Wading through correction
Investors have to gauge the underlying reason for correction before acting

The current corrective phase in the stock market would, in all probability, run for more time. All along, it has been a smooth, five-year run for the market from August 2013—when the bull phase started—except for three interregnums in which stocks saw two phases of correction with over 10 per cent losses and another one with over 20 per cent losses.

So corrections are not something new; they happened in the past and will happen in the future, too. But the sad part of this is that in all the three phases of correction, mid- and small-cap stocks lost much more that what the broader market indices reflected. Such incidence happens because most investors fail to recognise a correction until it hits the benchmark indices.

Finally, the market is into a ‘media acknowledged’ correction now, as the benchmark indices have corrected and probably the broader market correction that started three weeks back might continue for more time. The headwinds emerging from both domestic and international markets and high stock valuations are a perfect setting for more correction.

As usual, retail investors are now prone to draw conclusions that lead to wrong buy or sell decisions, which ultimately burn their fingers. This is the most common occurrence in all corrections.

In order to make the right decisions in a corrective phase and cut loss or profit, an investor has to take three aspects into consideration.

First, know the underlying reasons for a corrective phase. A correction happens for various reasons—global, local, sector-specific changes in business conditions, regulatory changes …the list is endless.

Second, make a distinction between corrections in broader market indices, sectoral indices, sectors and finally specific stocks. These are very different, though are all part of the equity market eco-system.

Third, recognise that correction in each of the above might be happening for varied reasons and at different time points.

Phase of correction

Let’s take the current phase of correction. The equity market has been correcting for the large part of 2018, but was not always visible on the benchmark indices, which have rather hit new highs in July and August. So, for a Nifty investor or trader, the correction has started only now. But for the majority of investors holding mid- and small-cap stocks, the correction had started way back in January. Only that the pace of correction has slowed for them in July-August.

Going forward, the benchmark indices could correct sharply, though the overall damage could be contained within a 20 per cent correction. The composition of the indices prevent them from falling steeper. Take the Nifty. the high weightage of IT stocks like TCS and Infosys would come to its rescue even if financial heavyweights like HDFC and HDFC Bank fall—they have already corrected 10 to 14 per cent from their recent highs and they don’t normally correct beyond 25 to 30 per cent, which statistically reduces the probability of them correcting faster.

PSU banks and private banks have probably seen their worst and may not now contribute big-time to index correction. Though some of the exchange traded fund (ETF) money may move out, domestic flows will counter-balance them. So, the overall correction would be least in the broader market index.

Specific sectors

Sectoral indices are likely to benefit from the law of average; bad performance of some stocks would be offset by the good performance of some others. However, sectoral under-performance can sometime get extended, which means while the broader market indices recover, sectoral indices might take longer to recover. But if a sectoral indice has high-weightage stocks, its speed of recovery is faster.

Now an investor has to guess which sector is going to ever remain corrected in a corrective phase. Take the realty sector. No realty stocks is now, in 2018, ruling above the range it had hit in 2008. Most are down some 80 per cent. It will be tough for these stocks to recover now. The plight is the same for infrastructure stocks.

Another sector that shows the same symptoms of the infrastructure space—where rookie companies got sky high valuations on assuming new names and gaining media attention—is the NBFC space. Some of the non-banking finance companies are quoting at unjustifiable valuations; some of them are recent entrants, which probably have seen just one credit cycle where interest rates have been going down and their ability to sustain in a rising rate regime and recover loaned money are yet to be tested. Some may go bust, still the sectoral indices representing NBFCs may hide this because of strong stocks like Bajaj Finance and Bajaj Finserve.

Finding reason

Most investment mistakes are committed at the stock level. While the broader market indices and sectoral indices hold some scope for covering up the bad with the good, no such leeway exist for individual stocks. Accidents like Gitanjali Gems and PC Jewellers do happen and are waiting to happen. Plenty of stocks still command high premium on the back of fudged books. Some skeletons have tumbled out of the cupboard in the last nine months, and many more will come out as the rotation of auditors happens.

When an auditor raises objections and refuses to sign a balance sheet, an investor should get out of that stock. And pronto. Serious audit objections have been raised in some 180 to 200  companies.

Investors should also get out of companies with high leverage levels, since a correction is a high-risk event. If the leverage level of a company has not come down in a rising interest regime, take that as a danger signal and make an exit. The ability of a management is tested in tough times and the last couple of years had been rough and patchy enough to test any management’s ability to change and adapt.

At this point, investors should also keep away from stocks that have gone under the hammer under the Insolvency and Bankruptcy Code. Many investors seem to have assumed that just because a new set of promoters has come in, a stock price will recover. It may or may not be the case. In some cases, where an Indian promoter with a good track record is buying the company, there is a probability that it might remain listed. But if a company is being taken up by a private equity fund or a foreign company, it may just be delisted later and one would remain a shareholder of the private company. An investor has to realise that he is not investing in a stock to become a venture capitalist!

rajivnagpal@mydigitalfc.com

(Rajiv Nagpal is consulting editor, Financial Chronicle)

Columnist: 
Rajiv Nagpal