Stock investing and the boiling frog syndrome

If you are interested in psychology or behavioural economics, you’d surely have come across the boiling frog syndrome. The theory goes that if you try to dunk a frog in a pot of boiling water, it will immediately jump out. But if you place it in cool water and slowly heat up the pot, the frog will ignore the small changes in temperature and simply boil to death. 

Thankfully, sceptical scientists testing out this theory have found that the smart frogs of today do not stick to this script. They do escape when the water gets too hot to handle. But the boiling frog syndrome does apply to human behaviour in many facets. For instance, climate activists argue that we humans are steadfastly ignoring hotter summer temperatures, colder winters and more frequent extreme weather events, because we would not like to recognise the existence of climate change. 

Can the boiling frog syndrome apply to equity investing? After taking stock of the investment mistakes that I’ve made in my portfolio, I think that the boiling frog syndrome applies to portfolio decisions too!  

If you are a fundamental investor, you buy a stock based on the positive triggers that you see to the company’s growth, earnings or valuations in future. But sometimes, you become so attached to the stock you bought that even if none of the positives you expected are coming good, you hold on. You keep hoping against hope that the stock will somehow deliver, despite the changed circumstances. Even seasoned investors and analysts are not immune to this syndrome.

BPCL’s strategic sale saga

A classic example of this is the stock of Bharat Petroleum Corporation Limited (BPCL), the public sector Maharatna engaged in oil refining and marketing. 

BPCL began to feature in the coverage lists of leading brokerages in November 2019, when the Indian government announced that it was going to divest its entire stake of 52.9% in BPCL to a strategic buyer in a bid to privatise the company. Past strategic divestments by the government, such as the sale of Hindustan Zinc and Balco to the Vedanta group and CMC to TCS have delivered enormous wealth to shareholders, so markets were quite enthused by the move and pushed up the stock to Rs 524 levels in October 2019 (which in hindsight proved to be its five-year peak). This event also swept the stock into the coverage lists of many analysts. But this trigger to re-rating has till date remained only on paper. 

The saga goes like this. In March 2020, just after the government invited Expressions of Interest from private bidders for BPCL, Covid’s first wave hit and the tender received a very tepid response. With Covid-related uncertainties hovering over the demand and pricing outlook for oil, the offer had to be extended multiple times. Meanwhile, contractual terms forbade BPCL from being sold to a private bidder while it still held a stake in Numaligarh Refinery. 

After long parleys, during which hopes were fuelled by BPCL fetching a good price for this refinery, BPCL divested its stake in Numaligarh Refinery to a set of PSUs and the Government of Assam at a modest price of 8-10 times earnings in March 2021. But if investors were hoping that this sale would push things along on the divestment front, it didn’t. 

As crude oil prices began to climb and oil marketing companies like BPCL were ‘persuaded’ not to hike selling prices, prospective investors began to question the government on its indirect price controls over oil marketing companies and seek assurances that it would refrain from interference. This was perhaps not forthcoming. So, after extending the EOI date multiple times, the government finally decided to call off the BPCL stake sale in April 2022. 

Meanwhile, BPCL’s fundamentals took a distinct turn for the worse. With crude oil prices rising and oil marketers not allowed to peg up their selling prices in line, BPCL has slipped from sizable profits into losses of over Rs 6,000 crore in the recent April-June 2022 quarter. All this has led to the stock being a consistent wealth destroyer in the last three years, falling from the peak of over Rs 520 hit just after the strategic sale news, to Rs 331 now. Thanks to losses, its PE too has moved up sharply from 15-16 times in November 2019 to over 25 times now.

Living in denial

But bullish analysts have refused to give up on the stock, incessantly issuing ‘buy’ calls after every negative event, citing triggers such as a likely fall in global oil prices, gains from future privatisation, a foray into city gas distribution and even BPCL’s mission of being a net-zero emitter, to justify their buys on the stock. Here’s what different brokerages said about BPCL over the last 18 months, amid the steady trickle of negative news.    

After the strategic sale didn’t find takers for a year

February 2021 Prabhudas Lilladher: Buy at Rs 422, Target Rs 505 

“We change our FY23E earnings estimates by 32% to incorporate inventory gains of Rs37.8bn in 9MFY21. FY22/23 earnings are changed by 6%/4%. During Q3FY21, core standalone EBIDTA adjusted for inventory gains and forex gains was at Rs34.6bn (+178%QoQ) due to higher marketing earnings. We believe uncertain global demand and high inventory levels will likely keep crude oil prices range bound to support marketing margins in medium term. Meanwhile GRMs will recover with pickup in economic activity and lower operating cost (due to soft spot LNG prices) will support refining earnings. BPCL remains one of our preferred divestment plays in the oil and gas sector.”

After sale of Numaligarh to other PSUs

May 2021 Motilal Oswal: Buy at Rs 468, Target Rs 570

“The company made huge progress towards privatisation in FY21, despite challenges posed by Covid-19, by streamlining its subsidiaries (divested its entire stake in Numaligarh Refinery Ltd., consolidated its stake in Bharat Oman Refineries Ltd., merged Bharat Gas Resources Ltd. with Bharat Petroleum) and sold off its trust shares.”

After government pressure on pricing hurt margins 

March 2022 HDFC Securities: Buy at Rs 364, Target Rs 420

“We are positive on Bharat Petroleum Corporation Ltd., given it has corrected ~30% from its peak over the last six months, owing to pressure on auto-fuel marketing margins and an increase in liquified natural gas under-recoveries. We believe the recent correction is overdone, and see BPCL's limited downside from current levels, led by improvements in refining margins, resumption of daily auto-fuel price changes, and a gradual reduction in LPG under-recoveries.”

