Dynamics of returns

Krishnan Thiagarajan

FOR investors with exposures in software stocks, either directly or through mutual funds, 1999-2000 was a dream year.

The fabulous returns from mutual funds that year were a perfect reflection of the bull run in software stocks. But after the Nasdaq meltdown in April, the software picture appears to have gone awry. With most software stocks, particularly in the second- and third-rung, plummeting 40-70 per cent in recent months, the harsh reality of the risks associated with the sector has hit investors.

Do the sharp run-up in the valuations of software stocks in 1999 and early 2000 and the steep correction after the Nasdaq meltdown hold lessons for investors?

Business Line tried to trace the `software services' story in the Indian market by computing the holding period returns of some 45 stocks in 1997-2000.

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Methodology

The objective of this study was to establish:

*Whether there were any discernible patterns in holding period returns that may point to future price trends, and

*Whether the trading cycle represented by ``an unprecedented surge and a steep fall'' of software stocks can influence investments in this sector.

For the analysis, Business Line took the prices of all stocks in the sample and computed the holding period returns in the following format:

*First, the dates on which the BL-250 Index touched the highest and lowest points in calendar 1997 and 1998 were identified. A similar exercise was carried out to identify the highest and lowest points touched by the BL Technology Index in 1999 and 2000. The BL-250 was taken as a proxy for the BL Technology Index in 1997 and 1998, as the BL Technology Index did not exist then.

*The closing prices and the price of each stock at the highest and lowest point were then taken to compute the holding period returns in 1997, 1998, 1999 and 2000.

*The holding period returns were broadly divided into two categories:

- Returns on the prices for each calendar year 1997, 1998, 1999 and 2000 (part of the year).

- Returns for the prices between the highest and lowest points touched by the index each year, to examine the extent of relative volatility among stocks in the sample.

The broad inferences drawn from the pattern of returns are:

Frontline stocks: From the pattern of returns, it is obvious that the key frontline stocks, such as Infosys Technologies, Satyam Computers, Mastek and Wipro, consistently recorded returns higher than the second- and third-rung software companies in all the four years. The year 2000 was a litmus test for frontline stocks in several respects.

With the BL Technology Index surging to an all-time high on February 22 and plunging to its lowest on May 26 (for the year), the relative volatility was bound to be fairly high. A study of the pattern of returns for these stocks shows that, compared to the 70-200 per cent returns for frontline stocks, the returns for second-rung stocks was 160-400 per cent. Clearly, the frontline stocks were less volatile than the second-rung stocks.

Finally, a comparison of the current market prices of frontline stocks with the closing price of calendar 1999 showed that the key frontline stocks, such as Infosys Technologies, Satyam Computers and Wipro, recorded positive returns of 20 per cent, 39 per cent and 25 per cent respectively. The fundamental strengths and resilience of the frontline stocks are significantly higher to the second- and third-rung categories.

Second-rung stocks: The universe of second-rung stocks is much bigger than that of the frontliners. In a bull run of the 1999 and early-2000 kind, selectivity was at play, but dictated more by the quality of management than concrete business models or financial performance. A close scrutiny of the pattern of returns of select second-rung stocks showed that more than selectivity, ``relative valuations'' were at play.

For instance, the returns in 1999. Select stocks, such as Polaris Software, Silverline Technologies, Trigyn Technologies, Onward Technologies and Orient Information Technology, recorded returns of 646 per cent (227 per cent in 1998), 331 per cent (147 per cent), 385 per cent ( 138 per cent), 734 per cent (98 per cent) and 789 per cent (135 per cent) respectively.

After the April Nasdaq meltdown, most stocks logged negative returns. While Polaris recorded a negative 5 per cent, Silverline, Trigyn, Onward and Orient Info declined steeply by 46 per cent, 65 per cent, 75 per cent and 38 per cent respectively.

Third-rung stocks: The third-rung stocks, which also participated in the bull run, were affected by the Nasdaq meltdown even more than the second-rung stocks. Infotech Enterprises, which appreciated 688 per cent in 1999, logged a negative 74 per cent return at the current price levels. Other stocks that registered sharp declines were Cybertech (82 per cent), Sierra Optima (61 per cent), Kale Consultants (73 per cent), KLG Systel (72 per cent) and SQL Star International (78 per cent).

Lessons

Significantly, even without any fundamental change in the software services industry in India, the Nasdaq meltdown triggered panic-selling in software stocks. In a globally-integrated environment, bad news travels fast, and fundamentals are forgotten in a bearish market.

From the pattern of returns it can be inferred that in any panic-selling situation, investors first unwind their positions in third-rung stocks, and then second-rung and, finally, the frontline stocks. Generally, given either the low floating stock or low trading volumes, the third-rung stocks are the most difficult to exit from in a bearish market.

The negative returns in the 65-80 per cent bracket seem to reflect that the market takes a while (in this case almost five months since the Nasdaq meltdown) to mark down prices to the averages before the bull run. Hence, for a lay investor, third-rung stocks are the most risky in the trading portfolio.

As the dynamics at play in this industry are understood only by a few players, `negative news' can be used as a good entry point into select stocks, if monitored closely. For instance, Mastek. In the second quarter of this year, it announced that owing to a loss of a key client, its earnings for the fourth quarter ended June 30 could be affected. The stock plummeted from a high of Rs 5,298 in February to Rs 1,171 in May, and remained rangebound for quite some time. After an impressive earnings announcement for June 30, in mid-July, the stock slowly gathered momentum and now trades at Rs 2,588 _ a 121 per cent appreciation from the yearly low. In this case Mastek's ability to tide over a difficult situation offered a significant investment opportunity.

As the industry matures, `selectivity' is likely to come into play. Investors may be better off tracking a limited set of software stocks, that is, stocks in which the quality of management the business model and the financial contours are reliable. The relative valuations at play in the market so far may soon become a thing of the past.