Disguised To Mislead

The Indian equity markets have been quite volatile in the last few quarters and in such a volatile situation, investors often tend to make mistakes. This is the time when they lose patience and take hasty decisions. This is the time when the investors follow the herd mentality and start investing in stocks which usually do not follow the fundamentals. We feel in this turbulent time, rather than focusing only on markets and predicting direction, it is time to relax. 

We have time and again stated that in uncertain markets, it is important to understand what to avoid, rather than what to buy? While the retail investors get confused, it is the time when operators get active and try to trap gullible investors.

In such a situation, most omnipresent character of all traders buying and selling is greed. And in such greed the investors tend to buy some shares, which having characters like scams, with managements and manipulative brokers have one agenda to snarl the susceptible traders. These are stocks that can be easily bought, but try selling them when the prices rise and you will know the true meaning of getting trapped. 

This is a serious situation and to make the moment lighter, we present you a story which is probably known to most investors. Since ancient times stories are considered to be the best and easiest medium of teaching. Stories are not only seen as a form of entertainment, but also as a tool to teach management lessons. Hence, even we thought of telling you a tale on the stock market. There are a number of stories to be told about the Indian stock market. However, this one seems to be more relevant from the Indian market perspective and current market scenario. The story in a simple way explains how the operators work and also indicates towards gullibility of the retail investors.

Once upon a time in a village, a businessman appeared and asked the villagers about their means of livelihood. The villagers answered that they were farmers and did farming. On hearing this, the businessman told the villagers that they must have an alternate source of earning and suggested that since the village was surrounded by a deep forest, it would provide for an ideal earning opportunity for them. He announced to the villagers that if they got him monkeys from the forest, he would buy the animals for Rs 10 each. 

The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. Everyone in the village earned in thousands. However, this frantic pace of hunting quickly diminished the number of monkeys in the forest and the villagers had to stop this activity.

Looking at the diminished supply, the businessman announced that he would now buy monkeys at Rs 20. This prompted the villagers to make a renewed effort and they now ventured deeper into the forest to catch the animal. Once again, however, the supply diminished and the villagers lost interest, returning to their farms for a living. But then the businessman increased the offer to Rs 25 each. This sparked off an enthusiasm in the villagers yet again. However, the supply of monkeys became so little that it took an effort to even see a monkey, let alone catch it. The businessman now announced that he would buy monkeys at Rs 50. The offer lured each and every villager. However, in between, the businessman had to go to the city on some business visit and his assistant started to look after the business on his behalf.

In the meantime, the villagers had befriended the assistant as they considered him to be their own. In the absence of the businessman, the assistant told the villagers: “Look at all these monkeys in the cage that the man has collected. I will sell them to you at Rs 35 and when the man returns from the city, you can sell them to him for Rs 50 each.” The villagers rounded up with all their savings and bought all the monkeys. But when they visited the businessman’s place, there was no sign of either the businessman or the assistant. There were only monkeys everywhere.

Now we guess you have a better understanding of how the operators work in the stock market. So beware of such things while investing in the market. The monkeys here signify the operator-based stock. The question is how to identify such stocks. Going ahead, we have tried to provide parameters based on which it would be easier for you to find out about such companies. While we get into the details of various malpractices, we give you a few examples of how the investors fall prey to the various schemes of the operators. There are few caveats the investors have to follow.

The Different Tricks

Investors often fall into hideous value-traps, designed by operators in collusion management of not-so ethical companies. While the age old practice of rigging the stock price to generate interest amongst investor community remains intact, the methods are always fine-tuned to keep up with time.

If there was an aspirational survey conducted in India, making quick buck in share market would rank at the top of the list. Hordes of grifters, hiding behind corporate veil, take advantage of this rags-to-riches hope of uninformed investor. Investors often forget a famous quote said decades ago by legendary Fund Manager Peter Lynch- “Although it’s easy to forget sometimes, a share is not a lottery ticket… It’s part-ownership of a business.” 

