One of the comforting factors for many investors during the Sensex rise to 21,000 was the valuation was still intact for many stocks. If bullish investors still didn't resort to profit-booking it was due to the fact that the average PE multiples hadn't run out of control. The common message from many fund managers was that the 2010 rally was different from that of 2007 mainly on this count. The recent correction in that sense is bound to throw up some questions.
While equity as an asset class has the ability to generate handsome returns over a long term, it also throws up uncomfortable corrections at regular intervals. The challenge, hence, for investors is to manage volatility through an effective investment strategy, right choice of stocks or funds, and align the portfolio with the overall objective of wealth management.
While timing is not a skill that can be perfected in a short period of time, stock picking requires tremendous patience and understanding of the company and environment. Again, this is a trait which can be perfected over a period of time and becomes less challenging when markets are in a downtrend. Since the current environment offers such an opportunity, here are some tips for value picking.
Large-caps or mid-caps?
After the meltdown, a stock in the mid-cap segment always looks a lot cheaper than the large-cap ones, but investors with a medium-term and medium risk appetite can stick to large-cap stocks. History has shown repeatedly that any revival in the market mood is driven by large-cap stocks and more importantly, liquidity and fund flows will be always dominated by large-cap stocks.
The current environment is no different. Hence, build your portfolio around largecap stocks with a time horizon of 18-24 months. Even within large-cap space stick to sectors which have visible earnings growth.
In the case of mutual funds, the strategy can be similar and diversified funds do the job of focusing on large-cap stocks. While sectoral funds and mid-cap focused funds have the potential to deliver better returns over a long term, they carry higher risk when compared to general funds.
A systematic approach through systematic investment plans (SIPs) or systematic transfer plans (STPs) could prove more beneficial.
Go by PEs
A simple tool to track the market valuations is the price-earnings (PE) ratio of a stock. Here, you can focus on both the average PE of the indices in general and the stock in particular. In a downtrend market condition, the challenge is less as the PEs are in a comfortable range. The task is demanding when the market mood is buoyant and liquidity drives the trend. For instance, during September-October 2010, many stocks had PEs in excess of 40 but no one was complaining.
Growth and PE
While a low PE can be comforting, check out the sector and the environment in which the company is operating. In the current scenario, the draw of PE is not comforting for a number of real estate stocks as the macro is still not rosy for the sector. Similarly, the company-specific environment can lower the PE even if the industry in general enjoys a good PE rating.
Coming back to the current scenario, the near 2,000-point correction in less than a month, has once again removed the excesses from the system. While a further dip of 5-10 percent could still be on the cards, the current market scenario should not be a worry for investors with an investment horizon of 2-3 years.
