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Friday, December 2, 2011

Can an Indian investor rely on signalling from FIIs, banks, auditors or volumes?

On 21st September 2011, SEBI issued an order , detailing how GDRs were used to manipulate stock prices. Apparently, the companies in question has schemed with a few issuers and Indian brokers, to convert the GDR into shares, indulge in circular trading and then sell those shares to unsuspecting retail investors, who saw this conversion as sign of confidence and due diligence by supposedly well informed FIIs. For more on this, read the SEBI order here(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1316607187418.pdf)

But if the investors thought they could rely on trade volumes of Indian investors, then there was another thing coming. Those tracking the markets would remember the tremondous rise and fall of Kwality Dairy, after SEBI discovered the existence of a cartel engaging in circular trades. That case should warn anyone who invests in penny stocks on momentum driven trading strategies(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1314688048292.pdf

But surely, one can rely on banks and auditors, right? Banks sanction loans to company on the security of inventory/current assets, and appoint stock auditors to periodically examine the asset quality. So should not secured loans on current assets be a good signalling practice for the company's asset quality? My classmate and friend Manpreet Singh(who blogs at http://www.the-value-stock.blogspot.com/) thinks the same thing. But one should remember that banks are not technical experts on valuation, and the mounting NPAs shows that even banks make mistakes. Also, when the auditor of an midcap pharma company(whose inventory counts for 70%+ of its book value) accepts inventory as valued and certified by the management,  then it is a cause for alarm, since that means the auditor is not confident in his own diligence on the inventory. Considering that banks normally take such asset valuation reports from the statutory auditor, I would be wary of accepting secured loans on such inventory, as evidence of the company's asset quality.

And auditor competence apart, the recent controversy over Deloitte's inflating a valuation report on the behest of one of its client's, shows that the issues exposed in the Satyam scam, are still live and kicking. When even Big4 auditors can make mistakes, what about the SME audit firms(like the unnamed auditor of our midcap pharma stock)?

Bottomline:- Unless an investor learns to read between the lines and look for what is there, and more importantly what is NOT there, he's setting himself up for a disappointment.

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