Profit Opportunity In Oversold Stocks

Investors are often faced with two questions – How is the market going to be? And when is the best time to buy stocks to build my portfolio?

The answer to both these questions may not be easy for a majority of investors. If the market history has taught us anything – it is the fact that some of the best times to buy stocks is during the collapses, drops, hiccups and free falls that may happen once in few years. These are exactly the tough times when the investors have to summon courage of conviction and show presence of mind to actually "buy" when the gut feeling says "sell".

 

Indeed, it is in such tough times that the investors are losing hope of grabbing multibaggers and struggling to clock decent double digit returns in the broader markets that we find plenty of 'beaten down stocks' or 'loser stocks.

Different investors adopt different investment philosophies in different market conditions. While some believe in buying growth stocks, others believe in investing in value stocks even as there are some who invest only in dividend paying stocks. Also, there are investors who bet on momentum stocks, while there are others who focus on beaten down stocks or loser stocks.

"If I could avoid a single stock, it would be the hottest stock in the hottest industry." - Peter Lynch

The ultimate goal is to beat Sensex in the longer run, no matter what strategy is adopted. Now the moot question is: which is the best strategy that can consistently beat the markets in the longer run. Any seasoned investor would know that the answer depends on how well the strategy is executed rather than which strategy is adopted. To start with, when an investor builds a portfolio, there has to be a realistic portfolio management strategy in place and the expectations of returns from the market have to be reasonable for investors to be successful. 

Says Parag Mandhana, who has been in the markets for over two decades, "In my initial investing years, I use to think I should get at least 40 to 50 per cent per annum from the equity markets. And I was not disappointed in my early years of investing career. I managed to get even better returns than 50 per cent in some years. But now I think I will consider myself a successful investor if my portfolio grows by 12 to 15 per cent per annum in the coming 5 to 10 years. Ittakes a lot of maturity to realise that the market in the ultra long term can deliver returns in the range of 10 to 12 per cent per annum." 

Parag further adds, "I have adopted various strategies in the markets, but somehow buying the loser stocks or these so-called beaten down stocks excite me the most. For me, it is far less risky that buying an overheated stock where the investor community is betting a lot. Must confess though that buying loser stocks is for seasoned investors and needs equity research skills that are above average. The strategy has worked for me in the past and I am confident that if I follow my stock selection filters in a disciplined fashion, I am going to generate alpha for my portfolio." 


Ramesh Shinde was an independent thinker and always succeeded in his business adventures. He was convinced that the rest of the world can be irrational most of the times and the trend of being irrational is getting stronger. One day while he was reading a financial daily he noticed that a reputed telecom company's share price was down by more than 70 per cent in less than a year. Quickly his instinct suggested that the share price of this company, that has been in the market for more than two decades, cannot go any lower. He immediately called his broker and bought 1000 shares of this beaten down company at Rs 30 per share. After one month, he noticed that the stock price has further fallen to Rs 20 per share and sticking to his original philosophy, Ramesh purchased another 1000 shares at Rs 20 per share, convinced that the stock should rebound anytime. On the contrary, the stock kept falling steadily. After couple of months, the same stock was now available at Rs 8 per share and Ramesh continued to back his investment thesis – that this beaten down stock cannot get any lower and averaged one more time by buying 1000 shares at Rs 8 per share. It turned out the company was declared bankrupt and the share price was close to Re 1 per share in no time, while Ramesh Shinde was holding on to his investments with huge losses in terms of percentage returns.

Once the stock price reached close to zero, the only consolation for Ramesh was that the stock price had finally hit its bottom and the price could no longer go down any further.

 Moral : Buying a stock only because it is down by 70 per cent or 80 per cent can be injurious to your portfolio health.

Investors while choosing beaten down stocks for the portfolio exposure should also assess if the company has any chance of survival as it usually takes long term for the company to get out of woods. Hence, adequate attention should be given to the leverage factor and the trend in profitability. Some signs of recovery in profits will a lot of good to build investors' confidence and bring the demand back for the stock that has come down heavily.

What are loser stocks ?

The loser stocks can be said to be those stocks that have fallen anywhere between 40 to 50 per cent in normal market conditions. In a free falling market condition, we can say that the loser stocks are those that have fallen in the range of 60 to 80 per cent. The loser stocks are the ones which have witnessed sudden fall in prices owing to change in business environment, government decision, corporate governance issue, technology disruption, product failures etc.. Often the reason could be a mix of some of these factors. 

Why look at 'loser stocks' at all ? 

Loser stocks are losers because of some reasons. There is also a theory that goes around in the market that says winners keep on winning and loser keep on losing. While there are several studies that support the above argument that winners keep on winning, while losers keep on losing, the result actually depends on what sort of data (time horizon) we are discussing here. In the short run – yes winners have been proven to do better than the losers, but the results are not same when we consider a five-year time period. Momentum investing is all about betting on those stocks that are trading close to their 52-W highs or even their life-time highs. Momentum stocks are found to be doing well for an investment horizon of one year, however the same cannot be said when an investor builds a portfolio for a five-year period. 

It is found that if an investor buys the bottom performers in a given year and builds an equal weighted portfolio and shows patience to hold on to the portfolio for over five years, the results are miraculously different than if the portfolio of losers was held for one year. 

