Chapter Fourteen
Don’t Get Emotional
How to Profit from the Panic
So how does a panic begin? What really happens? And as an investor caught in the downturn, or someone looking to cash in on the panic, what do you do?
The number one thing that you do is: Don’t panic. Panic, after all, is an irrational visceral response to a sense of powerlessness and helplessness, which often comes from a lack of understanding of the actual circumstances. But panics, odd as this may sound, are nothing to be scared of.
As Franklin Roosevelt once said during the Great Depression, “The only thing we have to fear is fear itself.” Understanding the origins of the difficulty can help to diminish anxiety. And in any number of critical ways, all busts start with a boom. Why? Because all busts start with a gathering consensus that a market has gone too far, too fast.
The same people who were so in love with the market, and with every stock in it, that they’d sell their grandmothers into slavery to buy more stock, now all of a sudden won’t touch a share of stock with a 10-foot pole. Objectively, this fickle attitude makes absolutely no sense. But that’s failing to take into account the rule of emotion, which tends to stimulate snap judgments. Emotions make people see only in black and white, good and bad, up and down, so what was good suddenly becomes bad. What do you do in such conditions?
Wait for the panic and the inevitable crash in prices. Then, calmly, buy.
Why? Because you’re being paid to take a risk that the short-term sentiment is greatly exaggerated. In the perception gap between emotion and reason, you’ll find your buy window.
In the perception gap between emotion and reason, you’ll find your buy window.
Become a Fan of All the Information You Can Find
Hoping to avoid getting roasted, some stock market crystal ball gazers perform a mathematical ritual known as technical analysis in the hope of forecasting these big market drops.
Such analysis is another aid to understanding what is happening in the market. It is the study of price movements across all kinds of markets, including stock markets. It is different from the fundamental analysis of such variables as price-earnings ratios, profits, earnings, market share, and other factors impacting corporate performance since it focuses only on the stock prices.
As I pointed out, early in my career, when I was working in Hong Kong as a consultant, I started my study of stock markets with technical analysis. From a chartist’s point of view, there are certain definable patterns in price movements as put on a chart, which could help us predict what could happen to the price in the future. In the case of the Thai crash, we discussed previously that the chart pattern was what is referred to as a quadruple top, where the market peaked four times before crashing. Such patterns are unusual, since most crashes are preceded by a head and shoulders pattern, as we discussed, or a double or triple top. A quadruple top usually means a severe and dramatic movement, which was experienced in Thailand.
In times of market volatility, to adopt a contrarian position, technical analysis can help the investor find the right times to enter and exit, provided that the value fundamentals are clear. The important point is that when everyone is dying to get in the market, when the stocks are too expensive, it is best to exit—but when everyone is screaming to get out and the stock are cheap, that is the time to buy.
When everyone else is dying to get in, get out. When everyone else is screaming to get out, get in.
I can still recall the frenzy around the listing of China Telecom in 1997, in the midst of the Asian financial crisis.
The New York Times expressed the spirit of the time when it stated: “For investors still willing to try the bumpy ride in Asia, it’s hard to think of a sexier pair of words than ‘China Telecom.’” (China Telecom was broken up in 1999, and reborn as China Mobile.)
Broker analysts had dubbed the company the hottest “red-chip” initial public offering to come down the pike since the handover, when Hong Kong was returned to China. (“Red chips” are mainland Chinese companies listed on the Hong Kong Exchange).
Even as Hong Kong’s financial secretary was publicly insisting that there was “no political or economic need for us to disband the Hong Kong Dollar peg,” one of the most renowned Hong Kong stock analysts was blandly assuring us that buying China Telecom was a “no-brainer”—and guaranteed to make money for those who purchased the stock.
“The issue is oversubscribed by 300 times,” he bleated, visibly salivating at the very thought. “It’s a hot issue. I’d buy as much as you can get. The gray market is saying you’ll double your money in one day. It’s putting a 100% premium on the market price.”
Whenever you hear the words “no-brainer” and “hot issue,” it’s best to turn on the alarms.
The issue was finally oversubscribed not by 300 times but by 30 times. Two days later, with the Hang Seng index doing a splendid imitation of a lead weight in free fall, China Telecom was set to open at HK$10.00—below the initial offering price of HK$11.68. This highly touted US$4 billion stock offering had promised to be the bellwether for red chips in the post-handover Hong Kong.
