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Who is your counterparty in equity markets?

Equity investing is tricky, for multiple reasons.

A lesser discussed aspect is : Who is your counterparty in a transaction?

When you buy a house, you know the seller. When you buy gold, you know the seller: the jeweller!

When you buy stocks, do you know who is the seller?

It is impossible to know who the specific person (counterparty) is.

It is not needed to know the specific person. Knowing the category of the counterparty can help you make better decisions.

The various stakeholders in equity markets are: promoters, domestic institutional investors, foreign institutional investors, and retail investors.

As a retail investor, here are the following possible outcomes of trading with the above mentioned counterparties:

  1. Promoters: Imagine for a moment. You are buying a stock and the promoter of the company is the counterparty (seller). What are the odds of making money in such investments? Well, there are various scenarios possible here: a] The promoter holds more than 75% in the company and hence is selling partially to comply with SEBI regulations. b] The promoter has some insider info and hence expects a fall in business. The promoter is privileged to have access to quality information and outsiders do not have that information. If you get on the other side of the promoters during a trade, chances of making money in that transaction are thin.

  2. Domestic institutional investors: The DIIs are fairly patient investors. This is so because the source of their money is mainly through mutual funds. Retail investors, when they participate in equity markets through mutual funds, are fairly patient. If you end up buying a stock which DIIs are selling, high are the chances that the DII knows something which you may not be aware of. Needless to say, the machinery available with the DIIs for keeping track of companies is more sophisticated. Again, being a counterparty to the DIIs, leaves retail investors with lower chances of making money in those transactions.

  3. Foreign institutional investors: Just like the DIIs, the FIIs too have good ways of keeping track of latest happenings with their investee companies. However, compared to DIIs, FIIs usually have lower patience levels. The lower patience is attributed mainly to the fact that the source of their capital lies outside the country. Many a times FIIs sense troubles within the country. Some examples are: a potential war with a neighbouring country, rising inflation or depreciating currency, political instability in upcoming elections, danger to the democracy of a country. During such cases, FIIs do not think twice before pressing the panic button. Such panic selling often leads to heavy volatility in equity markets. On numerous occasions, the underlying turmoil or insecurity is short lived and stability quickly returns to the markets. As a retail investor, if you can predict with a fair degree of certainty that FIIs pressing the panic button is overdone or unwarranted for, it makes sense to grab that buying opportunity. Making a panicky FII as your counterparty in the transaction can prove extremely beneficial in the long term (predicting the short term is tough during volatility).

  4. Retail investors: Having another retail investor as your counterparty, is more often than not a zero sum game. Sometimes the counterparty wins and sometimes you!, eventually knocking off the gains and losses. But, there are instances when your analysis is different from the counterparty's. Retail investors in direct equities have a lower level of patience. If the stock prices stop moving, boredom quickly kicks in. Most retail investors come to the stock markets for adrenaline rush. When the markets stop moving, a lot of retail investors choose to exit the markets and swear not to come back ever again! Grabbing good quality stocks from the boredom struck retail investors has very high chances of making money in the long term!

Analysing the shareholding pattern of a company may be helpful in providing insights on who the counterparty could be. Let me give some examples. Domestic institutional investors usually like companies that generate positive cashflows and deliver high return on capital. If you find such a company, please take a look at how much percentage of the company is owned by DIIs. If you observe that DIIs presently do not own any stake in the company yet, ask yourself the reason why DIIs are not yet invested in that company. Many times, the promoters of smaller companies are not accessible to investors. They choose not to conduct regular earnings conference calls, or their annual reports are not detailed. In such cases, DIIs find it difficult to understand the company in detail. It makes sense for them to skip such companies. Another instance why DIIs might skip a company is 'low free float'. When DIIs want to invest in a company, they often want to have a significant stake. In the case of low free float, DIIs may choose to skip that company because it often does not make sense for them to track a company, in which they cannot invest a decent chunk of their money. If you can find such smaller companies which DIIs are not able to invest for the reasons mentioned above, there are high chances of striking gold in such investment opportunities! As the business grows, many times the smaller companies start getting more accessible to institutional investors. If you can invest in such companies before they catch an institutional investor's eye, you stand a good chance of selling your stocks for a handsome profit (to an institutional investor who is likely to hop on at a much later stage).

Just like DIIs love stability in a business, FIIs love growth. The risk appetite of FIIs is usually higher than DIIs. India is a growth market and an FII that sets shop in the country wants to make the most of the growth aspect. Developed economies grow at a lower rate than emerging markets. This makes FIIs chase growth in emerging markets. If you come across a high growth company in which FIIs have started building stake, it makes sense to ask yourself a question. How likely is it that the FII would invest more in this company? If the answer is yes, you have perhaps found a good opportunity and it makes sense to get into the details. FIIs also love private placements. They usually look for companies that may be in need of fresh capital and may consider raising funds through a qualified institutional placement or a rights issue.

Summing up:

  • Buying large/mid/smallcap from DIIs --> Low chances of making money

  • Identifying companies which DIIs might buy from you at a later stage (for factors mentioned above) --> High chances of making money (Provided you select the right company as mentioned above)

  • Buying high growth companies from FIIs during panic --> Very high chances of making money (in the long term)

  • Buying quality companies from boredom struck retail investors --> Very high chances of making money.

  • Buying from promoters --> Low to moderate chances of making money

Thanks for reading. Hope this short article makes you think about who your counteryparty might be!

P.S.: These are high probable outcomes. Nothing is certain, especially in equity markets!

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