Bears manhandle but should you trust the red candle?
We all have just 24 hours to work, eat, sleep, dream, gossip, shop, chat on WhatsApp, watch videos, discuss politics, assume new responsibilities, and plan our future.
You see, planning the future has so many competing tasks? Thus, our future success largely depends on how intelligently we utilize our time, more so, when it comes to investing.
How many times does it happen that you read avidly, hear podcasts, watch videos—to keep up with developments in the investment world—but often end up drawing the same conclusions that are available already?
If this happens to you quite often, you perhaps don’t best utilize your time as an investor and depict first-level thinking patterns. In the lingo of Howard Marks, first-level thinking is superficial and attempts to spot obvious outcomes that every other first-level thinker may forecast.
In that case, it might make much more sense for long term investors to invest in markets only through Systematic Investment Plans (SIPs) offered by mutual funds and spare time for other activities. Let experts handle your investments. Living stress free is crucial, isn’t it?
However, if you want to invest in stocks on your own, to generate above average returns, you may have to develop second-level thinking. Second-level thinking goes far deeper and looks beyond the obvious.
Let us offer you more clarity.
Inflation and interest rates are the burning issues at present.
Inflation is going through the roof globally and central bankers are likely to raise interest rates faster than anticipated earlier. Perhaps, the world economy is likely to hit a rough patch in the foreseeable future, so I must sell stocks—first-level thinking.
How a first-level thinker typically arrives at conclusions
But how about this interpretation: Yes, high inflation may cause a recession but everybody who should know this might already know this. That’s why stocks have been falling. So should I buy since the worries are overdone? This is second-level thinking.
Here’s a caution!
The second-level thinkers wouldn’t buy stocks just because everyone else is dumping. In fact, they might consider a range of outcomes. This includes pondering on what if a consensus view turns out to be true, and stocks languish. Or, what if the market brushes aside the consensus view?
If the second-level thinkers find that chances of making money by betting against the consensus view are high, they might ignore the noise and invest. The opposite is also true.
Please don’t forget, until October 2021, majority of investors and even central bankers believed inflation was transitory. A second-level thinker would have become wary of rising prices and thought of a range of outcomes including what if the consensus view goes wrong and inflation keeps creeping up?
In short, there are only two ways to generate above average returns—outsmart or out-research other investors.
As an individual investor, it may not always be possible to out-research other investors. And that’s why, predicting macro-events such as index levels, interest rates, inflation etc. would be a futile exercise for most individual investors.
So how can you outsmart first-level thinkers?
Think like an old-school test match cricketer. Don’t try to hit every ball out of park. Instead stay longer at the crease. Wait for a loose ball. If you get one, don’t be scared to score the maximum.
For those who don’t follow cricket; you need not take unnecessary risks but when markets present you with opportunities, don’t miss them.
To be able to do that, you should be ready with a basic list of stocks that you want to work with when markets crash.
We thought of making your job easy.
Read this as a BIG FAT DISCLAIMER: the stocks listed later in this article are neither recommendations nor hints in any form. At best, you can treat them as companies worth placing on your watch-list.
We took Nifty 500 companies as our stock universe, out of them only 450 companies have so far declared FY22 full-year earnings.
Below is the process we followed to narrow down the list:
Step 1: Shortlisted companies that have clocked higher revenue growth in FY22 as compared to that in FY21 and in FY19 (to check where they stand vis-à-vis pre-pandemic times)
Step 2: From this pool, we shortlisted companies that clocked better EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) margins in FY22 than in FY21 and FY19
Step 3: At this stage we excluded companies that earned less than Rs 100 crore of net profit in FY22. Scale of profit matters during testing times, after all
Step 4: Next, we also filtered out companies having a Net-Debt-to-EBITDA ratio of more than 1
Step 5: Excluded companies that earned a Return on Equity (RoE)/ Net Worth (RoNW) of less than 15%
This left us with just 61 companies. In other words, 86% of companies failed to pass our stress test. Given below are 15 companies that scored well on the two most important parameters EBITDA margins and Return on Equity.
Superior EBITDA margins suggest that a company has a good bargaining power with its suppliers and customers. It can pass on rising prices to its customers. Similarly, higher RoE suggests that the company is running its operations efficiently.
As you would know, Price-to-Earnings (P/E) ratio often suggests how overvalued or undervalued a stock might be. However, please avoid an apple to orange comparison. A metal company, especially at the current stage of a cycle, would have a lower P/E as compared to that of a tech company and so on.
At this stage, some metals companies are under the weather due to unfavourable changes in export policies, besides mounting recessionary pressures.
How much of that is already factored in prices and what may still make metal companies a good buy? A second-level thinker may try to find out answers to such questions.
Need more examples?
Some pharma companies are eying high growth opportunities over the next 3-4 years. However, their valuations became very expensive just before the on-going market correction started. Dominant positions held by Foreign Portfolio Investors (FPIs) and subsequent FPI selling affected them badly.
Moreover, raw material price inflation, port-congestion, container shortages, and a challenging pricing-environment in major export markets affected many export-oriented pharma companies negatively.
Second level thinkers may want to track the developments on these counts. And they might be interested in finding out if the market is worrying too much about valuations and short-term hiccups, completely ignoring mid and long term growth opportunities? The same holds true in the case of IT companies.
Pro Tip: The first indication of exhaustion of a downtrend is when a stock stops reacting to negative news and rises instead, after a prolonged fall.
You may also like to read: Can new players give Asian Paints and Berger Paints a run for their money?
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