Investing in a bear market requires a different mindset: a strong value orientation and an attitude that rejoices declines instead of being petrified by it. Beat the current market slump by adopting the Warren Buffett way
With the Sensex plummeting below the 9,000 mark last Friday, investors have heard one phrase with chilling regularity: bear market. Battened on a five-year-long bull run, they will now need to change their strategy to survive the bear market that is upon us.

What?s a bear market?
While no textbook definition exists, a bear market can be identified by its unique characteristics. First, stock prices fall off precipitously. On the heels of the steep fall comes a long spell during which prices remain range-bound. What also distinguishes a bear market from a run-of-the-mill correction is that the prices of a majority, and not just a few, stocks decline. A bear market also signals a weakening economy and is marked by widespread pessimism. And finally, the supply of stocks far exceeds demand.

According to Jayesh Shroff, senior fund manager, SBI Mutual Fund, ?Any fall greater than 33 per cent and a period of subdued stock prices that lasts longer than six months could be called a bear market.?
Since its peak in January, the Sensex has declined by more than 50 per cent, and this phase of subdued prices has lasted about nine months. Hence, the current phase definitely qualifies as a bear market.

How long will it last?
For an answer to this question, let?s turn to the past. The first bear phase lasted four years from September 1994 to November 1998. The second one lasted three years and two months from February 2000 to April 2003. The current one, which started in January this year, is barely nine months old. Going by historical precedent, the current bear market could last another two to three years.
However, history might not necessarily provide the right answers. One view is that the current bear spell could be shorter as economic cycles are getting shorter. The contrary view holds that this bear phase could last longer since the financial crisis in the Western world that has spawned it is of a once-in-a-century magnitude.

What is certain is that the stock market is unlikely to revive in a hurry for a variety of reasons, both external and local:
FII inflows. More than 50 per cent of the funds from foreign institutional investors (FIIs) coming into India originate in the US. Till the crisis in the US gets sorted out, FIIs are unlikely to return.

Liquidity crunch. Despite the repo and CRR cuts by the central bank, banks are not willing to lend, preferring instead to park their excess liquidity with the Reserve Bank. So corporates are not getting the money they need to fund their expansion plans and to meet their working capital needs. Their cost of borrowing is also rising. All this is expected to erode profitability. According to Amar Ambani, head of research at India Infoline, ?Profitability growth for Sensex companies could shrink to 10 per cent in FY09, and to as little as 5 per cent in FY10.?

Elections. Political factors will also play spoilsport. First you have the state elections (November-December) and then the central elections (April-May 2009). Typically, it takes a new government three to six months to settle in. During this period few policy decisions are made. Hence, 2009 is likely to be a dull period for the stock markets.
Says Shroff: ?I expect the market to start moving up in the last quarter of calendar year 2009.?

Don?t forget the economy?s strengths?
While the present and the near future may be gloomy, as a long-term equity investor you should not lose sight of the inherent strengths of the Indian economy, which are likely to translate into strong corporate, and hence stock-market, performance over the years.
Resilience. India has been growing at 9 per cent and above for the last three years. Even with deceleration, it is likely to clock a 7-7.5 per cent growth, second only to China?s.
Demography. In 2020, the average age of an Indian will be only 29 years old, compared with 37 for the Chinese and Americans, 45 for West Europeans and 48 for Japanese. A young and expanding working-age population is expected to lead to higher demand and saving, which will in turn drive consumption and investment.
A large population with rising per capita income also means that the economy will be driven by domestic demand. A slump in the US will not impact it as much as the economies of export-driven countries.

Low credit penetration. The credit to GDP ratio in our country is low by international standards. In India it is 69 per cent, much lower than the level in China (136 per cent), UK (161 per cent), and the US (222 per cent). What this implies is that there is a lot of scope for credit-fuelled consumption to grow.
Outsourcing. Currently, the outlook for the IT-ITeS sector may appear clouded. But outsourcing is a trend that cannot be reversed overnight. If Western companies are under pressure to cut costs, they will have no option but to outsource work to low-cost destinations such as India.

?Nor overlook its weaknesses
The Indian economy is also beset by many weaknesses that prevent it from achieving its potential.
Dependence on foreign capital. There is a gap between the level of domestic savings and the level of investment required to sustain the economy?s 9 per cent and above growth rate. This gap is filled by foreign funds. According to Apoorva Shah, senior fund manager, DSP BlackRock Investment Managers, ?This year the dependence on foreign funds is creating a problem because money is tight abroad. For the short term, we can tide over this problem by using the reserves that RBI has built up. If their problems last for just one year, the Indian economy will not be affected much. But if they last, say, for three years, there will be an impact on growth. We will have to grow at the rate that can be sustained by domestic savings alone.?

Reliance on imported oil. Oil constitutes nearly 70 per cent of our import bill. Though crude prices have fallen from their $145 per barrel peak to about $61 currently, our oil import bill will not get the full advantage of the fall due to the rupee?s depreciation.
High fiscal deficit. On paper the fiscal deficit might be only 4 per cent. But when one takes into account the off-balance sheet expenses (like oil bonds, fertiliser subsidy, and farm loan waiver), the deficit is likely to be of the order of 8-9 per cent. If government borrowings balloon, they crowd out private-sector borrowing and investment. Says Amar Ambani, head of research, India Infoline, ?A high fiscal deficit, and much of it off-balance sheet, means that you are accumulating a bill that you will have to pay in future.?

