Beaten down stocks have different risk-reward characteristics compared to trending stocks and have the potential to provide a good rate of return and beat benchmark indices
Of late, investing in the stock market has been most confusing for individual investors. The Sensex reached its all-time high in January 2020 followed by a fall of almost 40% during March 2020 and again recovered 46% from March lows to August 2020. During the same time, BSE Small-Cap index recovered 56%and Mid-Cap index by 48%. In such a scenario what should investors do and is there still scope to participate in the market?
Reasons for the fall
Though the World Health Organisation (WHO) had sounded an alert about a new coronavirus during the last week of December 2019, it had not affected India then. The magnitude of the pandemic was realised only when it hit our country and the number of cases and deaths started moving upward.
Based on the WHO announcement, many countries suspended passenger traffic to stop the spread of coronavirus. This threatened smooth functioning of businesses.
India also prohibited entry of any international cruise ship, crew or passenger with travel history to corona virus-hit countries to its major ports.
Meanwhile, foreign institutional investors (FIIs) have continued selling Indian stocks. As per NSE data, FIIs have been net sellers every day since February third week. In March alone, they withdrew a net `20,831 crore from domestic markets. The carnage in March is also partially attributable to oil related fund-based selling as there was a sharp fall in crude oil prices.
Reasons for the recovery
Various announcements of the Reserve Bank of India on lending and supporting the economy sent positive vibes to the market. Sectors such as MSME, NBFC, rural economy, banks, etc., were the beneficiaries. The pharma sector has regained attention of the investors after three years of underperformance. Cement, metals and auto are favoured sectors in the short to medium term. The smart recovery is also attributable to Foreign Portfolio Investors (FPIs) as they like to invest in high beta stocks, especially in emerging markets such as India.
Can investors consider beaten down stocks?
Despite such a wonderful recovery, there are many stocks that have not fully recovered. Let us call them beaten down stocks. For our discussion purpose, let us define beaten down stocks as those shares whose prices have fallen by more than 50% from the January levels. It is easy to recognise these stocks but difficult to invest as momentum is lacking in such stocks. Essentially, beaten down stocks have a great potential to provide a good rate of return and could beat benchmark indices once investors recognise such stocks.
How to choose among beaten down stocks?
Before investing in a beaten stock, investors should study about each stock. Investors need to identify the major problems faced by those companies and identify the possible solution which might trigger recovery.
For instance, if the courts have given a favourable verdict to a telecom company on computing its adjusted gross revenue or a reputed group is investing a significant amount of money in it can be interpreted as a good signal.
To conclude, beaten down stocks have different risk-reward characteristics compared to trending stocks. So, investors should carefully choose beaten down stocks for a higher risk-reward ratio than simply investing only in momentum stocks.
Down but not out
- Beaten down stocks are those shares whose prices have fallen by more than 50% from the January levels
- Momentum is lacking in such stocks
- Investors should carefully choose beaten down stocks for a higher risk-reward ratio than simply investing only in the momentum stocks
- Before investing in a beaten down stock, identify problems faced by that company and possible solutions which might trigger recovery
The writer is a professor of finance & accounting, IIM Tiruchirappalli