Equity markets are witnessing heavy bouts of volatility due to a variety of reasons, such as a global growth slowdown, devaluation of yuan, sustained decline in oil prices, expectations of increase in interest rates by the US Federal Reserve, the credit crisis in Greece, and so on.
The recent stock-market mayhem has led many shares to touch their 52-week lows in terms of price, making them available at half the price-to-book value. Is it, then, a good opportunity for investors to buy these shares based on such parameters?
While there is a popular saying that “those who try to catch a falling knife only get hurt”, we also know that buy on ‘low’ and sell on ‘high’ is one of the strategies in stock selection. Let us discuss in detail as to how one should go about stock selection in a volatile market.
There is enough empirical evidence that the market always recovers. For instance, the S&P 500 gave a return of 367% five years after the Great Depression in 1937 and 178% after the great recession of 2009. This is a clear signal that one should not exit the market when it is volatile. If you are in the market with a long-term horizon, you have to be ready for the market going through short-term ups and downs.
Invest in defensive firms
Defensive companies are those whose future earnings are likely to withstand even an economic downturn. They have relatively low business risk and not much financial risk.
Typical examples are public utilities or grocery chains — companies that supply basic consumer necessities. There are many advantages of investing in defensive shares.
First, a defensive share’s rate of return is not expected to decline during an overall market fall. Even if it does, the fall is less than the overall market’s. Second, a defensive stock tends to have a small positive or negative beta due to which its returns are unlikely to be affected significantly in a bearish market.
Avoid cyclical companies
A cyclical company’s sales and earnings will be heavily influenced by aggregate business activity. Examples would be companies in the steel, auto, and heavy machinery sectors. Such companies will do well during economic expansion, but perform poorly during a contraction.
This volatile earnings pattern is typically a function of the company’s business risk in terms of sales volatility and operating leverage and can be magnified by financial risk. In a cyclical share, the changes in the rate of return are greater than that of the overall market because these shares tend to have high betas— they have a high correlation with the aggregate market, and greater volatility. When the market is volatile in nature, investors should avoid cyclical companies.
Give speculative companies a miss
A speculative company is one whose assets involve great risk, but also have a possibility of great gain. A good example of a speculative company is one involved in oil exploration. A speculative stock possesses a high probability of low or negative rate of return and a low probability of normal or high rate of return.
Specifically, a speculative share is one that is overpriced, leading to a high likelihood that during the future period when the market adjusts the stock price to its true value, it will experience either low or possibly negative rate of return.
Speculative shares outperform in strong bullish markets as investors have a higher degree of risk tolerance. On the other hand, these shares underperform in bear markets as investors tend to move towards large-cap shares assuming that they will be stable after the bullish period.
Check current portfolio
Check your current portfolio. If you are running with too much risk, be it equity or derivative or any other exotic product, it is not right to redress your position. If at all you wish to make any changes to your holdings, these should be done keeping in mind the goal of maintaining (of course, with a recovery potential) the portfolio’s growth.
Unfortunately, if you have reached your downside limit, you need to get to an appropriate asset mix by selling stocks.
To conclude, no one can predict, with reasonable assurance, as to where the market is heading in the short-to-medium term. Making significant changes to your portfolio during market stress leads to lower prices and higher emotions, which is fraught with danger. As an investor, you should be agile, and focus on long-term returns and care more about how your portfolio as a whole is performing rather than reacting to short-term ups and downs in equity markets.
What to do
* Stay invested. If you are in for the long haul, be ready for ups and downs
* Invest in defensive firms, that is, those whose future earnings are likely to withstand even an economic downturn
* Avoid cyclical companies whose sales and earnings are heavily influenced by aggregate business activity
* Give speculative companies a miss whose assets involve great risk, but also have a possibility of great gain
* Don’t adjust portfolio at the drop of a hat. If at all you wish to make any changes to your holdings, these should be done keeping in mind the goal of maintaining the portfolio’s growth
The writer is associate professor of finance & accounting, IIM Shillong