Forbes India 15th Anniversary Special

Is the Stock Market Overreacting?

Stock market over-reaction to negative news can yield new opportunities

Published: Feb 2, 2011 06:20:41 AM IST
Updated: Feb 2, 2011 03:47:13 PM IST

Few things are as predictable as over-reaction in the stock markets. In February 2009, the smartest investors seemed like rabbits caught in front of the headlights just before one of the most stupendous market rallies in history. Most often, earnings “surprises” provide the spur for investor over-reaction. However, a number of other mundane occurrences can be just as helpful. Considering that the response to an earnings shortfall is swift and savage in the current market and becoming fairly routine, how does the smart investor profit from such opportunities?
Should one gather courage and jump in right away or wait till the dust clears? Clearly a tough choice with no obvious answers though my personal experience suggests sitting on the sidelines for a while. The initial negative shock is usually followed by a series of lesser tremors which continue to keep the stock price subdued. Even though analysts respond by slashing estimates for the next quarter, the changes to their forecast fail to account for the damage in subsequent periods. So, being patient not only allows you to respond most rationally, it also acts as an antidote to ‘cockroach-in-the-sink’ theory!

So how does over-reaction really work? The hypothesis is rooted in the idea that investors are predictably irrational: They consistently overvalue the prospects of ‘best’ (typically high PE, high P/B, secular growth) investments and undervalue those of the ‘worst’ (low earnings visibility, cyclical, low PE & P/B, dull slow growth companies). Given that all it takes is a ‘mouse’ to extrapolate well into the future, favoured stocks climb to an enviable premium while the dogs of Dalal Street are available at deep discounts. Post an unanticipated earnings announcement or business development, there is a marked tendency for the ‘best’ to under-perform while those considered to be ‘worst’ significantly out-perform in obeisance to the deity of mean regression. Two further corollaries have stood the test of time. First, a positive surprise benefits ‘worst’ stocks far more significantly than it does ‘best’ stocks. Second, negative surprises wreak far greater damage on the ‘best’ as compared to the ‘worst’.

The BSE Sensex is down more than 7 percent (January 21) in the first three weeks of 2011. Can one detect a trace of over-reaction here? Figuring out the right answer is a tough call keeping in mind the present valuation of the market. Yet the impact on individual industries of rising interest rates has been disproportionately severe considering the 8-percent growth consensus.

A couple of stocks that keep flashing on my radar screen are Sundram Fasteners (Rs. 55) and Union Bank of India (Rs. 327). Sundram is an undisputed leader, both in market share and cost advantage. There is complete unanimity on the stellar credentials of the senior management and its work ethic. While financial leverage is high (debt/equity of 1), the company has an impressive track record of generating cash flow from operation and trades at just over 9 times March 2011 earnings. Union Bank is arguably one of the best managed banks in the country – 10 year average ROE in excess of 23 percent, a steady improving trend in cost control and asset quality combined with stable operating margins. Yet, exaggerated fears about rising credit provisions, a reversal in credit growth and net interest margins have led to the bank trading at 1.2 times FY2012 book value and 8 times current year earnings. In such trying times, it is useful to remember the pithy wisdom of the Oracle of Omaha: “Risk does not reside in price changes, but in miscalculations of intrinsic value.”

Disclosure: This column is neither an offer to sell nor solicitation to buy any of the securities mentioned herein. The author, a partner at Fortuna Capital, frequently invests in the shares discussed by him.

(This story appears in the 11 February, 2011 issue of Forbes India. To visit our Archives, click here.)