Playing the race to the bottom.

The Indian stock markets are clearly racing towards a bottom. The negative symptoms are quite overwhelming. Index heavy weights keep regularly hitting new lows. Money shifts from cyclicals to defensives. Retail money moves out of stocks into debt instruments. Stock broking houses are practically empty and activity is at a low. FII’s are selling everyday and exiting stocks. The next phase in the race to the bottom is when desperation grows and panic sets in. The selling spreads to the mid caps which see sharp slumps when FII’s sell them. Retail investors get to the verge of giving up and go into a state of limbo. Nobody seems ready to play the race to the bottom. The over arching fear is that the bottom could be far away and entering now could only add to the pain. But, is that the right thing to do ? Are we actually helping our own cause by shunning stocks ? Let us first understand how stocks behave on this rough-ride to the bottom. And, let us decipher how we should play the race cautiously and productively.

The race to the bottom is the ultimate test of contrarian investing. Stocks tend to be dumped as people want to sell before the markets hit the bottom. The selling gets frantic and desperate when investors press the exit button and simply want out. Valuations hardly matter when investors press the exit button. This naturally leads to stock prices getting disconnected from their intrinsic value. The disconnect between the price and value exists only for a short window of time. It is the contrarians call to pick up the challenge and make the most of this opportunity.

Normally, FII selling is characterized by this pattern. FII’ s decide to reduce exposure or to exit specific markets and this macro view drives investment decisions across stocks. They do not specifically evaluate the merits of individual stocks when they hit the CTR-ALT-DEL button to shut down an entire portfolio. They relentlessly dump stocks day after day at lower prices till they have emptied their holding in a company. Typically, once all the selling by such sellers is complete the stocks gradually revive and stabilize at significantly higher levels. Subsequently, the stocks get rerated in line with the business fundamentals of the company and prices once again return to being driven by the earnings and valuation metrics of the company. This pattern plays out in every single company where FII’s decide to press the exit button.

The opportunity thrown up by the mindless selling of FII’s is the most significant opportunity in the race to the bottom. Investors need to be sensitive to this opportunity and must mentally prepare themselves to take advantage of this selling window. If someone is selling at any price and exiting a stock, a contrarian must quickly evaluate the fair value of that stock and then get ready to buy it. Before starting to buy the stock, you need to decide how many shares you would like to own and what is the fair value of the stock. As the stock trades below the fair value, the contrarian must keep buying the stock progressively as the prices drop below the fair value. You need to ensure that you have bought the entire quantity you wanted to own when the stock trades significantly below the fair value.

When contrarians are buying , it is likely that the markets may well be in panic mode. The most crucial thing for contrarians to remember is to ignore sentiment and to be focused purely on valuations. Sentiment is fickle while valuations are forever. Sticking to the valuation and basing investment decisions on them is a sure-shot way to win the race to the bottom. Get rich by racing to the bottom.

Happy investing!

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