We find that in the year 2011 when the broader markets were reeling under pressure 137 stocks out of 500 constituents of BSE 500 were down by more than 50 per cent. Out of these 137 stocks almost 122 stocks delivered more than 100 per cent returns. In other words, almost 89 per cent of the oversold stocks managed to generate more than 100 per cent returns in three years. These oversold stocks delivered on an average 202 per cent returns in three-year period.

If we extend this observation to smallcap stocks basket we find similar sought of results. (refer table BSE Small-cap index: Loser stocks performance) 

We saw atleast 191 small cap stocks which were constituents of BSE smallcap index that were down by more than 50 per cent in 2011. Out of these 191 stocks 91 stocks turned out to more than double in three years- time frame while delivering 223 per cent returns on an average. These returns suggest investor would have made Rs 2,23,000/- as pure profits from an investment of Rs 1,00,000/- (Not including transaction costs) in three years. If the similar set of stocks were held for five years Rs 1,00,000 would have been Rs 5,90,450.

 

If an investor was to adopt a similar strategy of buying loser stocks in 2013, the 42 small cap stocks that underperformed in 2013 managed to deliver on an average 155 per cent returns in three years and 371.98 per cent returns in five years period. Almost 13 stocks out of 42 stocks managed to more than double in three years while 28 stocks out of the same list of 42 stocks managed to generate more than 100 per cent returns in five-year period. 

The broader market performance in the year 2018 and 2019 have been somewhat similar to the 2011 market performance. Chances are there will be several multibaggers emerging from the small cap space in coming three to five years. 

Over a five-year period, the loser stocks have shown tendency to recover and actually beat the markets. In fact, positive results are seen after the first three years. But then, does one need to buy all the loser stocks in order to remain diversified and safe?


 Risks of buying 'loser stocks' or beaten down stocks is

1. Beaten down stocks are often riskier than other stocks as at lower prices, the volatility increases. (Beta is high for loser stocks).

2. Sudden fall in the stock prices often increases the financial leverage and default risk

Rama Tanay Ratnam
Director and Head of Products, Centrum International Services Pte. Ltd.

Good stock which do not have an event risk but still are beaten down can be a good opportunity to invest, one has to analyse these opportunities in detail and should be willing to wait. As the principle of value investing suggests, do not own a stock for 10 minutes if you are not prepared to hold it for 10 years. When a company goes into the sluggish phase, whether it is due to a decline in its prospects, business cycle, economic shock or due to an event, many investors start to think and might enter a new position or exit a position in the same company. This can be profitable for both speculators and value investors, but is a double-edged sword, and investing in these beaten down companies should always come with checks and balances and thus a set of rules. Some basic set of rules for finding the right opportunity and the way of investing in these opportunities are as follows:

1. Look at the valuation from a bear case perspective, and the discount that is on offer in the market for the opportunity. (Use all major multiple based valuation metrics and cash flow models)

2. Read as much you can about the company, all news and articles plus their financial statements

3. Consider the company's credit rating and its outlook

4.  Use technical metrics to find the trends in the stock price and compare with peers; some metrics I use is enhanced RSI and enhanced Bollinger bands along with volatility

5.  Make sure that the event risk is considered and understood from a valuation perspective

6.  Have patience as there is a possibility that the price might fall further after you acquired the stock before it starts to outperform

7.  Acquire the stocks in smaller portions

How to build a portfolio of beaten down stocks? 

The most important aspect to remember while constructing a portfolio of loser stocks is to understand whether the underlying problems that caused the stock to deliver negative returns have been resolved. It can be the most important aspect while buying beaten down stocks and yet the most difficult one. While identifying such companies, it will help investors to check if there is any change in the management as any new management is willing to not only accept the mistakes of the previous management but also expected to have a refreshing look at the business problem on hand. 

Investor can also assess the restructuring actions undertaken by the company. Often investors can pay attention to what some of the heavily invested parties have to say about their investments gone wrong and what in their view is the solution. For example, there could be a pension fund or a mutual fund that has a sizeable exposure in the beleaguered company. The suggestions and advices of mutual funds are usually accepted by the company when it comes to taking remedial steps.

Conclusion 

While on paper the idea of investing in those stocks that have been beaten down heavily in the recent past looks promising, it is a high beta strategy and many times investors are not willing to face or accept the risks associated with such a strategy. The strategy of choosing beaten down or loser stocks can work if only when one applies appropriate filters for stock selection. While placing filters for choosing beaten down stocks, one must remember to avoid penny stocks and highly leveraged stocks and only those stocks should be chosen where there is a hint of recovery in the profitability. Higher weightage can be given to those stocks where the company has declared profits in the latest quarter after posting losses for several quarters. The past returns can considered from the previous years where only those stocks are studied which have fallen by more than 40 to 50 per cent. Identification of the business problem is a must for such stocks and the tentative recovery plan's forward looking implication should be assessed with greater scrutiny. 

This strategy has a potential as there is a tendency of overreaction to negative news in the markets and also due to investor psychology which disallows investors to identify recovery in loser stocks. Hence, there are multiple opportunities for investors using the strategy of buying beaten down stocks. 

Several studies have shown that the beaten down stocks do perform well in the longer run, however investors should be willing to witness negative returns before they finally start witnessing positive returns in this strategy. The most important aspect for investors while adopting this strategy of buying beaten down stocks is determining the long term investment horizon. A five-year holding period for a portfolio of beaten down stocks is advised, and even then, one must remember it is not a risk-free strategy.