Investing in small-and mid-caps with action can be a better trading strategy than putting money in IPOs
In the early 1970s, Warren Buffett offered to return investors’ money. He thought US stocks so over-priced that he couldn’t find reasonable investments. Buffett’s instincts were correct – the US market was entering a period of bearish range-trading that lasted till the early 1980s.
In every market, there are similar periods. However, few money-managers are capable of refusing money, much less offering to return it. In fact, most mutual funds depend on a pattern of greater inflows when the secondary market is up.
In September 2010, as the Nifty rose 11.5 per cent, total assets under management (AUM) of mutual fund schemes (including debt schemes) rose Rs 25, 721 crore, an increase of 3.7 per cent over August 2010 AUM. The total AUM inflow between Jan 2010-September 2010 is Rs 47, 611 crore – more than half of that came in September.
Booming secondary markets also trigger primary market activity. There are many initial public offerings (IPOs) in the pipeline. All those IPOs will try to exploit the current buoyancy to garner as much cash as they can. This is part of the job description for fund managers and merchant bankers. They need to raise cash any which way if it’s available.
It is a classic caveat emptor situation – it is the individual investor’s responsibility not to enter assets priced at high valuations. Investing heavily when prices are high is a classic pattern that normally leads to losses for retail investors.
It can be justified to a certain extent in the secondary market by the “greater fool” theory. Nobody knows how long a stock-market boom will last. If an investor enters below peak values and exits nearer the peak, by selling to a greater fool, he gets an acceptable return. The higher the valuations, the greater the risk but it is a valid trading strategy.
A similar strategy of going stag in IPOs and selling allotments for quick gains is much more dicey. This is because of the lack of liquidity in primary markets and hence, the lack of reliable price discovery mechanisms. If you’re employing a greater fool strategy in an IPO, you must be willing to dabble in the grey market and to offload any allotments you get on day one of listing, if need be.
There is a chance of a quick killing in IPOs but there is no safety net. There is no way to set a reliable stop loss and if the allotment is less than hoped for, there can be a horrible squeeze situation resulting from grey market sales.
In any event, these are trading strategies and not methods for a long-term buy and hold investor. A long-term investor would tend to avoid IPOs in bull markets. IPO pricing is usually done by comparative valuation with listed peers and bull market “comps” are high.
Investing via mutual funds, especially systematic investing plans, offers a safety net. If prices drop, an SIP automatically averages down. A Martingale strategy of increasing commitments if the market falls, lowers the average acquisition prices even more efficiently.
If a trader is seeking to make a quick buck in a rising secondary market just at the point when retail investors as a class are increasing exposure, there are some methods worth investigating. One, is to deliberately seek stocks that retail investors will target. These are generally going to be small-caps and mid-caps.
If you see a situation where the CNX500 is outrunning the Nifty, this focus on smaller stocks is likely to work. The method can be outlined as follows. First, seek signs that the retail investor is entering in a big way. These include high AUM growth, broad indices such as CNX500 outrunning narrow large-cap indices like the Nifty and Sensex, low or negative institutional buying in a rising market, etc.
Next, find the mid-caps and small-caps that have shown extraordinary volume expansion as well as strong price out-performance. This is the “hot” segment where trading action is concentrated. Third, narrow it down to a very small short list. One way to do this is to look at Google news references. A stock that's been mentioned a lot in the media is likely to have a stronger retail base.
After this, you can start trading that short list of stocks. Keep stop losses and pay heed to circuit filter considerations (this is important whenever you move out of the derivatives list). There are no guarantees of course but this could work better than IPOs. Note that fundamentals are irrelevant in this method and you are operating strictly as a trader.
