Why Are Retail Investors Often Left Holding The Bag?

Zomato’s existing shareholders have begun selling their holdings after the lock-in period ended. The traded volumes in the stock hit their highest levels on Monday, barring the day the stock was listed on the exchanges.

Around 23 crore shares changed hands, as existing shareholders began cutting their stake in the company. As of the end of June 2022, around 68 per cent of the shares were held by large investors. With the intense selling pressure, the shares collapsed by 14 per cent within a single day.

Market participants are speculating that the buyers are likely to be individual investors, who are looking to enter at a lower price, or continue to add to existing positions.

Market participants would know that this isn’t a new phenomenon. Retail participants are often attracted to stocks that have fallen significantly, expecting the stocks to return to their former glory. Stocks that fall in the penny stock category are usually quite popular among retail investors.

Several stocks that were a part of the “dirty dozen” non-performing assets hit upper circuits as retail investors bought into the stocks, hoping for a turnaround. However, ultimately, the old equity was wiped out after new owners took over the assets.

Another bankrupt food company was recently in the news for its stock being bid up by investors, while a bankrupt plastic products manufacturer saw its stock price rise as investors bought heavily into the stock. Later, the old equity was wiped out to make place for the new owners.

Famously, a bank facing several serious allegations was bought heavily by retail investors who saw it as a turnaround story. According to Zerodha’s Nithin Kamath, “lakhs of investors” kept buying as the stock continued hitting new lows. The stock price hasn’t recovered yet.

While Zomato does not belong to the same category of beleaguered companies, the business continues burning cash and is a relatively risky investment.

There could be several factors accounting for the behaviour displayed by retail investors.

Usually, investors get to know about these turnaround stocks through “tips”. In reality, these tips are often spread by operators to manipulate the stocks, since institutions do not deal in the stock anymore. Hence, the liquidity in the stock is quite low. Even a small amount of buying can quickly pull the stock’s price upwards. Retail investors offer manipulators an exit by bidding up the stock price based on rumours and tips.

Other investors base their decision on the news of large investors entering the turnaround story. There have been several instances where the entry of prominent investors has been seen as a positive sign. However, the entry of a celebrity investor might not be a cause for celebration. These investors might be taking a short-term call, creating a hedged position, or just using their popularity to make a quick buck.

If one discerningly looks at the portfolios of large celebrity investors, many have a bad track record at picking stocks, with just a few old bets accounting for a large part of their wealth. These few bets were often made in inefficient and relatively unregulated markets, which isn’t the case today. Hence, the entry of celebrity investors is rarely a cause for celebration.

For retail investors, stocks that have a low absolute price can be quite attractive – making penny stocks quite popular. A stock trading at Rs 10 looks more attractive than a stock trading at Rs 1,000 since they can buy more shares of the penny stock. For example, every few years a struggling wind turbine maker is touted as the next turnaround story, and retail investors buy into the stock based on the low single-digit stock price.

The line of reasoning is that a Rs 1 increase in the stock price of the Rs 10 stock, after a Rs 10,000 investment can “easily” net Rs 1,000. However, what they often miss is the fact that it would require a 10 per cent move in the stock price. In contrast, the same absolute increase would require only a 1 per cent rise in the stock price of stock worth Rs 1000. Clearly, a 1 per cent move is more likely than a 10 per cent move in a stock. However, retail enthusiasm for penny stocks appears to have little regard for logic.

Other investors see these businesses as contrarian, turnaround, or value picks that have the potential to return to their former glory. But, catching a falling knife might not be a great strategy. Turnarounds are usually quite difficult to execute, with only a few companies returning to their former glory. If they were easy, the stocks wouldn’t have fallen significantly in the first place.

Similarly, stories of successful investors having bought great companies in times of trouble often motivate retail investors to do the same. However, the two situations might be quite different, and being contrarian just for the sake of it, is usually not a great investment strategy.

While some “fallen angels” and value stocks do return back to their former glory after being cast aside by the market, most do not. Turnaround stories should be taken with a sack of salt, and be considered speculative trades until there is any real traction.

At best, these bets should be seen as speculative and sized accordingly. In case a bet goes awry or an investment hypothesis turns out to be wrong, cutting off losses is better than continually adding to the position. Investing only based on hope is a loser’s strategy.