Strategies for buying and selling stocks and mutual funds – analysis of readers' exercise (Part II)

Last week, I had analysed the first three questions of the readers' exercise about strategies for buying and selling. Today, the balance three questions are being addressed. To jog reader memories, and for the benefit of those who missed the earlier posts, here are the last three questions:

Q4. You had bought 500 shares of a small cap company about 2 months back. After stagnating for a while, the price recently shot up by 25%. Will you:

(a) sell all 500 shares and book short-term profits?

(b) sell 250 shares and reduce your holding cost on the balance shares?

(c) hold on for higher prices?

(d) buy another 200 shares at the 25% higher price?

Q5. You had bought 1000 shares of another small cap company about 6 months ago. The stock has been stagnating since then. A recent announcement of 20% dividend and a stock-split perked up the price by 10%. Will you:

(a) use the up-tick in price to sell out?

(b) wait for the dividend and stock split and then decide?

(c) buy another 250 shares at the 10% higher price?

Q6. You have been holding a well-managed mid cap MNC company's stock for a couple of years. The company recently announced delisting of its shares from the stock exchanges at a buy-back price that was 15% higher than market. Subsequently the price has spurted by 30%. Will you:

(a) hold on with the hope that the company may increase the buy-back price?

(b) sell your entire holding at the current market price?

(c) sell 80% of your holding now, but keep 20% aside in case the company increases the buy-back price?

(d) sell to the company at the announced buy-back price?

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Q4 and Q5 appear similar, but I would like to point out the differences. Small cap stocks are inherently risky because few analysts cover them and there is little information publicly available about their operations.

As small investors, it should be our primary goal to reduce the risk of losses. A spurt of 25% in 2 months is equivalent to an annual gain of 150%. The logical answers should be (a) or (b). Option (c) won't reduce the risk. Option (d) will increase the risk by buying more at a higher price.

If you have read my post about 'How to use Financial News', you will know that dividend and stock-split announcements can be classified as 'good news'. The effect of such news on the stock's price is temporary - lasting not more than 2-3 days - so it doesn't make much sense to trade on it. So, the logical answer should be (b).

A few words about stock-splits and bonus issues may be in order. In small caps, unscrupulous promoters often announce splits or bonus to jack up the stock's price through circular trading, only to cash out at the higher price and leave small investors in the lurch.

But reputed promoters either use stock splits to increase liquidity of high-priced stocks, or announce bonus shares to indicate that the company is in good enough financial health to shoulder the liability of the increased equity capital.

Theoretically, stock splits and bonus issues do not add to investor wealth because the stock's price gets adjusted after the split/bonus. But what actually happens in the market is beneficial for investors who hold for the longer-term.

Once the increased number of stocks following the split/bonus is credited to investor accounts, there is a tendency towards some selling, which reduces the split/bonus adjusted price some more. After a few months, the selling subsides and the stock price starts to move up again.

For well-managed companies, the price eventually surpasses the split/bonus adjusted price. Typically, a dividend paying company reduces the per-share dividend according to the split/bonus ratio, so that the dividend received by investors prior to the split/bonus remains the same.

Over the next few years, if the per-share dividend is increased (which is often the case), investors gain on both capital account and dividend account without investing a single paisa.

For the last question, option (b) should be the logical answer. Options (a) and (c) are speculation and not investment options. Option (d) leads to capital gains tax as per current rules, since selling to the company does not incur STT (securities transaction tax).

If the stock is infrequently traded, and an investor holds a large chunk, then option (b) may not be practical. Investors would have no choice but to sell the shares back to the company.

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