Indian stock market indices have record highs over the last few weeks despite the challenges posed by the Covid 19 pandemic.
Recently I came across a discussion on an online forum of a popular finance website, about the best banking stock for investment in current times.
While many were of the view that India’s largest public sector bank, SBI is the best bet, the majority favoured a leading private bank.
When someone asked for a reason, the common replies were “Because it has outperformed continuously in the past”.
Indeed, the stock of leading private bank being referred to in the forum has outperformed the market several times in the past by generating phenomenal returns for long term investors. However, past performance alone should never be a reason to invest in a stock.
This reminds me of a wonderful story that I am sure most of us may relate to.
Once there was a cap seller who used to travel to different cities to sell caps. In his journey across different villages occasionally he had to pass through forests.
I am sure you must have heard this story numerous times in your childhood.
But wait, there is a twist to it.
One hot summer day while passing through a forest, the cap seller got tired and decided to get some rest by sleeping under the shade of a banyan tree. While he lay asleep, few monkeys living on the tree happened to see the caps and climbed down the tree. They climbed up the tree and put the caps on their head.
When the cap seller woke up after some time, he found that his caps were missing. When he looked up, he noticed the monkeys wearing his caps. He tried all he could do to get his caps back but failed.
Suddenly an idea struck his mind. He removed his cap and threw it on the ground. Being known to imitate others, monkeys did the same, and the cap seller collected all his caps and went away happily.
Fast forward to many years later.
The cap seller’s grandson, a young man who was also engaged in the same business of selling caps, was passing through the same forest on a bright sunny day. He too felt tired and decided to rest under the same colossal banyan tree where his grandfather had rested years ago.
After he fell asleep, some monkeys living on the tree climbed down and took away the caps. After climbing the tree, the monkeys put the caps on their heads.
A while later, when the man woke up, he found his caps missing. When he looked up, he saw the monkeys wearing the cap. He remembered his grandfather’s story and threw his own cap on the ground with the hope that the monkeys would do the same.
To his surprise, monkeys did not throw away their caps. Instead, a young monkey climbed down the tree, slapped the man and went away with his cap.
There are two morals in this story.
Moral 1: On a humorous note, the monkeys also had a grandfather who may have passed on the story to his grandkids.
Moral 2: What has worked in the past may not necessarily work again in future.
From a stock market perspective, the second moral of the story is very highly relevant.
Indian stock market indices are at record highs; but many investors are surprised to see that their portfolios have underperformed.
One of the biggest reasons for this is wrong stock selection. Many investors tend to associate a stock’s past performance with its future performance while investing.
As a result, they often end up holding losing stocks and selling winning stocks.
A classic example of this is Yes Bank’s stock, once considered the best banking stocks to invest in India. But a gradual decline in the Yes Bank’s fundamentals such as falling profits, rising NPA’s, misappropriation of accounts and key promoters dumping the stock, resulting in a steady fall in its share prices. Unaware of these facts, retail investors kept buying the stock hoping that it will soon regain its past glory. From a high of Rs. 393.20 in August 2018, the price of Yes Bank stock is currently languishing at around Rs. 15-20 levels.
The stock of Yes Bank is not a one-off case. There have been many such instances where investors have lapped up stocks of companies with depleting fundamentals at low prices with the hope of selling once the price goes back to its earlier highs.
Sadly, some investors learn the hard way like the cap seller’s grandson in the above story.
While investing in a company, the past performance of its stock should be one of the last things to look at. Instead, one should look at the company’s key financial ratios to find out its financial health and its management quality and the overall outlook for the industry where it operates.
Key financial ratios include ratios such as Price-to-earnings(P/E) ratio, Price-to-book value (P/BV) ratio, Debt-to-Equity ratio, Enterprise Value (EV) by EBITDA, Price/Earnings Growth Ratio, Return on Equity, Current Ratio, Asset Turnover Ratio and Dividend Yield Ratio.
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Read more: How Long-term investing helps create life-changing wealth – TOI.