Vijay Kumar Gaba

The financial market regulators (RBI and SEBI) have repeatedly cautioned investors and intermediaries in the past few months. However, regulators’ cautions mostly went unheeded as both intermediaries and investors continued to ignore fundamentals, moved with the momentum, and exceeded their limits – regulatory and financial. Consequently, the regulators have begun affirmative action. Following some preventive and corrective actions the regulators took, there is palpable panic amongst the market participants.

There are a lot of queries, especially from small investors, who are usually gullible and easily get misled by the manipulative tactics used by the devious operators and end up buying junk stocks at high prices. The queries usually include – “should I buy more to average my cost?”; “it’s already down 40% from high, how much more could it fall?”; “The stock is falling daily, should I sell it now and buy lower?”

I do not have any specific answers to these queries. However, from my experience of over three decades, and having seen multiple instances of such manipulative euphoria and subsequent meltdown, I would say as follows:

Cost Averaging

Cost averaging in an individual stock is not a prudent idea, especially for small investors with limited resources. Investors need to aim to earn a return on their total investment. To maximize their return, they need to decide at the time of investing, which investment has the best return potential. If it is one of the stocks they are already holding, they should add to that holding. If it is some other investment option, they should invest in such a better option. Buying more of an underperforming stock if there are better options available would be a bad strategy. It might result in the dissipation of scarce resources (money), compounding of losses, and missing good opportunities.

Catching a falling knife

Not long ago, Future Retail Limited (FRL) was a famous company. The promoter of the company was considered a genius. He pioneered the organized retail business in India. Learning from global retail majors like Walmart (USA) and Asda (UK), he built a strong business in India. However, failure to manage growth and excessive debt created problems for FRL and several other group companies, eventually leading to insolvency. The problems for the group had started after the global financial crisis, but it survived for a few years through selling of assets and business restructuring. Covid-19 hit the company hard and it could never recover from that shock.

Post restructuring of the group in 2016, FRL hit a high of ~Rs634 in November 2017 and has been on a steady decline since then. At the time of Covid-19 breakout (February 2020) the stock of FRL was trading close to Rs350.

Tracking the stock movement from the high of 2017, we get this.

·         The Stock price fell 22% (635-493) in one year from November 2017 to November 2018.

·         If one got tempted to buy it in November 2018, it was down another 33% in the next year (November 2018-November 2019) from 493 to 330.

·         If one averaged it in 2019, it was down another 79% in the next year, from Rs 330 to Rs68.

·         In November 2020, if you thought that the stock is down 90 from its 2017 highs, and how much more it could fall, it was down another 29% in the next year to Rs48.

·         If one believed that it is now available at a dirt-cheap price and bought it, he would have lost 92% of his investment in the next year as the stock touched Rs4 on November 22.

·         If in November 2022, you thought there is not much to lose in this, the investments made in November 2022 are down by 50% as the current stock price is ~Rs2.

·         The investment made at this “lottery” price can still potentially lose 50% to 100%.

FRL is only one example. There are hundreds of stocks that were very popular at one point in time, fell 90-99.9% from their euphoric highs, and never recovered.

Therefore, before cost averaging, investors must understand that a stock down 90% from its high, is a stock that has fallen 25% from its immediate previous price eight consecutive times (100-75-56-42-32-24-18-13-10). If at any point of this journey, you thought that it has already fallen so much, how much more this can fall – the answer is it can still fall another 90-100%.

Selling to buy lower

An investor needs to understand his/her limitations. Most investors do not possess the skills required to be a successful trader in the market. So, it is better to avoid trying these kinds of adventures. If you are comfortable with the fundamentals of the company, ignore day-to-day price movements and stay put. If you are not comfortable with the fundamentals of the company, ignore day to day price movements and exit at once.

The government is making an offer for sale (OFS) for 3.5% stake in the Life Insurance Corporation of India (LIC). At Rs 902, the lower point of the price band fixed for OFS, the LIC will be valued at Rs 5.7 trn. At this valuation it will be the fifth largest publicly listed Indian entity. The OFS will yield Rs199.7bn to the government, about 30.6% of the total disinvestment target of Rs650bn fixed for FY23. The government has apparently cut the offer size from 5% announced in February 2022 to 3.5%, considering the jittery market conditions. We shall therefore see multiple follow-on offers from the government in the coming years.

