Tainted stocks: Which one will tumble in the next scam?

The fallout of a long bear market is that skeletons tumble out of cupboards. India has had more than its fair share of stocks that have been dumped due to issues of corruption, false accounting, corporate governance, price rigging, insider trading, regulatory breaches and other such misdemeanors. India is in the fourth year of a bear market with the Sensex and Nifty down from peaks seen in late 2007 and early 2008.

The unsuspecting investor who had invested in stocks from Unitech (2G scam), to Reliance Communication (accounting issues revealed by analysts) to Everonn Education (whose MD was arrested for tax fraud) has seen the value of his holdings in these companies fall sharply and has left him suspicious of equities as an asset class.

The fear now is if an investor looks to invest in any stock, he never knows what is lurking around the corner. Everyday media news is about some stock that is facing regulatory or government agency probes or an analyst report on poor accounting practices of companies. The latest news is the IB (Intelligence Bureau) report on price rigging on stocks such as Pantaloon, whose stock price is falling on the back of the report release.

The fear of the unknown will leave investors shunning stocks of well-managed companies. The good gets clubbed with the bad as investors lose faith in equities and this can lead to a situation where the bear market is prolonged or where the foreign institutional investors (FIIs) run the show. The absence of a strong retail base for equities, whether directly or indirectly through mutual funds and insurance companies, leaves India vulnerable to FII flows.

FIIs flows depend on many factors, including global liquidity, risk aversion and expectations of returns in the markets they invest in and these factors make FII flows volatile, leading to severe bouts of volatility in domestic markets.

Heavy bouts of volatility due to FII flows will further discourage investors leading to a self-fulfilling cycle of market volatility. This is a situation that the country does not require now, especially when India is going through a rough phase of growth coming off sharply from 8.4 percent GDP growth seen in 2010-11 to 6.5 percent growth levels seen in 2011-12. India requires a stable domestic investor base to fund its capital requirements.

What can get back the confidence of investors into equities? The daily doses of revelations that bring down equity prices definitely do not help.

Unfortunately, this daily dose of bad news is likely to continue as weak capital markets bring out more skeletons from the cupboards.

Investors can be encouraged to stick to well-known large cap stocks or to the large cap indices to avoid being caught on the wrong foot. Fund managers should cleanse their portfolios of stocks that have questionable management practices. The regulator should crack down heavily on companies that manipulate books or indulge in insider trading. The justice system should gear up for class action suits by investors who have been hurt by managements indulging in bad practices.

Unfortunately there is absolutely no conviction amongst investors that they will be compensated for losses suffered by investing in companies that have indulged in fraud. Satyam is a prime example where US investors were compensated for losses for $125 million due to fraud but the Indian investor got nothing.

It is a tough task to turn around sentiments but if there is a definitive move to protect investors, domestic investor sentiments could improve. Sebi has to take the lead in this.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com , a web site for investors.