Pump and dump is an unethical way to hype up the value of the stocks to make a quick big profit by selling them at a hyper-inflated range of prices in the secondary market. Even though it is illegal, as we know of it, it is still hard to identify the pump and dump propaganda. However, there are a few ways to identify this gut-wrenching scheme out. How can you save yourself from the players in the market persuading you with the increased value of stocks to make you buy them at expensive prices just to sell-off those stocks to lose their values overnight? Let's try to figure out a few ways.
The market is always observing its own price action as per the growth of the value of a company. As the theory goes, the value of a company increases in the secondary market as the company grows in its intrinsic value. The market capitalization of a company is one of the many ways to evaluate the real size of any publicly-traded company. Recently, people are purchasing the stocks at a price valued much higher than their intrinsic value.
Let me try to illustrate the point I'm trying to make by taking the example of the price action of Nepal Seva Laghubitta Bittiya Sanstha Limited (NSEWA) from the 8th of December 2019 until the 18th of December 2019.
There are only 6,00,000 units of the NSEWA scrip listed on the Nepal Stock Exchange (NEPSE) so far. As per the recent quarterly report of NSEWA, the company shows the earning of Rs. 4.54 per share (EPS). On the 8th of December 2019, the price to earnings ratio (PE ratio) is 86.34. This means people are paying 86.34 times more than the real value of one stock of NSEWA at Rs. 392 per stock. Let's face it, Rs. 392 for one share of a company that has the potential to earn Rs. 4.54 is pretty obnoxious.
The insanity doesn't end there. The investors got a notion that the company is announcing dividends for 2075/2076 pretty soon and the price action of the NSEWA scrip after the 9th of December 2019 was very intriguing to observe. The company's value increases by 10% from the 9th of December to the 12th of December 2019, excluding the 10th of December 2019.
The PE ratio of the NSEWA scrip on the 12th of December 2019 is 114.53 at the rate of Rs. 520 per stock. This is 114.53 times more than the intrinsic value of the scrip.
We can clearly see the price of the NSEWA scrip was pumped for the greed of the dividends by the investors who do not care about the dividends. Such investors pump up the market value of the company to sell the stock to the investors that are looking forward to buying the stocks for dividends with an obscene rate of growth. This is called pumping.
After these investors increase the price of the stocks at which they want to sell to make a profit, they start selling off. This is exactly what happened with the NSEWA scrip.
On the 13th of December 2019, the company proposed a 2.625% total dividend to distribute for 2075/2076.
How is 30% of increment in the value of NSEWA per share for 2.625% of distributable dividends justifiable? The answer is, it isn't justifiable. So, what can we expect to see in the market? You might have guessed it, dumping of the hyper-inflated stocks!
Now, we can see the stocks that were pumped losing their value after the 13th of December 2019. These stocks are being dumped and the investors that bought the stocks at Rs. 520 are now losing value.
Such investors tend to ignore a well-known quote "Be greedy when others are fearful and be fearful when others are greedy" and thus they are facing the consequences of their greed.
Just because a particular stock has high investor confidence, it doesn't mean it is a good stock. It could also mean that the stock is being pumped up by the investors with inside information to sell-off at a higher price to book a great profit! Dear investors, always remember to be patient and stay disciplined. It isn't advisable to follow the crowd.
Sometimes, it is better to stay out of the crowd and observe what is going on than to join the crowd because of the well-known investor's fear of missing out by risking a lot of money with the hope of making even more! It is time for us to take a closer look at a recent growth in the value of the insurance and microfinance stocks Just ask one question to yourself before purchasing the stocks with high investor confidence. Is the current growth in the value of the company justifiable?
Disclaimer: Investing can be risky and it can turn out to be hazardous as we grab a wrong notion of investing. So, do not take this article as financial guidance. Always consult a licensed CFO or portfolio manager for your particular investment plans and financial goals.