Why do not stocks move on news? Many times I read very big news concerning stock in the papers but then stock does not show considerable movement post news release!

Stock markets are considered to be informational efficient. This means, stock prices move instantly after any information is released by the company concerned. By the time the information is in the next day’s paper for laymen to know, the stock has already moved to its new price taking into account the information. So it is not uncommon for the layman to think that news does not move markets. Furthermore, the price might have even overshot fair value taking into account the information and the stock could even move in the opposite of expected direction.

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IPOs: Is it a good idea to buy IPOs (Initial Public Offerings)? Is it not true that IPOs always trade a significant premium to offer price in the initial days following listing?

Before buying an IPO, an investor should read the prospectus, understand the business of the company, analyze any financial statements if available and evaluate the corporate governance of the company. Only on satisfaction of all the above and other significant factors that may not have been listed above and could be company specific, should an investor buy an IPO. In bull markets, IPOs usually list at a high earnings multiple because the sentiment of the market is bullish. When market sentiment is bullish, the demand for any security is high leading to a high price of an IPO. The reverse is true in a bear market, demand for securities are low and even IPOs that have good earnings quality and prospectus could trade at a price less than the offer price. In my personal opinion, bear markets are the best times to buy an IPO that you are convinced about. Unfortunately, not many companies come out with an IPO during the bear market for the obvious reasons of low market cap and low demand for security.

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How important is it that the company management hold a significant stake in the company? There are many companies in which the management and related parties hold less than 5% stake and sometimes 0% stake:

Company management’s stake in a company can be viewed at from different perspectives. One perspective shows management stake being directly correlated to company performance. A higher stake leads to better performance and a lower stake to a poorer performance; this happen because as company stock performs, management makes more money. On the other side of this perspective, earnings numbers could have been manipulated by the company so stock price moves up and management makes money. Proponents of this side of the perspective argue that a low management stake coupled with an independent board of directors leads to good earnings quality because management is not really interested in how the stock price moves because they have nothing to gain with a low stake. In a nutshell, management stake must be looked at with reference to other factors like earnings numbers, preferably free cash flow calculations and their relation to net income and how it changes and board of directors independence and composition. Even then, conclusions can be different from the different perspectives.

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Developed markets and emerging markets: Why is it that many mid-cap and small-cap companies trade at low valuations in emerging markets whereas in developed markets like the USA, UK and Singapore, it is hard to find good companies with low valuations? Is it true that making money is easier in emerging markets than in developed markets?

This is an interesting question and knowing the answer will help investors understand why emerging markets are the way they are. Emerging markets have some inherent qualities that make them different from developed markets:

  • Corporate governance: Most emerging markets have a different system of corporate governance in which the chairman and the CEO is the same person. Corporate governance makes a strong case for the CEO and the Chairman of the Board of directors to be different so the agenda of the board of directors is carried out with independence from management interruption.
  • Lower analyst following: Most mid-cap and small-cap companies have a low analyst following, so information about the company and knowledge of the company’s business is not widespread. This is even worse in emerging markets with poor infrastructure because the facilities of the company might be located in an area of the country that has poor connectivity with public transport making it cumbersome for analysts to actually visit the company. In such cases, analysts have to solely rely upon capital market information for rating and analyzing companies. In many emerging markets, company also may not release timely information due to the lack of strong regulatory authorities. All this lets many good companies have poor analyst followings and hence low exposure and low valuations. By all means, if you know a company is good and is trading at low valuations and has only a few analysts following it, it could be a multi-bagger for you and you could buy it.
  • Emerging market economies: Many emerging markets with the exception of china have a high current account deficit. This means that the economies are reliant on foreign investments to fund their deficits. Sometimes, such emerging markets having high growth rates also have high inflation rates and low real interest rates, and there is a good chance for the currency to depreciate making it difficult for the governments to repay back the borrowed foreign currency loans. The sovereign debt ratings of the country must be looked at in an analysis. Investors also look at ratings in excess of BBB which is the lowest investment grade rating. Anything less than a BBB, we can have very low multiples in the local stocks because demand for securities in that country goes down.
  • Low liquidity: Unlike developed markets, emerging markets have many companies which have a very low liquidity and a high stock price. The required return is set higher for such companies because of significant liquidity risk. What is liquidity risk? Liquidity risk is the risk that an investor will not be able to sell off holdings in his company immediately because the trading volume is very low. Also, with a low volume, when you are a decent sized investor, you could cause market impact, where your selling drives the market price of the security down. With a higher required rate of return on this security, fewer investors end up buying it and hence, it can trade at low valuations. Again, if you will never be in an urgent need for cash, you can sell the stock over days or weeks and hence generate significant returns.

Taking all the above factors into understanding will help you make better risk adjusted returns in emerging markets. Personally, I like emerging markets because though there is risk, there is better risk adjusted returns available on offer.

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