Avoid high-debt businesses

MARKET INSIGHT

Investors should look at getting into stocks with a five to six year horizon. The returns could be as massive as those in the last bull run.

It is always difficult to retain a sense of perspective in the middle of a big bear market. Especially when it is logical to suspect that the pain could get worse for several reasons.

For example, the flight of foreign institutional investors’ (FII) capital may continue. India Inc will also certainly be facing stress on the debt front as it renegotiates foreign currency convertible bond (FCCB) loans that it never expected to repay.

Next year also promises to be politically turbulent with the central government and several state governments due for change. That might mean unpredictable policy changes and delays.

These are significant concerns and, taken together, make it likely stock prices will stay low through the next 6-12 months at the very least. At the bottom of the past cyclical downturns, such as 2002-03 and 1998-99, GDP growth dropped below 5 per cent. In 1992-93, GDP growth was zero. Nobody has yet made such dismal projection, but the dimensions of the current crisis are big enough to make this entirely possible.

Equity is likely to remain the best long-term asset. In situations where every asset offers negative short-term returns, equity is almost always the first asset class to see recovery. It is also the likeliest to generate high, long-term returns.

The global commodity cycle is in free fall. Real estate is experiencing bubble deflation. The likelihood of rising non-performing assets (NPAs) affects the quality of debt assets. Commercial interest rates may fall as the lagged effect of RBI’s attempts to release liquidity filters through. But debt funds will be dicey due to the NPA situation and the liquidity crunch.

Paradoxically, despite the real danger of further dips in stock prices, a cautious stock picker can create better safety nets than a commodity or debt player. Value investors can set conservative, narrow investment parameters and buy only blue chips that meet such criteria. The selection rules for a value investor are simple in the current circumstances. Avoid buying high-debt businesses. Look for low price-book value (PBV) ratios. Seek high dividend yields and stable dividend histories. Stay with businesses that have both size in terms of turnover and liquidity in terms of large stock-trading volumes. Companies that meet all these criteria will not fail. As the cycle turns and price-earnings discounts improve, they could be multi-baggers.

Mechanical filters can be applied to find companies that meet these basic criteria. Over 10 per cent of companies with market caps in excess of Rs 5,000 crore are trading at PBVs of less than 1. Of these, many are offering dividend yields of above 5 per cent. Exclude the ones that have debt-equity ratios of above 0.7.

All this will give you a basic list that can be subjected to qualitative judgment about sustainability of business, quality of management, positive cash flows, ongoing projects and expansions, forward EPS projections, etc.

The short list that arises from this selection process will not necessarily recover faster than the broad market. But it will carry considerably less risk because of the combo of low PBV and high dividends. The high dividend yields will offer a cushion and the low PBV ratios will limit the risk of a further capital loss.

However, far more than stock selection, the real challenge for investors lies in intelligent money management. Generating optimal returns through buy and hold strategies involves buying during the bust and holding till the peak. Very few players have the requisite discipline and patience to last an entire business cycle.

During a bull market, there is far less pain involved because the portfolio returns are positive. The longer a bear market lasts, the more difficult it becomes to buy and hold. The situation right now is akin to that in the long bear market from March 2000 to May 2003. The best returns came to those who bought between 2000 and 2003 and held till late 2007 and early 2008.

The implication is that the long-term investor could be looking at making commitments till 2014-15. However, the potential upside could be as massive as it was in the last cycle. Those who bought in the 2000-2003 bear market and held till late 2007 logged returns in excess of 300 per cent. A similar buy and hold through the current cycle, however long it lasts, could prove to be even more profitable.