After strategic sale is officially called off

June 2022 Nirmal Bang Securities: Buy at Rs 314, Target Rs 393 

“BPCL management aims to achieve net zero emission goal, including green hydrogen target of 10GW by CY40. Initial plans include Rs50bn investment to set up 1GW of green hydrogen capacity using electrolysis at its Bina refinery site (erstwhile BORL). The company is also investing Rs275bn in the city gas business across 25 GAs. BPCL’s future plans straddle both green as well as traditional fuels. This envisages investment in EV charging facilities and conventional fossil fuels, based on the positive growth outlook in India/Asia over the next 10-15 years even as it pursues green energy projects and its net zero target.
We maintain Buy on BPCL based on fundamentals of refining (which offer potential upside to street estimates), stable retail earnings (assuming eventual decline in oil prices from current unsustainable highs), additional margin from the new petchem project at Kochi and long-term cash flow potential from its CGD projects.”
After slipping from profits into losses

August 2022 Nirmal Bang Securities: Buy at Rs 334 Target Rs 391“BPCL reported standalone loss of Rs62.91bn for 1QFY23, which was higher than NBIE/street estimate of a loss of Rs28.9bn/Rs46.4bn, the higher loss was due to the higher-than-expected loss in the Marketing segment and higher forex loss. We maintain Buy on BPCL post our revised estimates and 0.4% decrease in the target price on an unchanged PE of 6X. We have cut FY23E by 42.8% and FY24E a tad.”

Regulatory change

In the BPCL case, investors have been subject to the boiling frog syndrome on developments within the company. But this syndrome is more common when the risks to a company’s prospects arise from external risks such as regulations. The Indian fertiliser industry is a classic example of this. 

In the last couple of years, stocks of India’s leading fertiliser makers such as Coromandel Fertilisers, Chambal Fertilisers, RCF and so on, have been on investor’s radar because of favourable factors such as good monsoons, rising global food prices and a global rise in fertiliser prices owing to the Russia-Ukraine war. Investors buying into the sector have been willing to ignore the fact that every aspect of operations for a domestic fertiliser maker is heavily controlled. Domestic fertiliser companies whether they make urea, DAP or complex fertilisers are required by the government to sell their products far below costs, with the difference between their actual cost and controlled selling price reimbursed as subsidy by the government. 

For long, players such as Coromandel or Chambal have managed to survive and expand profits in this highly regulated industry through extension activities, brand building, distribution strengths and the ability to come up with unique NPK combinations that farmers take to. With effect from this October however, the government has put an end to such product differentiation by bringing in new draconian rules for the industry. 

The new rules require all companies to do away with all branding and marketing activities and sell their different products under a single “Bharat” brand and sell fertilisers only in their immediate vicinity to save on freight costs. The Indian government is also making a push for running government-owned retail outlets for fertilisers and for replacing traditional fertilisers with “nano” versions, after testing out nano urea. These developments pose an existential threat to private players who have made legacy investments in brand and marketing of fertilisers. They will now have to find alternative means of rescuing their profitability in other agri inputs. (If you are a Growth subscriber you can read more about this here). But both the broking community and individual investors have been unwilling to rethink their bets on fertiliser stocks.

What you can do

The above instances show that the boiling frog syndrome does affect you as an equity investor. If your stock portfolio has a long tail of companies that no longer excite you and act as a drag on the performance, you are likely a victim of this syndrome. You may have bought into companies or sectors convinced of their brilliant prospects, but haven’t exited those bets when subsequent events took away those positive triggers to earnings or growth. 

Recognising the ‘boiling frog’ stocks in your portfolio at an early date can help you free up cash by selling such stocks and adding to exposures in companies with much better prospects.

Guarding against them

Here are three ways to ensure that boiling frogs don’t do damage to your long-term portfolio.

• Write down your investment thesis: We humans are hard-wired not to admit to mistakes. That’s why we saw those analysts, in the BPCL case, inventing new and creative reasons to rate the stock a buy even after the initial thesis had completely failed. With a personal portfolio, admitting to mistakes is much easier (you don’t have to make a public declaration of it!). So do maintain a journal of the 4-5 reasons why you are buying a stock, when you take on any new position. Later, if you find that the triggers you expected are not materialising or are vanishing, you’ll find it easy to sell the stock. 
• Monitor your stocks and sectors closely: If you’re a direct equity investor, there’s no escape from keeping close track of the company’s corporate actions, exchange filings, quarterly results, investor calls et al to see if the earnings are on track. In addition, you need to track the external environment for the sector and regulatory changes to identify if the investment case is becoming weaker. 
• Set a stop-loss: Fundamental investors can learn a lot about not being dogmatic from short-term stock traders. Most serious traders do not take large positions in a stock or index without a pre-set stop-loss. The stop-loss which is usually fixed 5% or 10% below the trader’s buy price, ensures that the trader does not lose too much capital and cuts losses quickly if his bets go wrong. Fundamental investors need not exit at a 5% or 10% dip in the stock price below one’s buy levels. But if you set alerts for the stocks you own falling, say, 20%, 25% or 30% below your buy prices, such alerts will force you to re-examine your investment thesis. If a stock has fallen 20-30% below your buy price, it’s a clear indication that either you timed your entry wrong (in which case you may decide to hold on or average) or that your thesis was wrong or that subsequent events have changed the investment case for the stock (which may call for a sell).