How to Invest in a Falling Market?

Indian equity markets are in the free fall phase from the past one month. Both the benchmark indices i.e. Nifty 50 and Sensex plunged 10.7% or 1234 points and 10% or 3838 points respectively during the period September 03, 2018 - October 08, 2018

Source: NSE

The recent fall in the market has resulted in heavy losses in the portfolio. Due to the fear of further correction in the market investors start selling their current holdings or avoid tracking their portfolio. Some investors even start thinking that investing in equities is a loss making activity, and hence, they decide not to return to equity markets ever. However, investors should not follow this approach and should consider this fall as an opportunity to buy or accumulate quality stocks to create wealth in the long-run.

Following are the key points to be considered while investing in markets during correction

Check the fundamentals of the company

Fundamental analysis is the keystone of investing in equities. It helps to understand the business outlook, financial performance and management of the company. An investor should select companies with good growth potential, expansion plans, fair valuations, stable management and nil corporate Governance issues for investment. However, during the bull market, even the stocks of the companies with low growth potential, corporate Governance issues or expensive valuations also rise. But as soon as the market enters bear phase, these stocks start correcting. Thus, investors should avoid investing in such stocks in the correction phase as they lack good fundamentals and may result in losses in the future.

Follow Systematic Investment Plan (SIP)

Generally, investors plan to exit from their equity investments in the falling market and sell the shares with good fundamentals too. According to us, when the market is falling, an investor should go for systematic investment plan in the companies with good fundamentals. This is because, in the bear phase, good stocks may correct more than what their fundamentals justify and are available at cheap valuations. On the bounce back, these stocks can double the wealth of the investors.

Buy Low Sell High

The key rule of investing is “Buy Low and Sell High”. This means buying more shares if the stock falls below the purchase price so that the average holding price comes down. However, averaging is advisable only when company fundamentals are not deteriorating and the fall is due to poor market sentiments. The advantage of a falling market is that good quality stocks can be bought at cheaper valuations. Therefore, the gains to be made can be substantially higher.

For instance: You buy 100 shares at Rs200 per share (for Rs20,000). If the stock falls to Rs100, you lose Rs100 per share or 50% of the investment. At this stage, if the fundamentals of the company look strong you can buy more 200 shares at Rs20,000. It will bring your average purchase price to Rs133 per share.

Margin of Safety (MOS)

Margin of Safety is a comfort level that an investor has while buying a particular stock. A good company can be a terrific investment if bought at an expensive valuation. Therefore, an investor needs to identify the point at which the margin of safety is the highest for the investment. At this level, the company can offer the maximum MOS and can be a good bet of investment.

For instance, let us compare the historical performance of Graphite India

Source: Ace Equity

It can be seen that Graphite India’s stock price has jumped multifold in the past 5 years. However, the real performance came in the past 14 months when the stock outperformed the broader market by huge margin. This was supported by shutdown of graphite electrode manufacturing capacity in China to curb pollution. This turned out to be positive for Graphite. If the stock had been bought in the first quarter of 2017 then it would have offered highest MOS.

Avoid Herd Mentality and be Patient

The investment decision of typical equity investor is influenced by their friends and relatives. If everybody is selling in the bear market, then he may also follow the same. However, this strategy will back fire in the long run. Therefore, if the stock’s business outlook, financial numbers, valuations and management looks promising then an investor should hold the stock in the falling market and wait for the right price to sell in the future. As the volatility rises, do not panic and sell your investments. Keep tracking the fundamentals, avoid acting on rumors and have conviction in your analysis.  This will help to earn good returns in the future.

The above mentioned points are discussed from behavioral point of view. Now we shall discuss in which sectors an investor should invest in the falling market

Invest in companies with higher exports

Source: Ace Equity, Bloomberg

The Indian rupee has depreciated ~12% in the past one year. It has touched a low of ~Rs74 in the current year. Rupee depreciation brings cheers to export oriented companies that earn a major part of their revenues in dollars. However, it is a challenge for companies with higher imports. In India, Pharma and IT companies’ earn revenues in USD. For example, Syngene International and Aurbindo derive maximum revenue from exports, while Infosys had earned 60% of its revenue from US in FY18. Therefore, it is advisable to invest in fundamentally strong pharma and IT company stocks.

Avoid putting money in oil oriented companies

Source: Ace Equity, Bloomberg

The price of Brent crude has surged nearly 49% in the past one year. India meets ~80% of its oil demand from imports. Hence, oil marketing companies (OMC) are likely to see pressure on their margins. Similarly, the input cost for aviation, paints and plastics industries may also rise. Moreover, the auto sales numbers of the automobile companies may also decline due to increasing crude oil prices. Therefore, it is suggested to adopt wait and watch approach while investing in these respective sectors.

Prefer Banks over Non-Banking Financial Companies

Source: Ace Equity, Bloomberg

The 10-year bond yield has been rising through the past one year. Rising interest rate does not augur well for the NBFCs, as majority of their borrowings are met through external markets (debentures, NCDs and CP). Whereas, banks majorly rely on deposits in the forms of CASA and term deposits to meet their funding requirements. This minimizes the interest rate risk for banks compared to NBFCs.

 Conclusion