labels: finance - general, investment - general, stock markets - india, markets - general
The lurking danger of a small stock bubblenews
Rex Mathew
28 March 2005

Investors rushing to buy stocks of small companies should remember that their prices may be manipulated and the risks involved are far too high.

As the stock market indices post historic highs, many experienced small investors are asking the same question - when is the next scam going to surface? In the last 15 years, we have seen two unprecedented bull runs before the current one. Both those rallies saw lots of excitement and hype, amidst expectations of retiring rich, before they came crashing down as scams involving reigning market legends surfaced. Is this rally also going to end in a scam? If you put the question to market analysts, they all insist that this time it is different. But that is what they said on both previous occasions as well, this time it is different.

Is it really different this time? The answer is yes, to a great extent. The last two rallies were built up purely on hype. The first one on the expectations raised by the start of the liberalisation process. The second one by the emergence of such significant technologies like the internet. Both rallies ran much ahead of the fundamentals before tangible benefits of the developments were visible in corporate performance.

Many of the lofty projections made during those two rallies have come true now. The country has attained a higher growth momentum and corporate performance is at its best in history. The results are visible on ground and in corporate profits. India is the toast of the world behind China and foreign investors are flocking in. So the current story is less hype and more real.

The Indian stock market is structurally very different from the days of the previous two rallies. Those days regulation was very poor and exchanges were private clubs of brokers who ran them for their interest. Individual brokers could swing market prices and there was no concept of corporate information, only rumours. The only significant institutional investor was UTI, which existed in its own world. Things have changed dramatically since then as foreign investors made their mark and private mutual funds grew in size. SEBI has done a good job of introducing more discipline and order among market operators. The emergence of the professionally managed National Stock Exchange as the premier exchange has forced the clubbish Bombay Stock Exchange to mend its ways.

As market values of companies have dramatically increased and institutional investors and foreign investors own large stakes, it is virtually impossible for an individual or small group of operators to manipulate prices of large stocks. The information flow from companies has dramatically improved and retail investors are much more knowledgeable about the market. So it is safe to postulate that the current stock market rally is not a bubble though stocks have run up quite and are not cheap anymore.

Recently, both the NSE and BSE issued advisories to their members warning them about unusual movements in stock prices and trading volumes. They have advised members to be more watchful about the trading patters of their clients and report any unusual activity. If everything about the current rally is backed by sound fundamentals and institutional buying, why this warning? Have the exchanges noticed something dangerous and risky for the health of the market?

Hyped up small stocks and their dark sides
If one were to read the advisory in detail, the exchanges are specifically targeting the unusual activities in stocks of small companies or small cap stocks. To quote the circular from NSE, "Some orders / transactions in illiquid securities / contracts have come to the notice of the Exchange where same set of members / clients have executed reversing transactions, both buy and sell, at abnormal price differences in the premium in the case of options, that had no relevance to the movement in prices in underlying securities at that point of time". This gives credence to a growing belief that shady operators, unable to manipulate the frontline stocks, have now turned their attention on smaller stocks and the smaller stocks in the futures and options segment.

Small cap stock form a majority of the companies listed on the exchanges. Most of these stocks are listed on the BSE, which has thousands of them which are not on the NSE. Many of these are unknown and invisible to the general public. They exist in obscure corners of the country and are generally very secretive on sharing information about their operations.

Many of these stocks have seen dramatic increases in prices in the recent past. Stocks which have multiplied rfive times or 10 times in value are not very uncommon. If you take the listing of stocks hitting new 52-week highs or price circuits in any financial newspaper, a vast majority of such stocks are of virtually unknown companies. Why are these stocks with shaky fundamentals being bought as if there is no tomorrow? The answer is it is a combination of manipulation by some operators and plain greed of investors.

We have heard number of stories about small companies growing into highly profitable giants making investors very rich in the process. Reliance, many IT companies, Bharti Tele, etc, are great examples. New entrants to the market as well those who missed these stocks wait anxiously to buy in to stocks of unknown and, often, unproven entities in the hope that these might turn out to be the next Reliance, Infosys or Bharti.

In their eagerness to buy into the next multi-bagger, investors often ignore the fundamentals of equity investments, relying instead on gossip, rumours and hype. This scenario enables market manipulators to create the hype that investors willingly believe in and take them for a ride. In this age of 24-hour business television channels, it is not particularly difficult to create an aura about a stock and bring it to the notice of investors in order to buy in to such stocks. When the hype subsides the stocks crash to earlier levels. In the last one year alone this strategy has been employed with many stocks.

One of the methods employed by manipulators to create an impression of high trade volumes and rising prices is circular trading. This is how it works: a manipulator sells a large block of shares to associates at a price higher than what is prevailing in the market, who in turn, sells them to another associate for an even higher price. The original seller then buys back the shares at a still higher price.

Within this group, all transactions cancel out each other and there is no net profit or loss. But these transactions also attract those outside the group to buy the stocks. As the momentum reaches its peak, the group of manipulators, who had taken large positions in the beginning, cash out. The advisory issued by the exchanges specifically talk about the possibility of circular trading (note the phrase 'same set of members / clients have executed reversing transactions' in the advisory) in small stocks.

Investors who get into such stocks should bear in mind that many of the star small stocks of the previous rallies do not even exist today. Many of those companies vanished and hundreds have been de-listed for not paying the listing fee to BSE. It is reasonably sure that the large companies would still be around even if there is a market crash and investors will get their money back when the next rally comes, whenever that is. But many of the small companies will not be around to see that day.

*A professional cost accountant, the author is a stock analyst and indepenent market trader

Disclaimer: The author doesn't have any position in the stocks specifically mentioned above at the time of writing this article. This analysis/report is only for the purpose of information and is not an investment advice. Readers are advised to consult a certified financial advisor before taking any investment decisions. While efforts have been made to ensure the accuracy of the information provided in the content the author or publisher shall not be held responsible for any loss caused to any person whatsoever.
also see : Manipulated equity research reports
Games promoters play

 search domain-b
The lurking danger of a small stock bubble