You should study history … history is important. And what you learn from history is, the market goes down, goes down a lot. The math is simple. In 93 years, market has had 50 declines of 10% or more i.e. once every 2 years the market falls by 10% or more! We call it “correction”, a euphemism for losing a lot of money rapidly 🙂 Of those 50 declines, 15 have been 25% or more. That’s known as bear market. So that means in 93 years, every 6 years the market has undergone 25% decline. That’s all you need to know! If you are not ready for that, you shouldn’t own stocks. And it’s good when it happens. If you got a stock at 14, and it goes to 6, that’s great. You understand the company, you see the balance sheet, you hoping it will go to 22 … 14 to 22 is terrific, 6 to 22 is exceptional.
Peter Lynch
One would have heard the term “bottom fishing”. The act of picking up assets that have undergone a price decline, and currently appears to be undervalued. It’s a very common strategy many employ to “buy low, sell high”. Having said that, one would also have heard the phrase “Don’t catch a falling knife!” It is a warning message to avoid bottom-fishing on ‘risky’ assets. Risk cannot be viewed as an isolated metric. Risk is always associated with something, a news-driven risk, an asset-quality-driven risk, or simply a speculative risk. In this post, I will break up some decision metrics I employ to buy a stock on the decline (or bottom fish as we say) instead of being always opportunistic. Not necessarily do I look at all the metrics as an union to make the call, but I rather utilize one or many of them to make decisions with more conviction.
Asking the FUNDAMENTALS questions …
Has this stock been a consistent compounder? I have shown two patterns of stock price movements. One has undergone a lot of non-linear trajectories with price stagnation, while the other has been a stable compounder (with intermittent dips which are buying opportunities). The latter stock shows a lot more resilience and confidence to go after. It exudes a more proven history of u-turns from declines.
Have the Sales and Profit growth been consistent and promising? I usually give a high confidence vote to a past consistent performer which continuously delivers YoY (if not QoQ). If you look at the stock example below, it builds investor’s confidence on the earnings, and as a result, the price uptrend ahead.
How good is the Promoter holding? Do they have strong faith in the stock, or is it getting diluted over YoY, along with pledging?
Asking the VALUATION questions …
How stretched is the P/E ratio? Correction could happen on a broader market level (say, an interest rate hike that squeezes liquidity out of the market, a global political unrest situation, or likewise), or just at an individual news-based (such as unsatisfactory QoQ earnings). Either way, keeping an eye on the current valuation would be a good signal of whether the correction for the stock was “healthy” for the long-run movement or not.
Consider looking at the current P/E ratio and comparing it with the trailing median P/E. Of the following two, it is quite evident which of the stock price correction would be more justified, and which one you can bet on to bounce back. For the first one, if there is a dip, it’s still well-valued, or even getting into an under-valued zone. So that would be my pick.
How sharp was the run-up before the correction? I’m not talking just about meme stocks, but a lot of popular quality stocks do get a sharp uptick based on news and short-term sentiments. The decision should ideally shift to “when to sell in that uptick”, instead of “when to buy when the stock price dives back’. The uptick was abnormal, not the pullback, is what one should understand. In such a case, it makes lesser sense to view the scenario as “Stock is down X% from its recent high”. Rather it should be viewed as “Stock was never meant to be at that high level”.
Consider this stock price movement. The 17% down may look enticing, but was the stock price at 180 sane in the first place?
Asking the TECHNICALS questions …
Is the correction within price Support Levels? If you have not checked out yet, you can read one of my previous posts on [How critical are Stock Entry Points?] (section – SUPPORT LEVEL [MID-TERM]) where I discussed the relevance of Support levels as entry points. Support Levels are purely technical indicators, and help resist the urge to enter into a stock in the slightest price dip. I have made mistakes in the past of downward averaging on even 3-4% dips only to see the price downtrend going much deeper. Too early, too soon!
Do the Trend signals indicate buying opportunities? This again, I discussed through RSI strength indicators and MACD indicators in the same post above (section – TREND SIGNALS [MID-TERM]). The idea is to make some inference on whether the pattern looks like a true trend reversal (in which case one shouldn’t be bottom fishing immediately) or it is just a blip (in which case it provides an opportunity to bottom-fish).
The fact remains that no one can accurately predict the near-term top or bottom of the stock. But building your framework and having the discipline to follow it is always a better direction than being entirely speculative. If not anything, you will learn the fallacies of your decision framework and improve on your model of investing.