Poor infrastructure. India has also not been adequately proactive in upgrading its infrastructure. ?It is estimated that 1.5-2 per cent GDP growth rate gets shaved off because of lack of infrastructure,? says Hitesh Agarwal, head of research, Angel Broking.
Lack of attention to agriculture. In the last four to five years, most of the government spending has gone towards boosting infrastructure and manufacturing. It has not paid adequate attention to agriculture because of which the sector grows at barely 2-3 per cent annually.
For the last three years we have been lucky to have a normal monsoon. If and when there is a monsoon failure, agricultural output would be affected, which would in turn impact GDP growth.

When will FIIs return?
With 10 per cent ownership, FIIs constitute the most important block of investors in the Indian stock markets after promoters. This year FIIs have so far withdrawn about $12 billion from India. The revival of the stock markets will depend on how soon they return.

But no clear answer to this question is available. Says Shah: ?It will depend on how much time it takes for the toxic paper, which the financial system in the West has invested in, to clear up.? Adds Agarwal: ?Globally central banks have infused a lot of capital into the system. Therefore, I believe that the banking crisis has been taken care of.
The liquidity crisis will, however, continue for some time as investors? confidence has been hit. FIIs will continue to sit on their cash for some time and not invest it for fear of further redemption pressures.? According to Ambani, ?Usually a recession in the US lasts 12-14 months. But the current problem is a once-in-a-century event. More problems could tumble out of the closet in future, such as defaults on credit cards, student and auto loans. The worst is not over yet for the US economy.?
Ambani is however confident that when the recovery happens India will be one of the first among emerging markets to recover.

Are valuations attractive?
The Sensex is trading at a PE ratio of about nine times forward earnings for FY09, way down from the PE of 21-22X at its peak in January. Says Agarwal: ?After April 2002, this is the first time that we have such attractive valuations.?
But others add a caveat. Stocks are cheap only from a long-term perspective, they say. They could still be expensive in the short term because the earnings estimates on which these PE numbers are based are suspect. Says Shah: ?There has been a lot of demand destruction throughout the world and business has slowed down. Earnings estimates will have to be revised downward.?

In a similar vein, Ambani says: ?A few months ago, people spoke of EPS for the Sensex for FY09 at 1,000 plus. Now estimates have been downgraded to 975. My sense is that EPS estimates are likely to be downgraded further to about 935. For FY10, a lot of analysts are assuming a 12-15 per cent growth. But EPS may grow by hardly 5 per cent. So the EPS of 1,000 may not come about even next year.? The bottomine: the current prices are attractive only if you can hold on to stocks for at least three to five years.

No alternative but to invest in equities
Over the long term, if you wish to beat inflation and earn returns higher than from fixed-income instruments, you have no alternative but to invest in equity. Here are a few more reasons that should convince you to stick to the conventional asset allocation (100 less your age is the percentage of your portfolio that should be invested in equities):

Diminished downside risk. Investors have suffered a decline of above 50 per cent. At the most the markets could decline by another 15-20 per cent. If you can tolerate this downside risk, you should continue to invest in stocks. ?The risk-reward equation now favours buying,? says Shah.
What you should also take into account is your level of exposure to equity. ?If you have high exposure and low tolerance, then don?t invest in equities. But if you have low exposure and high tolerance, continue to invest,? adds Shah.

Stay in the markets. Most market experts suggest that you should not exit now and attempt to re-enter the market when the climate improves. ?It is very difficult to predict the bottom. Moreover, when sentiment turns, markets recover 20-25 per cent in the blink of an eye,? says Agarwal. If you are out of the markets then, you will miss out on the recovery.
Invest systematically and for the long term. The markets are likely to bottom out over the next three to four months, so stagger your investments to minimise your cost of purchase. And invest with at least a three- to five-year horizon. The longer your investment horizon, the higher is the probability that you will earn index-beating returns.

Moderate your expectations. The last five years, which have yielded returns of 40-50 per cent, have skewed investor expectations. It is time now to moderate your returns expectations. Says Shroff: ?Now the risk-free rate of return has increased to 10 per cent, and the risk premium has also widened. Let us take that to be another 10 per cent. From current levels, 20 per cent is what you should expect from equities over the next two-three years.?
Eschew leverage. Invest your own funds that you will not need for the next three to five years. Do not invest borrowed money.

What to buy?
If you plan to invest in stocks by yourself, here are tips that will stand you in good stead.
Look for value. Avoid expensive stocks. ?Any stock whose PE is higher than that of the Sensex is likely to get hammered,? says Ambani. The stock price should not already discount a high growth rate. And the anticipated growth rate should not be suspect. Stick to companies with high growth visibility.

Cash rich. Look for stocks that are cash rich and low on debt (see table where we offer a list) as at present funding is the biggest bottleneck. Such companies will not have problems related to working capital needs, and in funding their expansion plans.
Stick to large-caps. Large-caps will have greater resilience and will be able to withstand the market downturn better. ?Buying good-quality stocks that are part of the index and holding them for three to five years should yield good returns,? says Ambani.

Go for rural plays. The monsoons have been good for the last few years. And the loan waiver scheme has injected a lot of liquidity into rural markets. Disposable incomes have risen in rural areas. ?Companies with large proportion of revenues coming from rural markets are likely to do well,? says Ambani.

If you need further convincing about whether you should invest in equities in a bear market, remember: Warren Buffett, the world?s greatest investor, recently said he is buying US stocks (despite, or rather because of, all the carnage there). Or look up the five-year return for the Sensex. Despite all the hammering, last week it still stood at 16.5 per cent. Not too bad, is it? Or read up legendary investor John Templeton?s recent biography by his grand niece to learn about the advantages of investing at the point of maximum pessimism.