The principle and overriding function of the securities market regulator, The Securities and Exchange Board of India (SEBI) is to protect the interests of the investors in the securities market. The other functions, viz., orderly development and regulation of securities markets are secondary, in my view. However, there is overwhelming anecdotal evidence to indicate that the regulators have given precedence to market development and regulation over the principle objective of investor protection. There are many instances in past 3-4years alone to indicate this. In the episodes of IL&FS, Franklin Templeton, Yes Bank, Jet Airways, Karvy etc., the interests of the investors in these entities were compromised. Moreover, little efforts were made to ensure that prospective investors are given full disclosures about the risk and reward of investing in the securities of these entities.

Recently, we have seen repeat of this tendency. On Monday, the 7^th June 2021, evening, DHFL informed stock exchanges about the resolution plan approved by the Mumbai bench of NCLT. It was clear from the resolution plan that in the successful bid of Piramal Group “No value was attributable to the equity shares as per the liquidation value of the Company estimated by registered valuers”. Besides it was also made clear in the communication to the exchanges that equity shares of DHFL shall be delisted upon completion of the resolution.

Clearly, the resolution plan envisaged zero value for the shares of DHFL Limited. Despite this the stock was allowed to be traded on Tuesday, the 8^th June 2021. To make the matter worse, it was allowed to rise 10% (the maximum permitted as per the applicable price band). Over 14cr shares were traded on NSE alone and investors took delivery of over 9crore shares valued close to Rs200cr. All this money will be lost. No broker warned the investors on Tuesday. The exchanges did not advised the brokers to caution their clients. SEBI did not asked the exchanges to suspend the trading. To compound the mistake, the stocks continues to be traded on both the exchanges despite the company formally informing the exchanges that the worth of equity shares is Zero. About 5 million shares were traded on Wednesday also. To be fair, many brokers did advise their clients on Wednesday.

Many “knowledgeable” investors in DHFL have been allowed to unfairly transfer their risk to unsuspecting gullible investors in past two days.

In this context it is pertinent to note that the model bye laws prescribed for the exchanges require that—

“The Exchange shall provide adequate and effective surveillance and monitoring mechanism for the purpose of initiating timely and pro-active measures to facilitate checking and detecting suspected or alleged market manipulation, price rigging or insider trading to ensure the market integrity and fairness in trading. For this purpose, the Exchange may, from time to time, apply, adopt, determine and implement various measures, mechanisms and requirements, as may be provided in the relevant Regulations and as may be decided by the Relevant Authority from time to time.”

It is therefore also the duty of the exchanges to act proactively to ensure fairness in trading. In this case the exchanges could have easily anticipated that some people have advantage of knowing the details of the resolution plan. An analysis of trading data for Tuesday will clearly show that the trading in DHFL was not fair. Not suspending the trading this stock is even more unfair to “unaware” investors and traders.

In past couple of years the securities’ market regulator the Securities and Exchange Board of India (SEBI) has amended many rules and implemented some new ones to bring the functioning of Indian securities markets further closer to the international standards. Being a signatory of the International Organization of Securities Commissions (IOSCO), a global body of securities market regulators, SEBI is mandated to implement global standards of market regulations in India, especially in the area of investor protection, systemic safety, and prohibition of unethical and fraudulent market practices.

Some of the more discussed and criticized latest standards introduced by SEBI are –

(a)   Segregation of financial intermediation and advisory functions. In line with the best global practices, to avoid potential conflict of interest and bring objectivity in advice, Investment Advisors have been prohibited from offering financial intermediation (MF distribution, brokerage etc.)

(b)   Tightening of norms relating to margining of leveraged trades and financing of such trades. This has been apparently done to minimize the systemic risk of markets; improve financial stability and minimize the cases of risk taking beyond capacity by traders and brokers.

