No excess can ever be permanent

A successful self trader – Rule # 25

In the last 20 years we all have learnt one basic lesson. No excess is ever sustained, either on the upside or on the downside. This applies to stocks, sectors as well as to overall markets. Be it technology quoting at 100 times earnings in 1999 or real estate stocks being valued on land-banks in 2007, it is one and the same! A real profitable trade starts when you can identify this excess, and time it right!

EVERY EXCESS RESULTS IN AN EXCESS IN THE OPPOSITE DIRECTION…

 There is a popular piece of market wisdom that “Markets top out when the last pessimist is liquidated and markets bottom out when the last optimist surrenders”. Big money has always been and always will be about trading excesses. Look back at the greatest trades of the last 20 years. Each of them identified the excess, timed it right and above all had the guts to hold on.

When Paul Tudor Jones started shorting the Dow just before the great crash of 1987, it was an excess of derivative positions. When David Tepper bought US banks in 2009 at penny valuations, it was plain excess pessimism. John Paulson is one of the best examples of a hedge fund manager who bet against sub-prime in 2005 and had the gall to hold on and book out in 2007!

Statistically called the mean reversion, the moral of the story is that no excess ever stays forever in the markets. It is these turning points that offer once-in-a-lifetime opportunity to get into a big trade. There are 3 criteria and 6 steps to identifying and profiting from an excess in the markets. We all know that excesses are not forever. It is just the “When” that is hard to decipher.

3 CRITERIA TO IDENTIFY A MARKET EXCESS

 DIVERGENCE OF VALUATIONS FROM GROWTH AND EARNINGS

 There are just two factors that determine valuations i.e. growth and margins. Great companies command valuations due to one of these. The day valuations outrun growth and margins, it is an indicator of excess!

 WHEN NOBODY WANTS TO BUY CHEAP OR SELL EXPENSIVE

 This is probably the most important determinant of a market excess. Psychologically it defines the frontiers of a human financial mindset where there are no buyers at the bottom and no sellers at the top!

 WHEN HUMBLE PROFITS ARE GETTING FANCY VALUATIONS

 We have seen this in internet, e-commerce, biotech and Indian cement companies. Indian companies like Flipkart and Snapdeal get billions of dollars at fancy valuations without a revenue model. Surely a case of excess!

In investing it is possible to be eventually right but temporarily quite wrong” – Jim Chanos

6 STEPS TO IDENTIFYING AND PROFITING FROM AN EXCESS

  1.  Let regulatory filings be your starting point. There is a lot of hidden stories in SEBI filings, MCA filings, tax filings, advance tax payments, balance sheets etc. When Arvind Mills was a star in 1995, its excess current ratio was a giveaway. These documents contain more information and wisdom than you think. Grab it!
  2. Talk to the forward and backward linkages of that particular company to best get an understanding of the robustness of the business. The ancillary companies give you the best picture of auto demand. The dealers give you the best indication of the consumer choice. These lead indicators are quite valuable.
  3. History is a bad judge but always a good guide. Human mentality has not changed in the last 100 years hence it is unlikely that the way they react to situations will change quickly. Generally peak pessimism and bottom P/Es tend to approximately coincide. Make the best of these benchmarks.
  4. Ratify that the business model is not disruptive and you are not missing out on a new trend. Look at global benchmarks, talk to industry associations and competition. Remember, technology, biotech, and alternative energy were all disruptive technologies where traditions models have not worked. Check it out.
  5. Decide on the methodology to play this excess. If you suspect a bottom, you can buy stocks, buy futures or buy long calls. If you suspect a top, you can sell out your holdings, short futures or buy puts. You have to best decide on the risk-return trade-off that you want to undertake. Above all, ensure that you participate.
  6. Finally execute to perfection. You have to decide if you want to play against the excess in bulk or phase out your trades. Normally phasing out is a better option. Determine the loss you are willing to take. Lastly, your guts will give you profits so, hold your horses and don’t let panic overtake you.

INDIAN CASE STUDIES ON EXCESS

 Back in 1991, cement companies attracted fancy valuations on replacement cost theory. By 1992, it was clear that it was free money and nothing else. In 1999, technology stocks were driven up by the new paradigm hopes. By early 2000 it was obvious that dubious shell companies with dubious credentials were the paradigm. In March 2009, everybody had given up on Indian markets. They bottomed out on the back of relentless liquidity. Each of these excess gave away at a certain tipping point. These tipping points are extremely critical in deciding your trade!

These macro level excesses are few and far in between. The real game is played in between. How did a Titan appreciate 40 times between 2005 and 2010? How did Eicher and TTK Prestige end up as multi-baggers in the worst years? And finally, how did blue chip capital goods and banks lose 70% of their value between 2010 and 2013. All examples of excess!

TAKEAWAYS FROM THE “MARKET EXCESS” DEBATE…

 There are some excesses you catch and some you mess up. But the key lies in making up. In 1998, David Tepper lost a whopping $80 million in Russian debt. But that was made up in 1999 by buying out Russian debt after the crisis at almost a throwaway price of 5 cents to a dollar. Missing one market excess is ok; but missing two is atrocious. You have to bounce back.

In the words of Jim Chanos, catchy phrases like “Too big to fail” or “This time it is different” are pure shibboleths which detract from your ability to identify and profit from market excess. At the end of the day, nothing is too big to fail and history always repeats itself. You have to combine guts and incisiveness to identify market excess. Of course, you can also pray for some divine intervention.

Get online stock market news and updates at Religare Online to identify and profit from market excess.

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