Around the turn of this century, I used to be a trader. It was a bad time to be a trader, but I survived, thanks mainly to my incorrigibly contrarian outlook on the markets. (i.e., I was short on IT, at a time when everybody thought that it, or rather, IT was rendering the business cycle extinct).
Around this time I went to a (foreign) bank to take a loan against my shares to meet my margin requirements. Now, my portfolio was entirely 'old economy' (a funny word, much in use in the last century). Since 95 per cent of trading volume was in IT stocks, liquidity on my portfolio was poor and the bank told me that it was not going to finance 'illiquid' stocks.
The stocks were Balrampur Chini (since then, up 950 per cent from Rs 75), Paper Products (up 370 per cent from levels of Rs.75), Bata and SRF (up 200 per cent and 590 per cent, respectively). With the exception of Bata, all the scrips were turned down. The scrips I wanted to short (mainly DSQ, now down over 95 per cent) were being happily financed by the bank, because of its huge liquidity. Bata, the only scrip from my portfolio which they were willing to finance, has been the biggest under-performer in my portfolio. With the benefit of hindsight, we can say very clearly that there is almost a one-to-one relationship between the bank's willingness to fund a share then and the scrip's subsequent under- performance. One would think that this is a statistical coincidence, but think about it some more. The bank's search for liquidity during bullish times coincides with my search for 'foolishness' during the same bullish times.
Sometimes, a stock has low liquidity because it is under-valued, and in 'strong hands', who are not selling till the stock is a multi-bagger. A good securities analyst would be able to figure out 'the strength of the consensus' and see absence of liquidity as a positive bullish sign. You would think a bank would understand that the liquidity it supplies to the stock promotes 'foolishness' and therefore if it has enough of a lending portfolio, it is the de facto supplier of foolishness to the market. What it is seeking to track (i.e., downside risk) is actually impacted mostly by its own lending actions (or that of the banking system). The bank calls in the loans at the end of the bull market and sells stock at the bottom. In fact, bank selling creates the bottom of the market, as we saw in 2001 after the Ketan Parekh scam. It relies on its ability to sell stock at the bottom, and this is called a 'business'. You would think that all those fancy foreign-trained MBAs in those hallowed granite corridors would have better sense about how to build a business.
If it is so obvious to an individual, why does a big bank not get it? Because of The Principle of Institutional Stupidity. The term was first used by Peter Lynch, who pointed out that structural flaws in the way organisations are built ensure that they do not operate at a high level of intelligence, even the basic level that we use as individuals. The level of foolishness is directly proportional to the number of people who have to evolve a consensus. An individual (at least, an intelligent one) is able to make complex trade-offs, which two individuals will never be able to agree on. And if you have a committee, your chances of understanding anything fall further. If you are a company, especially a big, arrogant and successful company, you don't have a chance. And God forbid, if you are the whole market ... even he cannot help you!
This article was originally published on January 01, 2007.
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