But come the fall, the overheated market in red chips had cooled considerably. By Black October, red chips had dropped 40% from their peak in late August. What to do? Well, the first thing I did was have a meeting with some of the top executives at China Telecom. Taken at face value, the numbers looked great.
China Telecom was, according to its glossy prospectus, expertly prepared by the lead underwriters of the initial public offering, “the dominant provider of cellular telecommunications services in Guangdong and Zhejiang provinces which are among China’s most economically developed provinces and the two provinces in China with the largest numbers of cellular subscribers.” In other words, la crème de la crème, cellularly speaking.
Not only that, but the telecommunications industry in China had experienced rapid growth in recent years, and the cellular services sector was one of the fastest growing sectors within the telecommunications industry. In short, what was there not to like? After all, China Telecom’s cellular subscriber base had grown at an annual rate of 88% over the previous three years. The strong growth trend was expected to continue, according to management. On top of that—as the stock underwriters had put it in touting the stock—“You’re buying an effective monopoly.”
Even without all the rocking, rolling, and roiling in Asian markets—which I calmly considered a fleeting epi-phenomenon—buying China Telecom at its high initial offering price was, despite the underwriters’ flamboyant assurances, by no means a no-brainer.
This was also despite the gray market placing a 100% premium on the shares—according to rumor. The gray market, incidentally, is a market in shares that have been allocated to certain subscribers at the initial share issue who immediately turn around and sell their share allocation, right out of the gate, to buyers willing to pay a steep premium for the shares before the actual listing.
My little head-mounted antennae were quivering like tuning forks, picking up danger signals. As best I could figure it, China Telecom’s assets when compared to similarly situated cellular companies elsewhere in the world were being valued at a very high price.
Of course, for everyone involved, buying this stock meant placing a bet on the future. For my purposes, I wasn’t as concerned about today’s price-earnings ratio as I was about those five years down the line. But for that price-earnings ratio to be any kind of bargain in five years’ time, China Telecom’s growth in revenues—as opposed to subscriber base—would have to be staggering. And even then, growth in numbers or market share wasn’t the point. It was growth in profits that mattered.
To their credit, I found the managers of China Telecom impressive. And I had not the slightest doubt that under such obviously capable management, China Telecom would flourish in its local market. But I did harbor some doubts about the company’s long-term revenue growth prospects. Simply put, as cellular phone service becomes more of a mass medium, prices—and possibly profits—were bound to go down.
The looming question was: Would increased volume compensate for the drop in revenue per subscriber? Add to that uncertain mix the feeding frenzy that typically accompanies these red-chip initial public offerings, and my gut response was rank skepticism.
When an initial public offering is oversubscribed, this means that more people—institutional and retail investors—have put in their bids (and in many cases written sizable checks for shares they hoped to buy) than will ever lay hands on the shares.
China Telecom’s underwriters had been granted the right by the company to essentially allocate the shares as they saw fit, which meant that a certain (small) percentage would go to New York in the form of American depositary receipts (ADRs), and a certain (higher) percentage would be listed in Hong Kong.
Initial public offerings are intrinsically unfair, insofar as both share underwriters and the company are permitted a wide degree of latitude in granting preferential treatment to most favored customers. With a “hot” one like China Telecom—piping hot until the day the bottom dropped out of the Hong Kong stock market—the gray market quickly bid the price way up above the initial share, or opening, price.
The gray market is made up of all sorts of frustrated buyers who, because they haven’t been given a share allocation, promise to pay a substantial premium to any people who did get their hands on some shares over the official market price, if they will sell their shares to them.
This means that anyone who’s lucky enough to get a chunk of stock on the first round—a privilege bestowed sometimes by random lottery, and at other times because of connections to the underwriters—can simply turn around and flip the stock, minutes after that investor bought it, into the gray market and make a tidy profit in no seconds flat.
One factor influencing the so-called gray marketeers is the expectation that the new share issue will soar like a hot-air balloon. What I often do in initial public offerings is hang back and wait to see what happens to the shares in the aftermarket—that’s the open market—in a few weeks or months. Of course, there’s no way to be sure that the price will drop, but once the initial euphoria has ended, it’s not uncommon in my experience for initial public offering prices to dip, or at least drift, once the support limits promised by the first round of buyers have been breached.
In any given share allocation scheme, a certain proportion of the total shares issued is guaranteed to be sold to the general public. So it’s perfectly possible for small investors to participate in an initial public offering.