile of an investor makes a difference in his investment strategy?
Vishal: Yes, definitely. If the investor is risk-averse, he would probably prefer being with the index. He would not want 30-40% return that may not be stable, he is content even if he is just getting the market returns of say 20-25%.I am not sure that an active manager who has beaten the index can do so in the future as well and also that he will be able to beat the market by a huge percentage.
The classical case of outperformance I have seen is the case when active fund managers are benchmarking their returns with the wrong index. There are people giving good returns say 40% (As against Nifty’s 20%), who are investing in mid-cap companies and comparing their index with Nifty Index. But obviously there is no comparison. So if you are investing in mid-cap companies, you should compare your returns with Mid-cap Index. Thus, when looking at the performance and returns of active managers, such factors should also be taken into account.I don’t think it is possible for any active manager to grossly outperform the market on a consistent basis and with time it is going to get all the more difficult.
Shruti: Then what do you think about people like Peter Lynch and Warren Buffet who have been consistently outperforming the market?
Vishal: They are exceptions. History shows that there are a very few people who have done it.
Shruti: In fact there are more than just a few people who have been consistently outperforming the market. So what do you think, it is their skill or matter of luck?
Vishal: I’m sure it is skill. If you are consistently doing it, there is skill. But how many people can actually do it, is a big question.Especially in India, I don’t know who that one person is. There were people who were beating the market on a consistent people, but they are not there today.
Shruti: Institutional Investors (question 3)
Vishal: Even if Fund managers and Institutional Investors are able to beat the market that number is going to be small and lot of their money is going to be eaten-up by the cost. So I agree with the statement.
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Shruti: What do you think are the reasons why Fund Managers are not able to beat the market?
Vishal: In India, the expense ratio that is charged to the investor on an active fund is 2.25% of the assets being managed. We are the passive fund and we charge 0.25%. So an active FM has to first outperform the index by 2% to beat the passive guy and get at par at what Passive Fund is giving. So he (active) has to work that much harder.To what extent can he do that? The information dissemination is the same. What information we have, the active guy also has the same. So there is very little chance that he is going to beat the market. Eventually, he is also going to give the market return.
If you look at the portfolio of active FMs, 80% stocks they have in their portfolio are there in the Index. This would mean that he is just going to play around with 20-30% of the stocks in his portfolio to generate returns higher than the market-returns, which again is a big call he is taking.So eventually he is also going to give you index returns. Simply because the psyche is that he also cannot deviate much from the index because of the risk that he might underperform. Everyone is looking at the Nifty, so they have to hold the Nifty stocks also. If he is completely off the Nifty and his selection goes wrong he would be in trouble and he would not want to take that risk. This is because he is benchmarking his returns with the index. So indirectly he is also tracking the index.
Shruti: Do you think there is a herding behaviour amongst IIs and FMs?
Vishal: There is a herding behaviour across all the investors, forget about active or passive. I have seen that when the market falls everyone is there to sell and when the market goes up, everyone is in the market to buy. There are very few people who have the guts to really go out and buy when the markets are falling.For example, in May 2006, all the markets slumped and I saw that we were getting huge redemptions. It was surprising that no one came in and bought. People were ready to put in money when Index was 12000 but when Index is 9000 no one wants to invest or no one has the money or guts to invest at that time.Logically if you are putting-in money at 12000 Index then you should be willing to put at a 9000 Index level, when fundamentally nothing has gone wrong in the economy or companies, when the economic condition of the country is same and there is no problem. This behaviour does not make sense. When the Index again ramped-up at 11500, people again started buying-in and investing.
Shruti: So do you think that because of the pressure from investors to outperform the market or follow what is ‘hot’ in the market, the IIs and FMs are not able to perform well.
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Vishal: Yes, there definitely is pressure and there is also peer pressure and all FMs are aware of that, and of them are quick to react to that pressure. That is why most of the active managers are also investing in Index. Most of the portfolios replicate the Index.
Shruti: If the manager or analyst stays disciplined, uses his judgement and does not act out of pressure and has the guts to go against everyone, do you think he will be able to outperform the market?
Vishal: Yes I think so, he should. But see it is like the ‘chicken and the egg problem’. I mean even if he has guts to sit in the market and also sit with his portfolio even when he is underperforming and still believe in his philosophy but people should also have faith in his philosophy. But it does not happen. Even his fund is underperforming his clients will shift to other fund managers and then he will not have the money to manage. For people to have faith in him and his philosophy it would require exceptional skills and a lot of experience, because such faith comes with a lot of years of experience like it took Warren Buffett forty years to build his reputation. At the end of the day, it is business. I might have a philosophy but I got to survive in the market.
Shruti: Do you think as economy will grow, we will start reaching efficiency any passive strategy would be made popular and start working.
Vishal: Definitely it will be and also there would be great regulatory push down from the regulators, In India we don’t have huge domestic corporations barring VTI or a LIC or a General Insurance company whereas in US there is a huge pension fund market. In India there is a huge pension fund market but they are not allowed to invest in equity.Government is now talking a regulation called the OASIS report, they have this committee where they have mentioned that when the pension funds would be allowed to invest in equity it will only be through index funds. So that will be a big regulatory push towards Indexing like in USA. Once this happens, there would be a lot of institutions coming into index funds and getting into it. And once these guys come into indexing there would be a herd mentality again. You’ll then find a lot of retail institutions getting in and a lot of talk happening about Index Funds and then a lot of MF’s getting into it. This would result in lot of advertisements and marketing happening for indexing a lot of awareness coming into people and a lot of information flowing. So it will gain momentum as the time goes by. That’s what we believe in, we are the only Fund House into passive funds And we believe in the coming time the market is huge for Passive Funds.