It is important to note that in past 25years, in times of crisis, Indian securities market functioning has been commendably stable.

To put this discussion in context, few readers have asked about my views on the recent listings of couple of financial intermediaries. While as usual I would refrain from commenting on individual stocks. However, I have some strong views on this sector, which I would like to share with my readers:

1.    The financial intermediation sector is set to transform in next five years. The changes that started a decade ago will accelerate at dramatic speed.

We shall see accelerated elimination of marginal and smaller players and consolidation of mid-sized and larger intermediaries, as Technology begins to overwhelm the manual execution and even advisory function.

2.    The experience of telecom sector will be replicated in securities’ market. The execution services will become “free”, just like voice calls, and come as part of bundle of services. The primary service will be “advisory” and “access” to global markets and products.

3.    Debt market will become bigger than equity market with most of the development and innovation happening in that segment.

So far the skills for debt trading are limited mostly to the primary dealers, their associated entities and a handful of intermediaries specializing in mobilization of corporate debt. The biggest opportunity for intermediaries perhaps lies in this segment.

4.    Financialization of agri produce trade would be another large opportunity that will unfold on next decade.

5.    Mutual Fund Industry shall be dominated by low cost passive investing (ETFs). Index making and management services will become prominent and dominant (ala MSCI).

“Generation gap” has perhaps been a subject of study, discussion and debate ever since beginning of civilization. The new generations have been adopting new ways and methods of living, and the older generations have been rejecting these ways and methods as degeneration. The human civilization has evolved, regardless of this persistent conflict between experience and experiment.

It could be matter of debate whether experience is good as a guide or driver. But in my view, there is no doubt that the innovation (experiment) of new ways and methods of living and doing things has been the primary driver of the human civilization so far.

With the advancement in science and technology, the life span of people has increased materially in post WWII era especially. This expansion in life span has material impact on the dimensions of “generation gap”. The gap which was historically visible mostly between grandfather and grandsons is now sometime visible even in siblings born 5-6yrs apart.

In Indian context, the people who grew up in the socialist ear of 1970s had a very different mindset from the Maruti generation of 1980s. The star war generation of satellite television era of 1990s abandoned the 80s mindset; was soon rejected as outdated by the Google generation of 2000s. The people growing up in post global financial crisis era skeptical about the idea of globalization and free markets, but are free from the constrained mindset of thinking in local terms. They are at ease with creating global corporations and thinking in terms of billion dollars. The generation that will grow up in post COVID-19 era, may have a very different outlook towards life and work.

In this context it is interesting to note the results recent study conducted by Bank of America (BofA) Securities’ Global Research. The key highlights of the study could be listed as follows:

·         The Zillennials or ‘Gen Z’ (as BofA refers to the current generation) have never known a life without Google, 40% prefer hanging out with friends virtually than in real life, they will spend six years of their life on social media and they won’t use credit cards. They’re the ‘clicktivists’: flourishing in a decade of social rights movements, with 4 in 10 in our proprietary BofA seeing themselves as ‘citizens of the world'. The Gen Z revolution is starting, as the first generation born into an online world is now entering the workforce and compelling other generations to adapt to them, not vice versa. Thus, about to become most disruptive to economies, markets and social systems.

·         Gen Z’s economic power is the fastest-growing across all cohorts. This generation’s income will increase c.5x by 2030 to $33tn as they enter the workplace today, reaching 27% of global income and surpassing Millennials the year after. The growing consumer power of Zillennials will be even more powerful taking into account the ‘Great Wealth Transfer’ down the generations. The Baby Boomer and Silent generation US households alone are sitting on $78tn of wealth today.

·         Gen Z could be EM’s secret weapon. APAC income already accounts for over a third of Gen Z’s income and will exceed North American and European combined income by 2035. ‘Peak youth’ milestones are being reached across the developed markets – Europe is the first continent to have more over-65s than under-15s, a club North America will join in 2022. In contrast, India stands out as the Gen Z country, accounting for 20% of the global generation, with improved youth literacy rates, urbanisation, and rapid expansion of technological infrastructure. Mexico, the Philippines and Thailand are just a few of the EM countries that we think have what it takes to capitalize on the Gen Z revolution.

