Don’t panic!


Director, Banyan Tree Advisors

December 20, 2011

Here’s the chance to restructure your portfolio.

THE WORD ‘carnage’ best describes the happenings on Dalal Street of late. The pink papers are awash in a sea of red and the rumour mills are spinning out a new sob story every day. Yes, there’s a lot of bad news out there.

Negatives abound. To start with, there’s the threat of a US recession–after several years of staggering growth, the US economy is showing signs of a slowdown, a prospect that has most world markets in a tizzy. US technology companies are finding it hard to match the astounding growth rates of the previous two years. As a result, technology stocks are getting hammered.

Then, there is the Tehelka expose, which threatens to bring down the government. And above all are the allegations of price manipulation and a payments crisis on the Indian bourses. In other words, there’s really nothing but bad news floating around. So, is it time to hit the panic button before the whole shithouse comes down in flames?

Ignore the momentum. The answer to that is an unequivocal no. Buying stocks during a frenzy and selling out in a crash is what sheep would do. And we credit you with far greater intelligence than that. The logic of the panic-stricken is that
there is downward momentum–so the market is going to go lower. Or something like “let me sell now–I can always buy it back lower”. This is a bit like the logic that drove IT stocks to five to 10 times their current values in February 2000. Would you sell your house just because the value of your locality is falling in the real estate market?

The truth is that when stocks fall off a cliff, it is precisely because of all the fears being expressed by all and sundry. While I cannot say with certainty that all these fears are unfounded, the truth is that stock prices currently reflect much of the bad news. You have to ask yourself two questions. One, am I certain that all these fears will come true? Two, will all stocks be affected uniformly?

Is the sale of toothpaste, for instance, affected by any of these fears? Will banks stop functioning? The market does not reward those who think with the crowd–because then you are part of that mob that is either rushing into a room or getting out of another. And you know what happens when you do that!

So, what should you do? You can either despair over what might have been or turn the prevailing weakness in the market to your advantage. Fact is, there are great money-making opportunities out there, provided you go about it the right way. A key component of this exercise entails reviewing your investment portfolio.

We present a five-step guide to carry out a mid-course correction.

STEP 1: Pare your trading positions

Much of the bloodbath on the bourses is because speculators (today, this includes people in all walks of life, thanks to the proliferation of trading terminals) were carrying positions far beyond their means. Trading on margin entails a lot of
risk. Badla, for instance, allows you to leverage yourself three to five times (in plainspeak, this means you can buy up to three to five times your bank balance in the forward market). When the market turns bad, as it has, a 20 per cent fall in
your stock can wipe out your entire capital in one stroke. While the risk of owning stocks is overplayed in our country, trading on badla is definitely hazardous and can lead to serious losses. We would advise you to either take deliveries of your trading positions, or square off the trades and book losses.

Agreed, some of you are probably carrying huge amounts of losses in your trading account, and the urge to make that one trade that will help you recover your losses is perhaps very strong. But that is precisely what a losing gambler does–he bets more and more until he loses everything! This should be a lesson for all speculators to stop trading on the basis of momentum. Don’t confuse speculation with investing, and you won’t find yourself on the wrong side of reason.

STEP 2: Clean up your portfolio

One of the peculiar features of stock markets is that the baby often gets thrown out with the bath water. When a crash like this occurs, in an effort to make good the losses of losing positions, speculators often have to sell everything they own.
This results in a lot of good companies getting hammered for no good reason.

Such aberrations in the market are a good time to do some spring cleaning of your portfolio. Take a good look at your stock holdings, and ask yourself the reason for holding each one of them. If you understand the business of the company you own and have faith in its management, hold on. Selling in panic would be disastrous.

However, all of us have some skeletons in our closets–stocks we continue to hold simply because we are continuously reminded of the loss we’ll have to face up to if we sell them. As long as we don’t sell, we don’t have to acknowledge the loss.

Ask yourself if your assessment is based on reason or driven by hope? If it is the latter, you may be better off taking that hit, and reinvesting the proceeds in commonly-acknowledged quality stocks. The returns might not be spectacular, but
they will be surer.

Here are a few quick tips that will help you in this flight to quality. The first thing to check about the stock you own is the integrity and intelligence of the management or the promoter. Any hint of notoriety on their part is good enough reason to stay away from the stock.

Next on your checklist should be the quality of the business, as measured by its ability and track record of free cash flow generation (net profit plus depreciation less capital expenditure) and a high return on equity. The last point on the
checklist is the tax rate. A high tax rate (above 20 per cent) usually implies that the company is not fudging its numbers. While a low tax rate does not necessarily mean that there’s something wrong, when you have 7,000 companies to choose
from and no access to management, it’s better to be safe than sorry.

STEP 3: Review your sectoral exposures

This is also a good time to do some sector reallocation. Technology stocks, which have been the flavour of the market for the past two years, are clearly out of favour. And while there are a lot of good software companies out there, generating healthy cash flows and with decent management to boot, there is a lot of junk in the name of technology and high growth. Also, the level of uncertainty in the technology sector has definitely increased over the past few months.

Moreover, current trends suggest we are not about to enter a period of certainty any time soon.

Although the technology sector does offer the lure of making quick returns on a rebound, there is no telling whether this bounce back will happen from current levels or from much lower levels. Hence, we would recommend you to wait for the
air to clear a bit before taking an aggressive stance in this sector.

The bearishness in the market has also brought down many old economy warhorses to reasonable valuations.

Given the current risk-reward equation, both new economy and old economy stocks seem to offer a similar upside (as long as you stick to good companies at reasonable prices), while the potential downside is not quite known for technology
companies. The intelligent investor would keep a balanced portfolio and ensure that no sector forms an extraordinarily high proportion of his total equity portfolio.

STEP 4: Rethink your asset allocation

There is no doubt that equities are attractively-priced at this point in time. More so, when you consider that avenues for earning a good rate of interest to beat inflation are few and far between. In many cases where they do exist, the  accompanying risk could be significant.

This crash provides the lucky few who have stayed overweight on debt to go out and increase their equity exposure. The exact quantum of this shift would depend on your income needs, age and appetite for risk. Experts believe an individual’s
equity holding in a portfolio should range between 25 per cent and 75 per cent.

Depending on where you fall in the spectrum, it may be a good time to increase your exposure to equity.

STEP 5: Stagger your purchases

While share prices are definitely low right now, there is no telling they won’t go lower. When the market gets nasty, the pendulum usually swings to an extreme. It is very tough to say whether we have reached that point. We may have, but no one really knows. So, instead of trying to catch the bottom, stagger your purchases.

Make some purchases now and then wait–if you are lucky, you may just get a point some time soon when the howls of panic are so loud that the roar is deafening. That would be the time to do some aggressive shopping. But remember at all times to stick to quality stocks.

The last word on investing is patience. The stock market is not for people who consider it to be a casino, where you make your money (and lose it) quick. Yes, the losses can sometimes be quick and easy, but the rewards only come to those
who have the ability to wait. So, once you have invested, do not expect your money to double in double quick time–and don’t keep looking at the pink papers daily to see how your stock has done. Do you check the market price of your house or your real estate investments every week?

Remember that Dire Straits song: “There’s always sunshine after rain/these things have always been the same”? To put it in pallid prose, bad times don’t last forever. Nor will this market remain forever in the dumps. But just make sure your ship is ready to weather the next storm.