331 Suspected Shell Companies to Stop Trading... Will This Spook the Market Rally?

Apurva Sheth

The market regulator on Monday directed stock exchanges to initiate action against 331 suspected shell companies.

A shell company is an entity without any active business operation or significant assets. They are often created to avoid taxes.

As per the notice, these companies will be put under Stage VI of the Graded Surveillance Measure (GSM) with immediate effect. This means that trading in these companies will be allowed only once in a month (first Monday of the month).

Stock exchanges have been asked to verify the credentials of these companies. If they find any misappropriation, the company will be delisted.

Meanwhile, the last traded price will act as an upper limit for the stock. Buyers will also have to give an additional surveillance deposit of 200% of the trade value, which will be retained by the exchanges for five months.

Some of these companies are not listed and some are thinly traded. Only a few are popularly known and have good trading volumes. The inclusion of certain companies on the list shocked their investors. A couple of the companies have categorically denied any wrongdoing.

Now I don't want to get into the details of misappropriations, if any, at these companies. That is for the regulator and exchanges to decide.

I want to talk about a fundamental aspect of the way retail traders invest and why they normally end up losers.

Warren Buffett famously advised investors to be greedy when everyone else is fearful and fearful when everyone else is greedy. But that's hardly the way retail participants invest.

They prefer to go with the herd. After all, there's comfort in numbers. If you are wrong, your excuse is that everyone else was wrong. And if you are right, you can brag about it to your family and friends.

Retail participants tend to join the herd when the trend is already in motion. They're usually the last ones to join the party. They start investing only when market sentiment is extremely bullish.

Now here is an example of extreme bullishness in sentiment. This is a group of stocks I created a month ago. I call them the 'Roll the Dice Group'.

The criteria for selecting these stocks were simple. First, they needed to be down 90% or more from their 2007-08 highs. Second, their current market price had to be below Rs 20.

Retail traders normally like low-priced, beaten-down stocks simply because they can buy more shares. Price movement in these stocks can act as a good proxy of sentiments in the market.

Roll the Dice Group
Name of Company Last Closing Price (Rs) Two Month Change One Day Change
JAIPRAKASH ASSO. 26.2 134.41% -9.50%
GVK POWER & INFRA 12.7 120.49% -5.58%
JAYPEE INFRATECH 20.8 91.67% -4.81%
JAIPRAKASH POWER 6.85 80.72% -8.67%
UNITECH 8.05 69.23% -8.52%
IIVRCL LTD. 5.85 38.46% -7.14%
GAMMON INFRA 5 20.73% 1.01%
JYOTI STRUCTURE 9.75 20.59% -4.88%
GMR INFRA 17.7 9.12% -4.58%
PUNJ LLOYD 20.5 5.67% -4.43%
BAJAJ HIND. SUGAR 15.3 3.22% -4.67%
BARTRONICS INDIA 14.8 2.73% -1.66%
OPTO CIRCUITS 8.35 2.26% -7.73%
UNITY AGRO. 6.95 0.00% -6.08%
GAMMON INDIA 9.45 0.00% 1.07%
PRATIBHA INDS 9.2 -0.49% -10.24%
PVP VENTURES 5.1 -2.88% 0.99%
SUBEX LTD 8.6 -9.14% -3.91%
SUZLON FIBRE 16.65 -9.90% -3.76%
Source: Spider Software

Many of these stocks saw huge gains over the last two months, which indicates retail sentiment is on a high. Trading volumes in many of these stocks have also risen sharply along with price, which suggests increasing participation.

None of the above companies were named in the regulator's notice. But most of them still closed with deep cuts yesterday. What does that tell us?

The market regulator's order has come as an eye-opener for many retail traders who tend to ignore risk while chasing returns in shady stocks. Most of the companies listed above have huge debt on their books, and they are finding it difficult to service that debt. Chances are some of these companies won't be around in a couple of years. But they rallied like crazy over the past two months.

This indicates that retail sentiment was at an extreme high and regulator's order has forced them to consider the risks while chasing returns. But whether market participants will actually learn anything from this remains to be seen.

However, the regulator's decision has taken some air out of the markets. Yesterday, the Nifty closed below the 10,000 level for first time in ten trading sessions. It also closed below the rising channel and thirteen-day exponential moving average for the first time in months. Bulls could lose their grip if the index sustains below 10,000. Let's wait and watch.

Nifty Closes Below 10,000

Nifty Closes Below 10,000

The markets have been on a tireless bull run this year. But are they set for a correction? In recent notes, Ankit Shah has been explaining the macro picture (that a flood of liquidity into the markets has been driving the bull rally). And one stock that makes the cut both technically and fundamentally has come under his radar. Now, as you know, at Insider, Ankit has access to the Equitymaster research vault. So today, make sure you sign up to get his recommendations.

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Market Notes

A Simple Valuation Ratio Says It Is Time to be Cautious...

For the past few months, Indian stock markets have been hitting new highs on positive sentiments and high liquidity. The Nifty 50 Index has rallied 42% from its February 2016 low and 300% from its March 2009 low.

This is prompting the talking heads to ask if Indian stock markets are in a bubble.

Maybe...

Maybe not...

'Bubble' may not be the right word for this bull market. It would be more accurate to say markets are currently in the euphoria stage. But one thing we can definitely say is that the stocks are expensive and perhaps due for a correction.

A simple valuation metric tells us that the stock markets are extremely overheated and now is the time for caution.

The price-to-earnings (PE) ratio is a simple yet powerful metric. It's easy to compute and readily available; indeed, it's the most common valuation metric among investors.

We calculate the PE ratio by dividing a stock's market price by its earnings per share (EPS). We, in turn, calculate EPS by dividing the company's net profit by the number of shares outstanding.

Though a number of factors go into determining the 'right' PE multiple, a stock's historical PE ratio can provide a lot of perspective. And going by the history of the Nifty PE ratio, we might not yet be in bubble territory, but investors do need to be cautious.

Nifty PE Ratio Since 1999

At the peak of dot.com bubble in 2000, the PE ratio was 28.47. The ratio was 28.29 at the peak of the global financial crisis. And the current PE ratio is 25.50, just 12% below the dot-com bubble peak and 11% below the housing bubble peak.

The PE ratio isn't telling us stocks are cheap. And it may not quite be flashing bubble warnings either. But stocks are getting more expensive by the day. The PE ratio is currently near the November 2010 and above March 2015 highs that preceded 25%+ corrections to the Nifty Index. So caution is certainly sensible here.

But we cannot rely only on one single measure. Yes, valuations are important, but as Lord JM Keynes put it: 'Markets can remain irrational longer than we can remain solvent.' The PE ratio can still run higher from here, even past the 2000 and 2008 levels.

Although it might appear we are in a bubble situation, we can certainly go higher from here.

But given the current PE ratio, should you be aggressively bullish at this stage? We have done some data crunching on the performance of the broader indices at different PE ratios. The data tells us what we should be doing at this particular stage of the bull market.

We will share this with you next time.

Until then, stay cautious...

From the Market Wizards...

'Many traders ride an emotional roller coaster and miss the essential element of winning: the management of their emotions.' - Alexander Elder

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