·         Gen Z is the online generation: nearly half are online ‘almost constantly’ and a quarter of them will spend 10+ hours a day on their phone. In our survey, over a quarter of Gen Z’s top payment choice was the phone, while credit cards weren’t even in their top 3. This generation is the least likely to pick experiences over goods, and values sustainable luxury – choosing quality over price as their top purchase factor.

·         Only half of US teens can drive, while our survey finds that less than half of Gen Z drink alcohol, and more than half have some kind of meat restriction. A third of them would trust a robot to make their financial decisions. Gen Z’s activist focus filters into their interactions with business, too – 80% factor ESG investing into their financial decisions, and they have also driven consumer-facing sustainability campaigns, such as single-use plastics. Harmful consumer sectors, such as fast fashion, may be the next focus.

SEBI relaxes cash segment margin norms for non F&O stocks

SEBI has increased the margining requirement for the non F&O stocks traded in cash segment, vide circular dated 20 March 2020. SEBI had also tightened the rule regarding market wide limits for individual stocks available for trading in F&O segment. The objective of increasing the margin requirements and tightening the exposure limits was to control the volatility, ensure market stability and orderly conduct of the market in view of the COVID-19 related concerns.

With effect from today, the enhanced margining norms for non F&O stocks traded in cash segment stands withdrawn. The restrictions on exposure to F&O stocks have also been relaxed. This implies that the market regulator now see lesser risk of market disruption due to COVID-19 related events and news.

The move has generally been received as positive for a rally in mid and small cap stocks. In past couple of weeks, many brokerages have published report favoring investment in mid and small cap stocks. For example, Edelweiss recently revised its outlook for small and mid cap stocks. A note from brokerage stated:

“The Q2FY21 earnings as well as the outlook beat expectations for most Small- & Mid-caps (SMIDs). Importantly, this led to 5–20% earnings upgrades for FY22 for nearly 63% of our coverage SMIDs; another 10% of SMIDs wallowed in 20%+ earnings upgrades. We like category leaders and—so far—this has helped our model portfolio outperform SMID indices by ~4% (over the past 12–15 months). We now include more recovery plays as sequential improvement plays through, having a bearing on stock performance.”

 A few month ago, the banking and monetary regulator in India, the reserve Bank of India (RBI), assumed the responsibility of stimulating the economic growth, in addition to its primary responsibility of regulating & supervising the banking & money market institutions, formulating & implementing monetary policy to achieve the objectives of financial stability and price stability. Given the state of economy, no one could find any fault with the RBI assuming this additional responsibility. In fact the RBI was commended for taking this extra load.

It is very well accepted that a well-functioning, deep and robust financial market is a must for economic development. On Wednesday, the financial market regulator, the Securities and Exchange Board of India (SEBI) assumed the additional responsibility for reviving the sagging Indian economy. SEBI’s chairman reportedly said “SEBI is considering multiple steps to reboot the economy through financial market reforms”. He said, “It will be challenging to achieve the government’s ₹100 trillion investment target for infrastructure by 2024-25 unless the bond market is adequately developed.”

Market regulator recognizing their role in the overall economic growth and development of the country is a very comforting. They committing to efforts for promoting economic growth and development is also welcome. However, the regulators actively assuming responsibility for growth may not be appropriate after all. All institutions and all citizens have a defined role in the functioning of the economy. If all perform their assigned roles as per their best abilities, the growth will happen automatically. The growth is hampered when the one or more segments of the economy fail in the performance of their assigned roles.

It is widely recognized that crisis in financial sector is materially responsible for economic slowdown in India. Obviously, it reflects poorly on the RBI’s ability to regulate and supervise the financial institutions and delivery of credit.

