. What’s behind your portfolio laggards

Stock market investing can sometimes be frustrating for fundamental investors. Stocks that one has bought for their good numbers after researching the sector and company can be studiously ignored by the market, while their peers with similar financials or prospects simply zoom. If this has been happening once too often to your personal stock picks, run a check on whether there are non-fundamental factors that are depressing valuations or prices. Here are some reasons why the market can take a jaundiced view of a stock despite the company having reasonable financials.

Supply overhang

Just like commodities, shares also need more buyers than sellers on a day-to-day basis for their prices to rise. A company which continually issues fresh equity or one where the promoter is steadily selling his holdings in the market, can see its stock under-perform due to supply swamping demand.

Investors in three marquee stocks - L&T, ITC and Axis Bank - have had a frustrating time in this bull market with the stocks chronically lagging benchmark indices and peers. L&T has delivered a 11 per cent CAGR in the last three years, Axis Bank a 10 per cent CAGR and ITC - the subject of many memes - a negative 8 per cent, against the Nifty 50’s 19 per cent CAGR.

One (though not the only) key factor weighing on these stocks has been the ever-present possibility of SUUTI (the government-owned Special Undertaking of the Unit Trust of India) off-loading its significant stakes in the market. Though SUUTI holds stakes in over 40 companies, these three stocks represent its most significant holdings and periodic government announcements about using SUUTI to meet disinvestment targets have resulted in a persisting supply overhang over them. In the last couple of years, SUUTI has offloaded most of its holdings in L&T and Axis Bank, but its gradualist approach to cashing out on the 7.93 per cent stake in ITC continues to cast a shadow on the stock. Many PSU stocks with reasonable fundamentals struggle in the market because the government regularly adds to their free float through disinvestment. If your stock is a laggard, check if increasing free float and its appetite for equity-raising are the reasons. Try to assess when this could stop.

Lost management credibility

Stock markets have a long memory. When a company’s management earns a reputation for talking big and never delivering, hails from a group known for anti-shareholder moves or has a chequered past on debt troubles or unrelated diversification, it may get stuck with a low valuation multiple irrespective of its current fundamentals.

Despite a turnaround in profitability, a reduction in bad loan numbers and healthy deposit growth, the stock of PNB has remained sideways and languishing at less than half its book value for the past year. The bank took a big write-off from the Nirav Modi scam in 2018 and the management gave repeated assurances that the ‘worst was behind’ for many years after, even as the bank’s performance went downhill. This appears to have led to markets becoming skeptical of turnaround stories about PNB.

Quite a few jewellery stocks in India (save Titan) have been chronic underperformers despite brand visibility, extensive retail franchises and export growth, as the market tends to be skeptical about governance standards in this sector. Past instances of companies in the sector defaulting on overseas dues, figuring prominently on bank defaulter lists and reporting high receivables have led to their under-performance.

Checking out a company’s past annual reports/analyst calls for signs of promoter hubris and reading corporate history can reveal skeletons that help you stay off such sectors and stocks.

Impending corporate action

Impending corporate actions such as mergers, divestitures or capital restructuring either rumoured in the market or in the early stages of execution, can act as a potent overhang on stock performance. Investors, in the dark about the likely swap or demerger ratio, may prefer to have this information before betting on the stock.

At times, a company’s financials may be perfectly sound, but troubles at other group entities or the promoter family or heavy pledging of promoter shares may keep smarter investors at bay. For long, the ADAG group’s debt troubles acted as a potent overhang on Reliance Nippon Life AMC’s valuation, with a re-rating taking shape only after the ownership changed hands fully to the Nippon group.

Family tiffs too can depress stock valuations, as the end-result could be a healthy company’s shareholders having to put up with dole-outs to group entities, cash diversion or spinoffs/mergers designed to keep peace in the promoter family.

Too late to the party

This bull market has encouraged the belief that ‘quality’ stocks are good acquisitions at any price. But this is a patently wrong notion because the market’s definition of what is ‘quality’ changes with every cycle.

The higher your entry valuation for a stock, the lower your long-term returns from it are likely to be. A higher valuation for a stock always builds in the expectation that the company will deliver multiple years of uninterrupted and high profit growth. With such stocks, the market’s tolerance for the slightest disappointment with earnings or growth tends to be pretty low. Any realisation that the company’s moat, market dominance, brand strength or pricing power has been over-rated can lead to a sharp shrinkage in PE multiples, leading to poor returns for investors who joined the party late.

Investors who bet on paint stocks in January 2021 at PE multiples of over 100 based on the belief that these companies had strong moats and pricing power have had to put up with poor performance, as recent quarters have brought a reality check, with paint company margins dented by spiralling raw material costs.

A good way to know if you’re too late to a ‘quality stock’ party, is to measure how much of its past 3- or 5-year returns came from actual earnings growth and how much from PE expansion. If the latter is the main driver, best to stay off.

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