Picking up stocks of fundamentally strong companies

Picking up stocks of fundamentally strong companies during the corrective phase on certain valuation benchmarks could benefit investors when the market turns around

"There is nothing so easy to learn as experience 

    and nothing so hard to apply" 
    —Josh Billings 
    This seems enduringly applicable to equity investors, especially during the market volatility in the last one and a half year. The last year bear market plunge and the subsequent rally have baffled investors and traders worldwide due to the sheer price moves in both directions. 
    In retrospection while it may be easier to say that one could have ridden the trend both ways and benefited from the swings in prices, it is very difficult to pinpoint an opportunity to enter the market during a phase when such sharp price moves take place. 
    However, an ET Intelligence Group study of the last three major corrections in the markets since 2003, show that it is possible to benefit from the corrective phase of the market by accumulating stocks of leading companies which have sound fundamentals and which closely follow the market trend. Even if it may not be possible to bottom pick these stocks, various valuation yardsticks can be explored to buy them at an appealing price. As and when the market revival sets in, these stocks can either be sold for profit booking at an attractive price or kept in the portfolio for long term returns. 
THE DRILL 
For the study we considered the data since 2003, the early period of the biggest bull run for the domestic markets. It thus encompasses two major corrections, one in 2004 and the other in 2006 besides the historic fall of 2008. We selected those companies, which sustained their presence in the major indices. This criterion helped us pick companies that maintained their position in the leading indices through out all ups and downs of the market due to their operational and financial performances. For simplicity, we have restricted our analysis to companies that are part of Nifty-50 and Nifty Junior indices and whose financial numbers are available for last seven years. Further we dropped real estate firms such as IFCI from the list. This gave us a sample of 44 companies. 
    We further refined the list by finding out the companies, which have given the maximum return by annualizing the median monthly return of their stock prices since 2003. This exercise brought to light some leading performers in terms of monthly price gains. 
    In order to highlight companies that efficiently influence the market due to their presence in the respective indices, we found out the standard deviation of the monthly return of the stock prices. Since the standard deviation is a gauge of the dispersion of a data array from its mean (or average), it can also be looked as a tool to measure volatility. Thus a higher standard deviation of a company's stock price from its mean indicates that it reacts swiftly to the move in the market, in both the direction. 
OUTPUT 
At the end of the drill we were left with companies (see the table), which not only have provided high monthly returns since 2003 but also were highly sensitive to the change in the market's direction. As the table indicates, most of these volatile stocks belong to cyclical and high growth sector including metals, automobiles, financial services and capital goods among others. As the revenue and profitability of these companies vary widely during a business cycle, their share price shows sharp and sudden reversal depending on the mood on the Dalal Street. 
    What this means is that an alert investors can use any of these stocks or a mix of them to ride the ups and down in the market and make a neat profit. Accumulate when their price is falling and start booking profits when the counter began to heat up. The question however is 'when to press the buy button and when to sell.' As we found it's not that tough, as long as you remain optimist and have the resources to play the waiting game. 
PRACTICAL EXAMPLES 
Let's take the example of Tata Steel. One of the oldest and widely tracked companies in India, Tata Steel's stock price shows a high correlation to the broader market. For instance, during the 2008 meltdown, the stock fell lost nearly 85% of its peak value, compared to around 50% fall in the market. The turnaround in its fortunes has however been equally sharp. Since March this year, the stock has more than tripled against 86% rise in the Nifty during the period. So the stock was a right candidate to play this strategy. But one may ask when was the right time to press the buy button on the stock? The signals will come from comparing various valuation ratios of a company -price to earning (P/E) 
multiple, dividend yield and price to book value (P/B) over a long period. 
    For instance, Tata Steel valuation has fluctuated between P/E multiple of 18 and 6, while the dividend yield on the stock rose to high of 6% in FY03 to a low of 2% in FY08. The price to book value ratio of Tata Steel ranged from 3.1x in FY05 to a low of 0.9X in FY01. The above valuation range act as marker for initiating buy and sell call on the stock. For example, Tata Steel would be a screaming buy if its P/E multiple falls below 6, dividends yield shoots past 6% and its stock price falls below the book value. Now cut back to the last calendar year. The stock began the year with historically high valuation ratios and as the year passed-by it got cheaper. Between November 2008 and March 2009, Tata Steel was trading at a P/E multiple of between 3 and 4 and the dividend yield on the stock was well above 10%, highest in nearly two decades and for months the stock was trading at half its book value. 
    Ditto with other leading stock listed in the table below. Let's take the case of ICICI Bank. Excluding the outliers, the stock traded in the P/E band of 15-20 in the last four years. Similarly, in terms of P/BV, it traded in the bandwidth of 2-3. In March'09, P/E touched 0.7 and P/BV was at 9.9. This shows that the stock was trading at a huge discount then. And, it would have been wise of long-term investors to accumulate it. In the current rally, its stock price has shot up. Consequently, ICICI Bank is trading at P/E of 24.5, which shows that investors should start reducing exposure to this scrip. 
    Similarly, ABB's P/E ratio touched a low of 14.2 for the month of Feb'09, more than 80% lower than its peak in Oct'07. The PE was lower than its average PE during Sept'03, nearly the beginning of the economic upturn, providing an 
attractive entry opportunity. 
    The message is clear. Have a price band for very leading stock in your portfolio. Whenever the price falls below this band; buy the stock without waiting for it to bottom-out. If it falls further, accumulate more shares, if you have the resources. Similarly, start booking profits, whenever the stock price crosses your upper price band. The reversals in the stock market are sudden and come without warning. So never be fully invested nor sell your entire holdings. Idea is to maintain the flexibility to take advantage of the market volatility. As the legendary investor Warren Buffett says, "Be fearful when others are greedy and greedy when others are fearful".