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How to spot value stocks in a beaten-down market

Category : NCFM-Capital Market

Source: The Economic Times (Published on Jan. 16th, 2012)

It is a strategy as old as the stock market. Hunting for stocks at attractive valuations in the beaten-down sectors, especially when the market is down and out, has always been considered a sure shot formula to make money. No wonder, the theory has some takers in this market too.

And for obvious reasons: the market benchmark BSE Sensex lost 22% in 2011, and there are some sectors, such as banking (BSE Bankex -29%), power (BSE Power -38%), capital goods (BSE Capital goods -46%) and real estate (BSE Realty -49%), which have underperformed broader markets. Some of the stocks in these sectors have crashed much more than their respective sectoral indices.

Does it make sense to go for some of these beaten-down stocks in troubled sectors? "A stock of a company with sound business in a beaten down sector available at a beaten-down price can be a high-risk high-return opportunity, which can add alpha - superior returns over market returns - to your portfolio. One can consider investing 5% to 20% of his portfolio in such stocks depending on his risk taking capacity," says Rikesh Parikh, head- equities, Motilal Oswal Securities. Needless to say, you have to be extremely careful when you invest in beaten-down stocks.

Choosing the right horse

"Never buy a stock just because it is in a downtrend or it is at 52-week low or have lost 90% from its 52 -week high. It may be cheap, but it can be cheaper tomorrow," says a fund manager with a mutual fund. "Investors getting anchored to numbers such as yearly-low, 90% down from the yearly-high run the risk of landing on the wrong side of the market. The stock may not fall from these levels. But may not participate in the up-move when the sector comes back in blue or the market sentiment improves, if underlying business is not doing well," adds the fund manager.

Though fall in the stock price is a good starting point, it cannot be the only factor to buy a stock. "You have to understand the business of the company and sector dynamics. Identify factors that have pushed the stock price down," says Abhishek Jain, head of research, JHP Securities.

A good understanding of the business and sector can help you make an informed decision. If you understand the factors that have pushed the stock price, you can track them better. You can also estimate how these factors may play out in the near future. For example, if you are considering a banking stock, you should understand the interest rate scenario very well. The upward moving interest rates have brought down credit demand, increased non-performing assets, raised the cost of funds and marked to market losses on bond portfolios - in short, a recipe for disaster.

In such a situation, if you expect interest rates to go down in a couple of quarters, it makes sense to have a look at banking stocks.

Rising interest rates have also impacted infrastructure stocks. But that is not the only factor. Rising commodity prices was also a reason to worry. Segment specific factors too played key role. For example, capital goods companies saw stiff competition from cheaper imports resulting into lower margins. If you are expecting some improvement in factors that have caused the stock prices to go down, you can buy the stock.

For example, if you expect the government to introduce some protection in the form of heavy import duty of more than 30% on capital goods, it will aid the margins of domestic manufacturers which in turn make a capital goods manufacturer worthy of investment.

"Be with a market leader. Market leaders in respective sectors are picked up first by investors when sentiment improves," says the fund manager.

There has to be a possibility of improvement in business in foreseeable future. "Never buy a stock if the very existence of the company is questioned," says Rikesh Parikh.

Hoping for a better tomorrow does not count. Especially, companies in debt trap are to be seen with utmost care. Though the interest rates are expected to come down, the company in debt trap should be in a position to get its loans restructured and then service them over a period. If there is no clarity on how the situation will improve for the company, just stay away from such stocks.

Risks

Investors may do all the due diligence before buying a beaten down stock, but still they are exposed to some risks. The first is going wrong on assumptions. For example, what if you are buying banking stocks with a premise that interest rates will come down over next one year by at least 1%, and the opposite happens? Obviously, you may be in for a rude shock. The stock that you bought cheap may become even cheaper.

Promoters and management of such companies also play a key role in such situations. If the management fails to post earnings growth by taking advantage of improvement in business environment, the stock may not rise when sentiment improves. Risk of sustained underperformance of stock to sectoral peers and broad market may drag down your portfolio returns.

The Right approach

A disciplined approach can help an investor to mitigate the risk effectively and benefit from any opportunity. Identifying the bottom of the stock price is a difficult task. "Always buy in tranches on bad news affecting broad market sentiment. Never commit all your money at one go," says Abhishek Jain. After you have finished buying into the stock, you have to introduce a stop loss price for the stock, based on how much loss you can take and more important strictly adhere to the stop loss price.

"You have to keep track of your investments at regular intervals, especially factors in which you are expecting an improvement," says Rikesh Parikh.

If things don't improve within the time frame you have decided, be prepared to accept the loss. If the underlying factors are moving as per your expectations, it is likely that the stock price will follow. Be patient with such stocks, sometimes they may take time as the market may spend more time than expected to build the confidence in the stock.

"The biggest risk is selling too early when the stock starts moving up with improved fundamentals and improved sentiment," says Abhishek Jain. You can choose to exit in a phased manner with trailing stop loss.

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