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Only buy stocks that will gain from the change in the business cycle and are run by competent managers
The equity markets are running up again. The return of optimism means a sense of urgency about investing. Most investing mistakes are made when this frame of mind dominates the investing decision. When the market moves up after a prolonged bear run, quality becomes crucial. If investors do not have a framework for selecting stocks, they may be seriously disappointed.
Cut back to 2008. It was the time when every business was optimistic. Broking firms were raising money from IPOs and expanding furiously. Real estate companies were going public on the basis of their land banks and construction plans. New companies across media, roads, power, telecom and technology were confident about revenue and were borrowing heavily. When the markets crashed, it was not just the stock prices that were hit. The business plans of many optimists were also hit. The balance sheets of many companies and their lenders were impacted. If the equity markets have not crossed the high of 2008, it is because these companies needed time to get their businesses back on track.
When the markets crash, all stocks crash. However, it is only the best that return and rise. Investors have to choose carefully, more so when a surge in liquidity is pushing prices up and taking stocks away from the fundamentals. At the top of the cycle, momentum in prices can increase the gap between price and fundamentals. Investors believe that nothing can go wrong when they have seen a persistent bull market. Similarly, at the bottom of the market, investors expect every battered business to return to profit. The prices move up in anticipation of a brighter future and the gap between price and fundamentals widens.
What are the types of companies to buy? The top picks in a falling market are companies whose revenues are not hit by a downturn. This was why pharma and FMCG remained favourites in the past. However, as the cycle turns, the companies that turn around first are those that do not have debt on their books; those that earn cash profits and do not have net cash deficits on their books; those that have a smaller amount of debt compared to their equity capital and profits; companies that have benefited from cost-cutting in their operations; and companies with a cost structure that responds faster to increases in revenue. These companies will benefit from a change in the economic cycle.
There are three broad types of stocks to choose from:
First, fundamentally sound companies that had borne the brunt of the economic cycle, but continue to represent business portfolios that are inherently profitable and are well-managed. Such companies will not be cheap, but worth buying when the risks of business cycle abate.
Second, the companies whose managers reworked the business portfolio in the downturn so that they are able to correct the mistakes of the past. Such companies will turn out to be multi-baggers of the season.
Third, the companies that depend on the ups and downs of the business cycle to be able to make profits, but do not hold great business portfolios or good managers. Such companies will enjoy high speculative attention.
If investors are able to differentiate the impact of these three factors—business portfolio, quality of management and impact of the economic cycle—they are likely to make good choices. The others may see themselves as buying multi-baggers, but end up with speculative stocks that fall at the slightest correction. If a stock selection exercise does not involve analysis, merely the rise in price in the immediate past, investors expose themselves to high risks.
There are two other dangers in the markets.
The first is the misplaced sense of value investing.
The second is the mistaken hope about past losers.
In the first case, investors extend the optimism about the future to stocks that have fallen sharply in price. The PSU and banking stocks are a good example of this fallacy. Several investors believe that these stocks are undervalued because the markets oversold the lack of performance and NPAs. They think that these stocks should go up, only because they have fallen too much. The ability of these stocks to take advantage of a bull run could be hugely compromised due to the quality of their business and managers.
Then there are past losers. Investors in ‘past winners turned losers’ are keen to recover their losses from the same stocks. They think that a rising market will take their stocks up too. They should go back and see if the business has changed in the time that the stock was battered. Investors should ask whether there is a case for buying the stock now. If the stock is not good enough to buy at this time, its price is unlikely to respond even in a bull market. Long-term investing is a good thing to do, but long term is unlikely to make a bad stock better, unless it has fundamentally changed.
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