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How to make use of market corrections

April 20, 2021

by invitation

Human nature is generally programmed on self-destruct mode when it comes to the stock markets. We want to buy when everyone is happy and join the cheer. When everyone is forecasting doom, we want to be selling and patting ourselves for having apparently got out before the big crash. This behaviour unfortunately, is very injurious to wealth.  Let me talk about the ‘market falls’ or ‘crashes’ that happen in stock markets. Here is a chart of just five years –

In this five-year period, there were at least a dozen panic moments when markets fell, with the March 2020 being the most pronounced. What you did during the falls will surely have an impact on your portfolio returns. If you sold out fearing the end of the world or thinking that you will buy lower, you have probably missed a chunk of the returns in the rebound. Emotional reactions with respect to your investment portfolio generally lead to a hit to your returns.

Going back to portfolio construction, one usually has a continuous flow of money and is either investing through a SIP route or keeps investing directly. The important thing is how much money do you keep in spare. I am not arguing with our famous mutual fund managers who say that their job is to ‘invest’ and not to keep cash. They can afford this nonsense because it is not their own money.

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Mind the rule-book

Whenever you start investing in equities, it is absolutely essential to have a rule-book ready. It tells you when to buy, when to sell, what are the measuring spoons to use and so on. And this rule book is not for show alone. You must follow the rules strictly. The rule book you make must be based on two things :

  1. Fundamentals of the company you are invested in; and
  2. Price of the company shares, using a couple of measures.

Most of the rules will flow from the above two points. Many think they can time the market. I am not one of those. For me, timing the market is always with reference to the price at which I buy or sell a specific share. I like to use two reference points to decide on buy or sell, when there is a choice to be made. They are simple and not fail-proof. I like to use the historical references to “Price to Book” and “Price to Earnings”.  

When there is a panic attack in the market, the most common reactions of an investor are:

  1. Simply stop SIPs or new investments
  2. Sell in the hope of being able to buy lower or simply sell and cut perceived losses
  3. Sell only those shares which show a ‘profit’ and hang on to those under water

These reactions are what hurt a portfolio. No one can say when the tide will turn. One should remember that today, markets move based more on funds flowing into the market or out of it, rather than on news flow. There is an information overload and there is so much money that bear markets turn out to be short-lived. Yes, I remember 2008-09. I also think there is far more money in the system searching for a home now than ever before.

Exploiting buying opportunities in market falls

If we go back to the five-year chart above, we see that every fall has been a buying opportunity. However, panic makes us do the exact opposite. The best way to prevent panic attacks in our portfolio is to have a set of rules. We must also have a decent sum of cash ALWAYS, which can be used to take advantage of unexpected bonanzas.  I can give you some recent examples.  For example, let us say, I had Cholamandalam Finance in my portfolio through the last so many years. Last year, the stock crashed with everything else. At around Rs.125 to 130, I thought it was a bargain. I picked up some more and then at near Rs 400, I exited that portion which I had bought in addition. This gives me more ammunition. The important thing is to have the discipline of holding cash and not to chase everything that moves. Using cash judiciously is important. 

I could have taken the call at Rs 150 also. Greed made me wait and luckily it paid off. My indicators told me that anything below Rs 180 was a great price to buy at that point in time. So logically I should have started buying it at Rs 180. Yes, the fall did give me some opportunity to make quick money, without disturbing my portfolio.

I have also made some mistakes. For instance, HUL generally used to trade between a 30 and 50 PE. When it went to 60 times, I sold some of it. I’m still waiting for it to revert to mean! It’s PE is now in the 70s and 80s! While it is part of my plan to reduce my exposure to equities, the continuing price surge does prove that we can never time the market to perfection. 

ETFs based on indices are great trading tools too. It MAY be easier to take a call on the index than on the individual stocks. When the world was crashing around us (in the world of stocks) last year, apart from Cholamandalam, I also picked up a chunk of Nifty BeEs from 100 and going down.  This gave me a decent fifty percent boost in good time, when I got out. It also saved me the bother of tracking individual stock prices. 

In all this, my portfolio continued without any action from my side. The market recovered and I was back on track. The rearview mirror will always show all of us to be inadequate investors. The important thing is to accept that we have a goal and so long as that goal is met, our actions have been right. If I missed ninety percent return in a year and got only seventy percent, but my long term run rate is still at fourteen or fifteen, I should not bother about changing my methods.

Use the dips to deploy extra cash. But while deploying still stick to your fundamentals. High quality at a bargain price will always give you returns. Poor quality can make you lose everything, even at any price. Imagine buying Ferro Alloys Corporation shares only because it fell to Rs.5 from its peak of near Rs.25. Even when buying on dips, it is important to adhere to quality checks. Many times, a turn in the markets also washes away some bad quality forever. Do not get trapped by the game of 52-week lows and highs. Instead, keep your quality filters unchanged whether the markets are in a waxing or waning phase.

Use the dips to deploy extra cash. But while deploying still stick to your fundamentals.

I also have a thought on the ‘extra cash’.  I use it to grab some great opportunities. However, I do not hang on to what I buy. I would like to see it get back to cash as soon as possible.

Trading profitably

I have only talked about investing above.  However, when it comes to your trading portfolio, where you may be into opportunistic stocks like commodities, use a ‘stop loss‘ on every buy. I also have a ‘stop profit’ rule. Generally, I do not want to lose more than ten percent and am happy with a thirty percent gain on my trade. My patience for the trade to get completed is less than two months. In that period, if neither boundaries are breached, I still get out. This discipline, has helped me protect my capital in the worst of times. I have had rides through many bad phases in the market. I have seen that quality is important even in trading. Today, there is this mercurial factor of excess cash across asset classes, which have re-rated every asset to astronomical levels. Panics seem to be short lived. So long as global flows of portfolio money in to our markets are not threatened, panics will be short lived. 

It is important to be aware of all the factors around us- company fundamentals drive prices over the long run. Short run (can be a many years) the stock markets may seem like a game of prices and not value. The new age has begun. Value seems to be only in the eye of the beholder. However, I am happy to keep my investment analysis framework intact while using the opportunities that the new paradigm offers.

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