The Hindu Business Line : The perils of theme-based investing

STOCKS in the banking sector have been basking in the limelight. Over the past six months, this sector has resonated as a "theme" in the minds of professional and small investors alike.

And the stock prices have more than doubled for most public sector (and some private sector) banks over the past year. Have any fundamental changes been afoot to drive this stock price momentum in the sector? To a large extent, the answer is a resounding yes.

A sharp fall in net non-performing asset (NPA), improvement in the capital adequacy ratios, better cost control measures, return of capital, debt buyback and solid treasury gains have helped improve the banking sector's asset quality.

However, over the past month, banking stocks of all hues, especially the public sector (both top and second tier stocks) have continued their trading frenzy at the bourses. Suddenly, it seems that the markets is going beyond performance to discover triggers to sustain the rally in the sector.

In the past two weeks, several public sector banks, such as Punjab National Bank, Oriental Bank of Commerce, Bank of Baroda and Andhra Bank have either decided or proposed to return equity to the government at par, without any premium linked to the market price.

Mid-week, an official spokesperson of the Ministry of Finance also confirmed that the government does not propose to charge a premium on the capital being returned.

Barely two days after this decision, this Friday, the Finance Secretary made a volte-face by announcing that no decision has been taken yet on pricing.

Will this decision trigger a stampede among banking stocks? Are the banking stocks nearing the last leg of their rally? Is the two- or even three-fold rise in trading volumes sustainable? Markets tend to have a mind of their own, and one can never predict their course with certainty.

As the "banking theme" faces a crisis of confidence, it may be important to highlight some features and pitfalls of theme-based investing from the small investors' standpoint. Over the last five years, the Indian stock markets have been witness to at least five major theme-based rallies from software, through pharma, to PSU disinvestment and auto/auto ancillary stocks. And all of them have echoed these common traits:

Early bird catches the worm: It has been consistently proven that theme-based investing is a solid story worth pursuing in the early stages.

Generally, it starts by capturing the undervaluation in top tier or frontline stocks in the sector, with relatively sound fundamentals and then works its way down the rungs of the sectoral ladder.

Greater fools theory: As the rally works its way into the second-tier (or third-tier) stocks in the sector, at some point, the greater fools theory unobtrusively comes into play.

Invariably, at these points, professional investors stand on a relatively stronger footing than small investors. Basically because they are better placed to palm off the shares in their hands to the so-called "greater fools" at even more inflated prices.

It is different this time around: Most theme-based rallies as they pick up momentum seem like they are different this time around. Invariably, reasons for a sustained rally for a long period are born out of mass psychology and take the character of "the madness of crowds" at some point in time. An outstanding example of this phenomenon is: "The Nifty Fifty" stocks in the US of the 1970's.

These were big capitalisation stocks belonging to the stable and respected companies in the US at that time. It was felt that investing in these stocks will solve the problems of portfolio management for ever.

But even these stocks were bid to such astronomical levels that they soon became a speculative bubble which was pricked eventually.

Multiple underlying themes: Invariably, several underlying themes (say, engineering or commodity) work in the market at the same time, while only one may be on the ascendant.

Since several economic, social or business forces are at play, one theme may suddenly lose its sheen and shift to another.

For small investors who play on these theme-based rallies, choosing the right time to stay away from the market or catching the next theme may be as important as digging one's heels in.

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