In this context, it is pertinent to note the conclusions made in a recent Working Paper of RBI, titled “Bank Capital and Monetary Policy Transmission in India”. The “paper examines the role of bank capital in monetary policy transmission in India during the post-global financial crisis period. Empirical results show that banks with higher capital to risk-weighted assets ratio (CRAR) raise funds at a lower cost. Additionally, banks with higher CRAR transmit monetary policy impulses smoothly, while stressed assets in the banking sector hinder transmission. Recapitalization to raise CRAR can improve transmission; however, CRAR above a certain threshold level may not help as the sensitivity of loan growth to monetary policy rate reduces for banks with CRAR above the threshold. Therefore, it can be concluded that monetary policy can influence credit supply of banks depending on their capital position. (emphasis supplied)”

The paper also concludes that “Presence of non-performing assets in a bank also weakens monetary policy transmission and lowers the loan growth rate. These results support the need for bank capital regulation in India.”

Similarly, multiple scams and malfunctioning of securities’ market institutions like Mutual Funds and Stock Exchanges have negatively impacted the investors’ sentiments. SEBI must share some responsibility for this also, and focus more on “Regulation” rather than “Reforms”. For, “Reforms” is a function of policy making and not of regulation.

A large section of the market participants and investors believes that “over regulation” and “misdirected regulation” by SEBI in past few years may have caused more than damage to the capital markets and therefore economy than SEBI’s reform measures would have helped anyone.

In my view, building a vibrant retail debt market is imperative for the sustainable economic growth of the country. But this is a function of the government. SEBI’s role should be limited to efficiently regulating the market.

A web series on the infamous Harshad Mehta scam of early 1990s seems to have triggered a debate on the present state of the financial regulation and risk management practices in India. The key point of interest is whether a scam similar to Harshad Mehta scam could recur!

During late 1989-1992, a Mumbai (then Bombay) based stock broker Harshad Mehta used the inefficiency and lacunae in the banking and stock market systems to create massive pseudo credit. The credit so created was used to manipulate stocks prices, causing the first major bubble in Indian stock markets. This was the time when Indian economy was struggling with unprecedented balance of payment crisis, political uncertainty and higher energy prices due to war between Iraq and US (an ally of Kuwait) in the Persian gulf. Given the despondent economic situation huge short positions were built by traders in Indian equities. In the summer of 1991 the Congress government led by P. V. Narsimha Rao assumed office and unleashed a slew of radical reforms. Using this pretext, Harshad Mehta squeezed the short sellers by using the pseudo credit he could manage by defrauding the nationalized banks. The bubble finally burst in April 1992 when the modus operandi of Harshad Mehta was exposed.

The immediate fall out the bubble burst were (i) promulgation of the Securities and Exchange Board of India (SEBI) Ordinance 1992 to establish an autonomous regulator for regulation of securities market in India; and (ii) up-gradation and modernization of interbank settlement system of government securities. SEBI immediately issued a slew of rules and regulation to regulate the operations of stocks exchanges and market intermediaries. The first fully electronic stock exchange (OTC Exchange of India) modelled on NASDAQ of US was established in 1992. A National Stock Exchange (NSE) was established in 1994, as a nationwide fully electronic trading platform. Establishment of NSE eventually led to elimination of floor based trading and closure of 27 of the 28 regional stocks exchanges. India thus became the first country in the world to have 100% electronic trading in equities. Later Depositories Act was passed to enable establishment of depositories, dematerialization of securities and settlement of trades in electronic form.

The improvement in trading and settlement systems; tightening of margining norms; tightening of compliance procedures to protect the interests of investors etc. have been a continuous process since then. Each instance of fraud & manipulation, accident, unethical behavior has resulted in some improvement in the regulatory process in past 28 years.

However, the continuous strengthening and tightening of regulatory has not deterred the manipulators, fraudsters, and unethical promoters & intermediaries from indulging in fraud and malpractices. The IPO and plantation companies frauds of 1994-1996, dotcom fraud (Ketan Parekh) of 1999-2001, Sahara public Deposit scam, PACL Chit Fund Scam, LTCG Scam, numerous cases of insider trading and front running by mutual funds and corporate officials, act of impropriety by mutual funds (e.g., Franklin Templeton, Kotak MF, Birla MF) etc kept rocking the market intermittently. In fact it has been a 28yrs long episode of Tom (SEBI) and Jerry (Manipulators) where both are consistently trying to dodge each other. Hence, there is no assurance that a Harshad Mehta like scam will not recur in Indian markets.

