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Sunday, Jan 30, 2011
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Markets - Insight
Columns - Young Investor
The three laws of motion can help investors understand market movements too.
Isaac Newton's contributions to physics and mathematics proved revolutionary. He didn't, however, prove to be as astute an investor, as evidenced by his losses during the South Sea bubble. The company ultimately imploded as it had over-promised on potential and under-performed in terms of actual showing. Newton traded frequently in the stock, making a small fortune which he proceeded to lose with a series of ill-timed trades. Traumatised by the event, he famously commented, “I can predict the movement of stars, but not the madness of men.” His more famous three laws of motion can, however, prepare us better for the madness of markets.
The First Law
Newton's first law states that every object that is moving or at rest has a tendency to remain in that state unless an external force is applied to it. The basic idea this law conveys is that of inertia or the state where things show a great resistance to change unless some news or event of truly notable magnitude compels change. Have you ever picked a stock held up as the next hot company or a screaming value buy only to watch the stock move sideways? This law serves to drive home how perceptions of value, in cases ranging from an individual stock to a macroeconomic bet on a country, can turn out to be a double-edged sword. Investors pay a heavy price for holding to businesses whose ‘intrinsic' value goes unacknowledged by markets for longer than certain investors can bear. As Keynes put it, “The markets can stay irrational longer than you can stay solvent”.
Regardless of how splendid a business may perform, even the most exemplary management or business economics can do little to save a business that is saddled with a chequered past. This could be due to heavy competition, heavy-handed regulation or naughty promoters toying with their share prices. Such scenarios could result in the business trading at a perpetual discount relative to quality businesses of similar size and growth potential. Certain companies in the textile space, small-scale steel or commodity producers are a few whose alluring P/Es or P/Bs turns out to be too good to be true, considering the oft-dismal economics of the segments. Inertia in a stock can be an expensive lesson for an investor.
The Second Law
This law states that the greater the mass of an object, the more force you need to apply to move it at the same speed as a lighter object. Think of what kind of news it would take for a Reliance Industries to move up by over 10 per cent. It would have to be something as drastic as probably the company's retail arm becoming 10 times larger and more profitable than expected or crude oil and petrochemical prices spiking to $150! Basically it would take big news of the almost impossible-to-foresee variety to move a large entity.
But imagine this. Suppose an FII decides to mop up shares in a Rs 250-crore obscure tile maker from Gujarat or, say, there's a strong buzz pointing to an imminent share buyback plan by the company. The ensuing frenzy, in both the cases, is capable of sending stocks soaring (depending on individual circuits). The point to take home from the second law — always put in perspective the impact of potential news such as re-ratings from mergers or IPOs in the same segment, a significant strategic investor entering the fray and other such events. While it may not always be possible to ascribe a precise number to such events, taking stock helps put an investment in perspective. The law also highlights the importance of the magnitude of market consensus on a stock-specific event. Wipro is a recent example of a company whose price was battered by almost 10 per cent, reflecting lacklustre results and a management shake-up. However, fellow member of the IT pack, Infosys' share price has remained largely unchanged despite some healthy top and bottom line growth.
The Third Law
The third law states that for every action, there is an equal and opposite reaction. Equity markets behave like a rather complex living and breathing organism. They respond to a multitude of factors, ranging from interest rates, corporate results and self-appointed market gurus. To borrow Donald Rumsfeld's words, when dealing with uncertainty in equity markets there are the known unknowns and the unknown unknowns. The known unknowns can include expectations of poor upcoming quarterly results, upcoming legislation, which could hamper profitability or pricing power, structural changes in a sector such as increased capacity or competition or just anticipated inflation, which could result in higher interest rates. These can be vaguely foreseen but their quantification could be a fool's game with anywhere between a mild and severe market reaction based on how right or wrong the consensus opinion turns out be. But rest assured, a reaction does occur and is based on the magnitude of the news acting on the markets.
But the truly challenging market scenarios arise from the unknown-unknowns. The recent floods in Australia caused coal prices to spike by 30-40 per cent and disrupted global supplies, something that few market observers or even industry participants anticipated. The more infamous example is that of the market implosion during the sub-prime bust. Market history is littered with violent reaction, both good and bad, to news that few saw coming. The sheer vagueness of news that often shapes the lemming-like behaviour witnessed in equity markets serves to validate that every action, especially the unforeseen variety, often evokes a disproportionate reaction from the markets! The markets move in the opposite direction in cases including higher inflation levels and higher interest rates, among other scenarios.
Uncertainty has proved to be good hunting ground for the smart and prudent investors. However, they need to be forearmed, even if not with a precise explanation for uncertainty, at least with a vague framework to better deal with it. Dipping into Newton's laws provides a certain rationale when unexpected things happen.
Renowned investor Warren Buffett added another law of wisdom to Newton's three laws, a fourth which he believes Newton could have benefited from, “For investors as a whole, returns decrease as motion increases.” Maybe doing nothing too could be an option sometimes!
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