No one can resist the onward march of an idea whose time has come, Victor Hugo said. In bull markets, there are many who apply this to stock investing as well. While conventional investors run screeners, scan company filings and analyse quarterly numbers to identify buys, idea investors believe that to find multi-baggers, all they need to do is latch on to a powerful idea.
So, the moment the Centre announces an Atmanirbhar Bharat push, they’re buying chemical or pharma intermediate companies. In a Digital India push, they’re buying fibre-optic cable makers. When it announces higher FDI in insurance or defense, they’re buying up listed insurers or PSU defense equipment makers. If e-commerce is taking off, they buy logistics stocks and if States are ramping up Covid testing, they bet on diagnostic labs.
But exciting as it may seem, selecting stocks based on such big-picture themes seldom adds durable wealth to one’s portfolio. If you’re itching to try it out, watch out for these pitfalls.
Skipped homework
Most long-term winners in one’s stock portfolio come from understanding a company’s business better than others in the market, spotting a sector trend early or buying a business when the market is under-estimating its potential. But when you’re chasing hot new ideas, there’s often no room for deep study of a company or a sector. Being in a hurry to ride a wave before it fizzles out, can force you to skip necessary homework, leading you to buy lemons.
A recent and somewhat extreme example of an idea stock that proved to be full of hot air is Bombay Oxygen Investments. As the media filled with reports of oxygen shortages during the second wave of Covid, thematic investors scrambled for companies that would gain from this theme. Bombay Oxygen Investments, thanks to the keyword in its name, shot up by 140 per cent between end-March and mid-April from ₹10,000 to over ₹24,000. But after little digging revealed that the ‘oxygen’ in the company’s name was a legacy of the past, the stock crashed 40 per cent.
The company, earlier in the business of manufacturing industrial gases, had discontinued this activity in August 2019 to secure a NBFC license from RBI. Since December 2019, it has been engaged in investment operations that have nothing to do with oxygen.
Shifting focus
While Bombay Oxygen may not have set out to deliberately mislead investors, there are many companies in the Indian market that are ever willing to oblige fickle markets by entering any business that seems to be the current flavour of the season. Scores of obscure firms attached ‘cyber’ to their names during the dotcom boom, construction companies transformed into ‘infra’ firms in the 2007-08 bull market and several new ‘logistics’ companies cropped up in the e-commerce boom. Owning such companies can be quite a roller-coaster, because you may find that instead of sticking to and scaling up in the business you bet on, they are constantly shifting shape to cater to market preferences.
Investors in Vakrangee Software have seen it morph from a company focussed on last-mile financial inclusion, to a play on e-governance and Digital India, to a retailer for Bharat in a short five-year span. Originally a franchisee for the Aadhar UID project in 2010, Vakrangee pivoted to being an e-governance firm that helped folks in tier-3 towns and villages perform internet-related tasks through an extensive network of over 40,000 Vakrangee Kendras in 2016-17. It then made unrelated forays, through subsidiaries into providing logistics for e-commerce giants and retailing gold. Even as the company’s revenues have taken a sharp tumble, it is readying yet another pivot, from e-governance to setting up a pan-India ATM network. While the stock has crashed over 90 per cent from its peak of ₹500, the company has run into governance issues as well after scotching a ₹1000 crore buyback plan, abrupt resignation of its auditor and penalties from SEBI for fraudulent trading in the stock.
To avoid betting on such wrong horses, run a check on the company’s annual reports and management commentary over the years. Frequent business pivots are a sign that the management is more focused on managing its stock price than on building a scalable business.
Execution woes
Idea investors focus a lot on big-picture trends that will play out in future. In the process, they may forget to check if the company they’re betting on has the execution capability to translate its larger-than-life vision into reality.
A good example of a great-sounding idea turning out to be a pipe dream is Educomp Solutions, a favourite stock with idea investors between 2008 and 2010. Listed in 2006, the company’s management successfully marketed the idea that Indian schools mostly using old-world methods of chalk-and-board teaching, were ripe for digital transformation pan-India. The hardware company, engaged in the computerization of schools pan-India, showcased itself as a high-growth play on ed-tech solutions for K-12 education. Within three years of listing, it was reporting 100 per cent revenue growth with operating profit margins of 48 per cent. Having installed its Smartclass solutions in about 2500 schools, it set itself a target of expanding to 15,000 schools and a ₹1000 crore revenue. It later transpired that in its aggressive bid to sign on more schools, Educomp didn’t pay attention to whether these school tie-ups actually translated into revenues. After many delayed or skipped payments, the company faced mounting receivables and debt, defaulted on bank loans and turned an NPA in 2016. It was later subject to CBI raids. The stock which hit dizzying heights of over ₹1000 in its heydays is currently at ₹3.
Educomp’s story is a lesson that captivating big-picture ideas need not translate into profits on the ground. It pays to be particularly wary of managements who set order-of-magnitude targets and sell you big dreams.
Not all idea-based stocks turn out to be lemons on the scale of a Bombay Oxygen or an Educomp or a Vakrangee. Investors in the stocks of diagnostic chains or pharma API companies have for instance, made significant gains in the last one year. But this is more because such companies already had established business models that had evolved over many years and had operating metrics, even before the Covid opportunity came by. Even in such cases, long-term investors may need to ask two questions – whether the big pop in earnings from the opportunity will sustain and whether stock valuations already factor in a best-case scenario.
Overall, even if idea-based investing excites you, it may be best allocate only a fixed portion of your portfolio to such opportunistic bets.