During the period lasting from 2007-2010, the GDR issuances had been a favourite method of operators to drive such price rigging and then dumping these penny stocks to retail investors. Investors are often attracted to low multiple penny stocks, in the hope of striking the next big thing. Such companies garner maximum attention on positive news flow like large fund raising. The rush towards such stock turns out to be near fatal when the news has a foreign angle. 

Retail investors who have been tricked into putting their money in such companies have found their entire capital erode with the passage of time. Actually, the shares issued in foreign markets in form of GDRs are bought by operators in collusion with promoters. A GDR issue generates ample interest in the domestic market.

However, these GDRs are gradually converted into shares and sold to retail investors in India. 

Our research desk has always guided investors against such issuance. If investors could recollect, we had done a similar story on the IKF Technologies a few years back. In that we had categorically explained how the convertible warrants were issued at lower prices (around Rs 3-Rs 5) and then the promoters made an exit at Rs 12-13 in the next 24 months. 

There are other examples, companies like Avon Corp, Jupiter Bioscience, which were under the scanner for similar malpractices. And then, taking a note of excessive price manipulation, SEBI had banned seven companies in September 2010.

• Asahi Infrastructure & Projects
• Avon Corporation
• Cals Refineries
• CAT Technologies
• IKF Technologies
• K Sera Sera
• Maars Soft ware International

In its order dated 22 September 2011, SEBI stated - “The various aspects of GDR issues, like the large size of the issue vis-à-vis existing size of the issuing company, unimpressive financials of the company, common initial investors, high proportion of cancellation of GDRs repeatedly by a set of FII/sub-accounts, sale in Indian exchanges, most of which are with a constant group of clients, and further off -loading by them, point towards an elaborate scheme to manipulate markets.”

Taking these sorts of parameters, investors can find out about various stocks that may be involved in the fraudulent activities. To name a few, the ones who had been allegedly involved in the past are Birla Cotsyn, Birla Shloka, Jupiter Bioscience and Zenith Birla. Promoters of these companies have duped investors by dumping nearly worthless paper stocks at high premium to Indian retail investors. Stock prices of these company are highly manipulative in nature and hence not worthy of investment.

Going ahead we give you a few companies which are involved in such malpractices. We have tried to provide a modus-operandi which would help the investors avoid such mistakes in future.
[PAGE BREAK]

Avon Corporation: Weighing On Investors

As stated earlier, the investors are often lured to penny stocks trading at low multiples in the hope of making quick bucks. Attention towards such companies is at peak when they are able to raise capital, especially from foreign markets. But the investors have to be cautious while investing in such companies. This applies not only to equity, but also in other financial instruments offered by such companies. Avon Corp was amongst the 7 companies banned by SEBI from raising money from the public. However, the company still offered a fixed deposit scheme. With higher interest rates being offered many were lured into it, but a detailed analysis shows some different aspects.

Let’s first understand the business of the company. Avon Corp manufactures personal and industrial weighing scales. A few years back, the company trading a low PE of around 2-3x and growing over 50 per cent a year was an ideal multi-bagger candidate.

With strong positive aspects like lower Price to Book value of 0.5x, and an impressive growth rate, it was really a good investment. However, in stock market such a performance is too good to be true. And a complete analysis of the company provided the following insights. There was a constant equity dilution. While the profit after tax (PAT) increased from Rs 1.86 crore to Rs 22.69 crore over a period of 4 years (FY08 to FY11), EPS declined multifold due to an increase in equity base, from Rs 2.85 crore in FY08 to Rs 16.58 crore in FY09 and then Rs 64.58 crore in FY10, only raising doubts on the management’s intentions. Apart from that while profits surged, the company’s operating cash flow has always been negative, not a sign of viable business. The company in between offered a GDR. 

This sort of financials indicate that business is not in a good shape as the P&L indicates, and the promoters need cash to hide the operational inefficiencies. The alternative is a sinister one; the promoters are issuing shares to themselves through proxies at throwaway prices and taking minority shareholders for the ride. The company initially witnessed a strong performance on the bourses. But things changed completely as the so called “foreign investors” started converting their GDRs into shares and offloading them in the Indian markets. The share price tanked from 52-week high of Rs 11 and is now trading at less than Rs 1 per share.

