Pick stocks based on fundamentals, not perception

This is a joke I read about 2 decades ago in a magazine. A humble-looking wise man wearing a simple dress goes to a restaurant – based on his look, the waiter doesn't give him a good service. Still the wise man gives a phenomenal tip to the waiter. After a long gap, this humble looking wise man goes to the same restaurant, but gets very impressive service from the same waiter this time. However, the wise man doesn't give him any tip this time – while reminded politely he says "I paid you tip that day for today's service"!

Roughly 22 months ago, a pharma company gets alerts from the foreign regulator for its plants. The stock price crashes as much as 80% over next 4 months as it became a victim of gloomy news flows. The stock was downgraded by many in the industry. It was a bad news for the company – no doubt. But the market ignored the facts like: majority of Indian pharmaceutical companies could get back their normal status for their plants from the same regulator within roughly 18 to 24 months period; the promoter of the company accumulating the stock officially at such a bargain price; and the valuation of the remaining businesses, solid deleveraging of its balance sheets over the years, etc.

Today the stock is up more than 5 fold within 19 months – "suddenly" the prospects of the company turned rosy in the eyes of the markets! In the process, many retail investors, who sold the stock due to negative perceptions, are worried a lot.

Similar is the story of many retail investors entering the stocks too late based on positive perceptions driven by news flow of takeovers. They have lost anywhere from 25% to 30% within a month in some of these stocks. Of course, many good quality stocks also fell down as much as 20% as midcap segment is going through severe corrections in the last 2 months. However, as long as valuation gap remains in positive territory, most of the stocks are likely to recover back. But most stocks, which moved up purely on perceptions without fundamental backings are likely to suffer for a much longer period, if not for ever.

Perceptions distort the price beyond what fundamentals dictate. The retail investors who are solely guided by the fundamentals and remain composed on negative perceptions and make use of bargain buys, and the ones who exploit the opportunities thrown open for huge profit bookings on positive perceptions are the ones who make wealth in the markets consistently. The wise man's smart story of discounting too early is more apt for the stock markets!