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Shruti: What kind of stocks do you think institutional investors concentrate on? Is there a bias?
Vishal: There obviously is a bias towards large cap stocks. But at the end of the day the MF and money managing companies in India and across the world has to survive and keep coming up with new ideas. So they have to have diversification in their funds. So what is the new idea I have come up with or the new story I have come up with? Say now I have come up with mid-cap funds and then I sell the mid-cap story. That’s why you nowadays find in India a lot of new mid-cap funds coming in. I have to keep generating the ideas and selling those ideas to people. So I come up with mid-cap stocks and generate the mid-cap story but then suddenly the mid-cap stocks are over-valued. The large-cap stocks are overvalued. So now what’s next? Then I might shift to small-caps. Its a business and at the end of the day I have to survive in the market. I have to get the money, pay salaries & bonuses. So it’s like flavor of the month that’s why today the whole flurry of investors are into mid-caps stocks & funds.There is a herding. At the end of the day I have to make money. I will have to generate a story and sell that to people. People will buy that story. So you have to first make that story, I have to make a fund and then I have to go & sell that fund otherwise I won’t survive. If other FMs are selling a new idea I also will have to get into it.
Shruti: Can you provide some examples of irrationalities on part of II’s because of which they are not able to perform well despite all the efforts they put in research & analysis?
Vishal: Herd mentality not only from II’s but also from retail investors. Why is a MF also selling in the market? Because it is getting redemptions from retail investors, from its own customers. So that mentality goes across the board right from retail investors to MF’s customers & FM’s to institutions and all other players in the market. And that is very irrational. But I don’t blame them. Because what happens is everybody panics, everyone craves. There is so much of information today and everyone starts creating a panic scenario like markets are going to plummet, the India story is over, you are going to loose, so that is irrational.In Indian market selling is very distributor led. MF companies are paying the distributors more and earning less. It’s like a chicken and egg problem. If I don’t pay them I will not get money. I think it’s a bone in the whole system, it’s the investors who are losing. Asset Management Company is earning irrespective of whether the investor is losing or earning. The FM is earning, the distributor is earning. Custodian, registrar, the accountant are earning their commissions or salaries but at the investors expense.The investor is being taken for granted.
Shruti: Does passive strategy allow you to do that, i.e. make subjective decision?
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Vishal: Passive strategy is a vehicle to use your judgment and take a call on. Passive FM never comes and asks you to make a call on the market. It is on the customer to do that. If the investors think market is going to do well he comes & invests through the passive funds because he does not believe in active fund manager & therefore he uses his own judgment.Shruti: What is your view on behavioral finance?
Vishal: I think people have run out of ideas to beat the market and that’s why all these things are coming up. Fuzzy logic.
We have exhausted all active fund management ways, we have done all the kind of valuation models, different types of research and the passive investment also, so what’s next? So therefore the behavioral finance has come up.
Shruti: Do you think that if people’s behavior causes inefficiency & they actirrational, so we can learn from their mistakes and outperform? Nobody has been doing consistently well.
VISHAL: each strategy is bound to bomb at some point of time.I might invest according to behavioral patterns and some day it might bomb on my face. I don’t know to what extent it would work, it is stable, does it work in different scenario. Every strategy bombs at some point of time. Some day this might go wrong & you don’t know why has it gone wrong.Even if you try to understand people all the time you are not you will always be able to outperform, & outsmart them. And you won’t know what else has gone wrong. For e.g.- if everyone investing in the market and buying in and the markets are going up, you might think that I will do the opposite because the people are stupid and you might shot. And the market might just keep going up, what you are going do then? Your judgment might go wrong. You might think that everyone is stupid and I am smart. And I am studying others behavior and I know what not to do. But that might also bomb on your face.“Fundamental guys say technical is bullshit & technicalists say fundamental is crap”But each thing has its own value. Fundamental also works at the end of the day you have to look at numbers. Similarly in order to time the market you also might need technical analysis. You might even need behavioral finance. So you need inputs from everything, and use those and the make your decisions. I don’t think one thing works all the time. Don’t base your decisions on just one thing. Base your judgment on all the inputs.All these things might work or might not work. So you got to take inputs from everything, inputs from fundamental analysis, technical analysis, behavioral finance and your own judgment.
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Shruti: Can you outline some of the irrational behavior of investors?
Vishal: In India there is tip behavior. Without using their judgment & research people listen to the tips from the market and act on it.First time they go right, second they again go right. First time they put Rs100, second time they put Rs200 on that tip. They are happy & decide that this guy is always right & next time they put Rs1000 & then the market completely bombs on him.So basically they follow tips, it goes right once, it goes right twice it just bombs on you.Everyone out there is to make quick money, they don’t look at it as investment.People in market are driven by greed.Need a disciplined approach, a proper asset allocation and a proper strategy to do well in the market.