Jupiter Bioscience: No Chemistry At All

This was another company which had an alleged involvement in the artificial price rigging of the stock prices. Even if we consider basic aspects of analysis, one can be convinced that Jupiter Bioscience has duped investors by issuing GDR and is not worth being considered as an investment. Following are few pointers indicating towards the same. First and foremost, the company’s profit fell drastically in the past few years. Apart from that, promoters holding less than 5 per cent in the company created ample scope for fraud. A few years back the company had issued GDR at Rs 90 per share, which were converted into shares last year and subsequently sold to retail investors at less than issue price.

We remain convinced that the company had not received cash from the GDR issue. Most likely the promoters in collusion with the operator had rigged the share price before the GDR issue. These GDRs were eventually converted into shares and then sold to public, making a gain of over Rs 150 crore. The most important indicator was that the company’s secretary resigned in June 2011 giving further boost to the fraud theory. Th us, we foresee fraud in GDR issue in the company and do not consider it fit for investment purpose. There might be operator driven spurts in the stock, but we don’t have prowess to predict such short-term movements.

CORE Education: Victim Of Pledging Game

The shareholders of CORE Education & Technologies will not forget 25 February 2013, the Black Monday that brought to life their worst nightmare on the stock market. The rumours that lending institutions had sold the shares pledged to them by the promoters spread like wildfire and the stock tanked 62 per cent, falling precipitously from Rs 295 to Rs 110.50. Two days later, it fell 45 per cent to hit Rs 60 mark. 

The noticeable factor here has been the number of pledged shares in the company. Pledging emerged as a major threat to many counters, especially where the promoter pledging has been higher. The carnage was triggered by rumours of financial institutions selling the shares pledged by promoters. The latter often pledge a part of their holding as collateral for raising loans. This is a standard industry practice and, per se, not a reason to be alarmed. It's only when the promoter pledges a significantly large chunk of his holding and the overall floating stock of the company is very low that problems can crop up. Brokers often facilitate this funding route for smaller companies, which find it difficult to raise funds through the traditional routes. Even so, most lenders do not offer more than 60-70 per cent of the value of the shares pledged.

This operator-driven, informal funding route exposes the stock to manipulation. Operators zero in on such stocks, hammering down the price to lower levels. The steep decline in the stock price makes the lender demand additional margin from the promoter. The borrower has to either cough up more shares or return some of the money to the lender, to ensure that the margin is maintained. Unfortunately, margin calls can sometimes have a domino effect on the share price. At the slightest hint that promoters are unable to arrange additional shares or funds, panic grips the market and the shares nosedive. This is what happened in the case of CORE Education & Technologies. 
[PAGE BREAK]

Geodesic – The FCCB Worries

While CORE Education fiasco occurred due to pledging of shares, there is another evil on the street called foreign currency convertible bonds (FCCB). The Indian corporate found this route easier as they could raise the funds at cheaper rate. It is shown as a loan and the lenders are offered bonds which can be converted into equity at a lower (already agreed price).  But this was based on the premise that the stock prices would only move upwards. But the consequences of fall in the price were much harsh. If the equity share prices are lower than the agreed price at the time of conversion, the lender would opt for charging interest. And the amounts would be enormous. Geodesic, which is an internet software and service provider, witnessed a similar fate. The company has run up more than Rs 1200 crore of liabilities and defaulted on payment of its FCCB and loans. During the June 2013, all the independent directors resigned from the post of directorship and till now the company has not appointed any independent director on its board, offending the clause 49 of the Listing Agreement. 

Moreover, its accounting is still in a mess. Geodesic submitted its year-ended June 2013 results, revised year-ended June 2012 results with its September and December quarter standalone results to the exchanges on 15 February 2014. We believe this is a scam of large proportions with accounts fudging and siphoning of money. 

Geodesic had raised funds through FCCB during the year 2008, which was due for repayment in January 2013. However, the company has not been able to discharge this liability. The FCCB holders through their trustees, Citibank London, filed a winding up petition against the company for defaulting on the dues. Recently in February 2014, the London Court had given a summary judgement and directed Geodesic to pay Citibank a sum of USD 157 million towards actual repayments and USD 14.88 million towards unpaid default interest till 07 February 2014. Geodesic results announcement said that it is facing difficulty in arranging working capital finances, delay in receivables as-well-as higher debts. 