The best thing however is that Indian markets have remained amongst the safest in world in past two decades. We were perhaps the only market in India that did not impose any trading restrictions during global financial crisis.

The recent measures taken by SEBI and Stock Exchanges to tighten the margining norms to dissuade excessive speculation have been severely criticized by market participants. However, in my view, COVID-19 has warranted SEBI to consider Negative Commodity price and Act of Gods as White Swans for risk management system for securities market. I therefore expect even further tightening of margining and compliance norms.

The last weekend was unusually hectic for most participants. Friday evening, the market regulator issued fresh guidelines for asset allocation by the mutual fund schemes operational under the "multicap fund" category. The guidelines specify that these mutual fund schemes must allocate at least 25% of assets under management to each of large cap, mid cap and small cap category of stocks. SEBI also directed that the minimum equity allocation of these funds shall be 75% (presently 65%) at any given point in time. The mutual funds are required to comply by these directions in six months, i.e., by February 2021. SEBI further clarified that these guidelines have been issued further to the guidelines regarding categorization and rationalization of Mutual Fund Schemes issued in October 2017.

It is pertinent to note that as per SEBI directions, top 100 listed companies in terms of market capitalization are categorized as Large Cap. Companies ranked 101 to 250 are categorized as Mid Cap and the others come under small cap category. As such, NMDC is 100trh ranked stocks with Market of Rs27500cr; P&G is 250th ranked stocks with Rs8100cr market cap. So stocks below Rs8100cr market cap are small cap stocks.

Over weekend most of the brokerages and AMCs came out with their views on the proposed changes. The brokerages' reports were mostly focused on two aspects" (i) how much money will have to be reallocated from large cap to mid and small cap stocks to comply with these guidelines; and (ii) which are the stocks that could see higher demand due to this reallocation exercise and what is the trade opportunity in this. The AMCs mostly focused on highlighting the challenges in compliance.

I am sure that any guideline followed or not followed by mutual funds has any bearing on my investment process or investment strategy. Given the past track record of a large majority of Indian mutual funds, I do not draw any comfort from the due diligence done by mutual funds as to the quality of any business or credibility of any company (and management).

I do not find any substance in the argument of higher demand from mutual funds leading to sustainable re-rating of a stock. We all have seen in recent past, the high MFs holding into a small cap stock is a two edged sword. In the good times, the stocks run up sharply; and when the tide recedes the losses are also overwhelming (remember 8K Miles, HEG, Graphite, Eveready etc.) Even the best of the fund managers have lost huge money in stocks like JP Associates, HCC, NCC, Jet Airways etc. In the present times also I find many mutual fund schemes holding commodity (including chemicals) stocks where the companies have seen sharp rise in earnings due to temporary commodity price cycle. We shall see a repeat of HEG & Graphite in these stocks in 2021 for sure.

Another thing I am missing is that no one has dared question the validity of the rationale and authority behind the October 2017 and the current circular of SEBI. In my view, the following questions need to be asked to SEBI:

1.    Why AMFI does not have an SRO status? As a signatory to IOSCO charter, it is responsibility of SEBI to promote self regulation in securities market. It is 28years since private mutual funds were allowed in Indian markets. The industry has grown materially in past 10years. Why SEBI is not able to persuade AMFI to become an SRO?

2.    A mutual fund investment is a contract between an investor and AMC. The Key information Memorandum (KIM) is an essential part of this contract. SEBI forcing MFS o change KIM for the investments already made may not be good as per the law of contracts.

3.    Fund management is not one of the various businesses of SEBI. Why it is not left to AMCs? In case SEBI finds that AMCs are indulging in unfair practices or their conduct is prejudicial to the interest of investors or securities' market, it has enough powers to reprimand and punish the respective AMC, including cancellation of its registration.