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This is not the time to buy beaten down stocks

Last updated on: January 11, 2012 12:45 IST

This is not the time to buy beaten down stocks

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Devangshu Datta in New Delhi

Bear markets play out many ways. Sometimes prices crash rapidly. Then value investors can start selectively buying under-priced stocks. There can be a rapid recovery after a high-speed bear market, if underlying fundamentals are sound.

Sometimes prices drift down over a long period. In a slow motion bear market, tired bulls gradually shift out of equity. Value investors have to wait. The apparent capital destruction in a slow motion bear market is often not that large.

But there is a time value and opportunity cost to holding assets yielding negative returns. A slow motion bear market eventually hurts much more than a high speed bear market.

Sometimes, a slow motion bear market changes character. The downtrend accelerates. This changes the psychological dimensions. Most investors find it difficult to adjust their attitude when this sort of change of pace occurs.

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This is not the time to buy beaten down stocks

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India has been in a slow motion bear market over the past 13-14 months. The capital destruction has been substantial in aggregate. But it has averaged out at a loss of about 2 per cent per month. This is in contrast to 2008, for instance, where prices dropped by over 50 per cent in 10 months.

Is there a chance that the gently sloping downtrend of 2011 will transform into a steeper Southern slope? I hope so. It is much easier to invest when there is less fear of a price downside. There are two key uncertainties for all equity investments. One is the price trend. The other is the expected time period for positive returns.

The time-horizon will always be uncertain. But if prices have already seen major corrections to levels of under-valuation, the price trend is less uncertain. In a slow motion bear market, with relatively small price corrections, one is always afraid of further large downmoves.

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This is not the time to buy beaten down stocks

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While in the middle of a slow motion bear market, one knee-jerk reaction is to sell off all equity holdings after getting tired of accepting capital losses for a long period.

Another common response is to buy stocks with apparent defensive strength (low or negative beta) while selling high-beta stocks that have lost more ground than the market index.

Both actions may be misguided when holding a diversified portfolio. A diversified portfolio will move more or less in tandem with the overall market, which means that there will eventually be a recovery. That recovery will usually be led by the stocks that have lost the most ground.

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This is not the time to buy beaten down stocks

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If a diversified portfolio is sold off within say, 10-15 per cent of a bull-market peak, that's good. But if prices have dropped by over 20 per cent from the peak, a sell off will just book paper losses, leaving no prospect of future upside. So, if you hold a diversified portfolio and you didn't exit near the peak, don't sell once prices have fallen a long way.

The second point: If a bear market lasts long enough, even defensive stocks give negative returns. Defensive stocks just lose ground more slowly. The best-performers in the early stages of a bull market are usually the stocks that have lost the most ground in the previous bear market.

So there is not much point to restructuring to become defensive in the middle of a bear market. It is better to keep an eye on big losers. As and when the trend reverses, an investor who is overweight in such "losers" usually becomes a big winner in the next bull market.

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This is not the time to buy beaten down stocks

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Selecting a portfolio of losers that could be turnaround stocks involves following some rules. One is, of course, that the company should remain in business. It may be in desperate straits. But it should still be in operation, and reporting its financials. The share should also be traded and liquid.

A second criteria is that any business problems should ideally be cyclical, rather than permanent in nature. For example, look at auto stocks, at shipping and capital goods - the problems there are major but they are cyclical.

A turnaround in the business cycle could make them big winners. But avoid beaten-down energy PSUs unless there is a balance of payments crisis that actually compels a round of reforms.

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This is not the time to buy beaten down stocks

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It isn't yet time to buy beaten-down stocks of any description. India is still in a slow-motion bear market. There is still a major downside. Right now, the best anybody with a beaten down portfolio can do is to average down systematically.

But if the Nifty loses another 15-20 per cent, preferably in a hurry, buying stocks that have dipped more than the market will be a winning strategy.

That's when a smart investor will start picking up the dogs.



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