On the financial front, during its December 2013 quarter, its net loss increased to Rs 37.58 crore from Rs 18.96 crore while its sales stood at Rs 8.13 crore compared to Rs 100.42 crore a year ago period. In its year-ended June 2013, it made a net loss of Rs 43.13 crore despite sales of Rs 172.77 crore. Geodesic share was trading around Rs 100 on BSE during January 2011, which is now trading near Rs 3. Its share prices plunged 77 per cent in the last one year from Rs 12.85 to Rs 3.05 as on 25 February 2014.

Opto Circuits (India): Aggressive Acquisitions

Another stock that witnessed a setback was Opto Circuits (India). The company went for aggressive acquisition plans but eventually burdened itself with heavy debt. The stock has been marred by corporate governance issues, high debt and weak quarterly results. The downward trend of the stock began in January 2013 after the management announced the resignation of its company secretary, more than two months after his departure. This raised concerns over corporate governance and financial management practices. To make matters worse, the company has been facing working capital issues and high debt. The stock failed to stage a comeback since then and recently plunged after disappointing fourth quarter results.

Vakrangee-Sudden Cash Flow 

While there are companies where the management is involved along with the brokers, there are a few companies that have a sort of deceptive revenue pattern. For eg, there are a few events that drive the sales for a particular period and the stocks usually gain some traction ahead of the same period. Take the example of Vakrangee. The company is into providing Aadhaar cards and election ID cards that usually generates traction ahead of elections. But again, investors should consider the overall performance of the company and not the one-time business. It only provides an impetus in the near to medium-term and there are short spurts in the stock prices for that period.
[PAGE BREAK]

Factors To Identify The Operator-Based Stocks 

Sharp Price Movement: All operator driven stocks witness sharp price movement in either direction. Look out for any sudden and unexplained uptick or slide in the stock prices. Typically, these stocks will hit the upper circuit when they are in uptrend and vice-a versa. 

Mismatch with Company Fundamentals: A big spike in the stock price without any improvement in the fundamentals is an obvious red flag. It clearly indicates that some one is manipulating the stock. Retail investors can easily check out such movement in comparison to growth in sales, net profit and most importantly cash flow. 

Usual Culprits: Operators usually tinker with the same stocks at every opportunity they get. Investors need to look at the historical performance of the company to identify the usual culprits.

Measures To Avoid Such Stocks 

Pedigree Check

• Stick to well-known stocks which have higher trading volumes. Further, try to stick to the stocks that are analysed by the experts. The thinly traded obscure stocks are easy to manipulate. 

No Hot Tips 

• Do not believe the hot tips on phone and SMS. 

Control Your Greed

• Do not blindly follow stocks that are on the way up. Avoid the scrips where the price rise seems disconnected with the company’s fundamentals.

Be Skeptical 

• Do not take every brokers recommendation at face value. Quite possible he may be putting the stocks on behalf of someone else. 

Learn To Cut Losses

• Even if you get into such stocks, make sure you cut losses immediately. 

Conduct Your Own Research 

• Conducting own research is important as it provides a good understanding of the business. Always verify the claims made by the company. Try to get to the roots rather that just watching the window dressing done by the company. 

We have also provided a list of ratios which will help you to find out companies with poor fundamentals. We have provided a detailed study of how to crack down on such stocks. 
[PAGE BREAK]

How to Avoid the Sick Men of the Stock Market

We all know in hindsight there is a perfect vision of 20/20. The problem is, though, it does not help in most situations and more so in case of equity investment. The cemetery of equity market is full of investors who lost money by investing in bad companies. There are umpteen investors who have learned it the hard way.  There are many examples where a company was doing well, financially and otherwise, few months or days before it went bust. The best example in the global arena is Enron, which was perceived to be one of the best companies run by the smartest guys and even earned the “America's Most Innovative Company” for six consecutive years, before it got bust. Even in the case of India, we have seen companies manipulating their books to showcase how well they are running their companies. One such example is Satyam Computer Services whose management was awarded with the highest honour of Golden Peacock Global Award for excellence in corporate governance in 2008 by UK-based World Council for Corporate Governance, four months before it was revealed that the company’s chairman Ramalinga Raju had falsified accounts and assets. 

Investment in portfolio of clean companies can help us avoid large losses and outperform the market returns. The problem, however, for common investors is how to find the sick men of the stock market. There are many simple ratios that can be employed to predict if a company is cooking its books. This should, however, be used as a gatekeeper and further probe needs to be done before deciding on the commitment of any funds. 

Operating Cash Flow (OCF) Compared To The EBITDA

A consistent rise in the EBITDA to OCF ratio should be used as the first red flag. As EBITDA is treated as proxy to cash flow there should not be much volatility in the ratio. Moreover, if this ratio rises consistently, which means EBITDA is more than the operating cash flow, it indicates that the company is using accounting aggression to boost its topline. Therefore, rising ratio should be used as the first filter to probe further and one should raise the first red flag. For example in the case of Opto Circuits (India), the company in the last two years (FY13 and FY12) has consistently shown a positive EBITDA, however, it has negative cash flow from its operations. Some may argue that the company might be having large interest outgo that is eating its cash flow. Regardless, interest charges are not substantial for the company and have remained within Rs 36 crore. Therefore, rising EBITDA to OCF ratio was the first signal that company was aggressive on booking revenues. The fact can also be substantiated by the considerable rise in debtors of the company and increase in debtor’s day in comparison to its sales. While the sales of the company increased by 46 per cent, debtors increased by a staggering 156 per cent between FY11 and FY13.  Debtor of the company increased from Rs 228 crore at the end of FY12 to Rs 584 crore at the end of FY13. During the same period debtor’s day has increased to 220 days from 204 days.

The above mentioned criterion is the simple method and should be applied in the first step of separating the wheat from the chaff. There are other methods, too, which a sophisticated investors can apply to arrive at clean companies. Two such methods are Scaled Total Accruals (STA) and Scaled Net Operating Assets (SNOA). In the case of STA, the measure identifies the current flow of accruals, whereas SNOA captures the growth of accruals over time. These methods can be employed to check if a company is fudging the accounts to show good sales momentum. They keep us from investing in stocks that appear to be high quality, when in fact the numbers are heavily manipulated by the management to create an illusion, far from reality.

STA was first used by Richard G Sloan, L. H. Penney Professor of Accounting, University of California at Berkeley, and is defined as net income less cash flow from operation divided by total assets. The entire universe of listed stocks, except for the financials, is taken into account and STA is calculated. Then each company’s STA is given a percentile rank and companies with higher STA percentile ranking should be avoided, while one can look at investing companies with lower STA. In our analysis of BSE 500, excluding the banks and financial companies, lowest deciles companies have outperformed the top deciles company by huge margin. The average return of the lowest deciles companies comes out to 14 per cent while for the highest deciles it was negative nine per cent. Even in terms of percentage of companies that have given positive returns, the lowest deciles exceed that of companies in highest deciles. Some of the prominent companies appearing in top deciles are Torrent Pharmaceuticals, Navneet Education, Elgi Equipments, Triveni Turbine and many jewellery companies such as Goenka Diamond & Jewels. We advice the investors to be cautious about these stocks.

SNOA was formulated by professors of Fisher College of Business, and is based on the premise that when cumulative net operating income (accounting value added) outstrips cumulative free cash flow (cash value added), subsequent earnings growth is weak. It is calculated as operating assets less operating liabilities divided by total assets. Following the same process that we employed in STA, we find that companies with lower SNOA have again outperformed the companies with higher SNOA. Three companies namely Kappac Pharma, BF Utilities and Rasoya Proteins have given huge returns in the last one year. However, they are on the highest deciles of SNOA and thus we advise our readers to avoid these companies.  

In addition to the above mentioned ratios, investors should also look at cash yield of the company and auditor’s qualification, which can give some indication if a company is fudging its books.