What to do in a volatile equity market

Choose large-cap, dividend-paying companies and invest systematically

Volatile and uncertain markets have put investors in a dilemma whether to invest in equities or not. Staying away from equities is not a good idea because as and when the economy improves, you will not be able to ride on the wealth generated through the stock market. However, during volatile times, it is advisable to invest with caution and not aggression.

Currently, there is high amount of uncertainty in the stock market. Many stocks and sectors are seeing three or five year lows. Stocks in sectors such as banking, infrastructure, real estate, etc are seeing a phenomenal decline in prices. Are these low prices reason enough to buy stocks? Or should you avoid stocks as their prices could fall further?

When the economy is booming, most of the stocks perform better irrespective of their business model or sector in which they operate. However, in times of slowdown, some stocks or sectors are affected much more than stocks in other sectors. This is due to the impact of factors such as interest rates, crude prices, fiscal measures, inflation, etc. However, certain sectors are less affected by the downturn. In capital market terminology these stocks are known as defensive stocks. Companies in the defensive sectors are those whose businesses are not dependent on general economic prosperity. Also, they have a competitive advantage in terms of brand, pricing power and low borrowings.

A stock like Marico or Colgate, for instance, which caters to personal care segment, will not see its business affected during a downturn considering the demand for such products will continue irrespective of the market or economic conditions.

The Information Technology sector, to some extent, is also a preferred sector. The sector's earnings are more insulated to the domestic economy and the companies benefit on account of depreciating rupee. This may be more so during a slowdown due to lower forex inflow, as foreign investments slowdown. The defensive sectors are FMCG, Pharma, Information Technology etc. (e.g. GlaxoPharma, Marico, TCS, Colgate, Bata etc.)

Stocks in sectors such banking, infra, real estate, commodities, etc are best avoided now. These are interest rate sensitive, demand sensitive and the industries are cyclical in nature, which is why they are expected to see a decline. It is better to avoid them as they may cause further depreciation in your portfolio value.

Auto companies also would be impacted in a rising interest rate scenario, like we are seeing currently, or in an economic downturn as people will postpone their car purchases. Interest rate sensitive sectors like auto, banking and real estate and infrastructure would be the absolute opposite of defensive sectors.

The table shows the performance of various indices performance in the past five years. (see table)

Sectors such as realty, capital goods, metal have been worst performers if we track the three or five year returns. Stocks of Public Sector Undertakings have also been poor performers. One reason for this could be the government milking them to meet their fiscal deficit.

However sectors such as FMCG, Healthcare, IT have provided considerable returns even during a sluggish economy.

Identify defensive stocks: Stocks can be identified as defensives based on parameters like the beta (i.e. stock-price change compared to the overall stock market change) of a stock and its dividend yield. Defensive stocks typically have a beta of less than 1. A beta of 1 means the stock price moves at the same rate as the overall market, whereas a beta of less than 1 would mean that the stock would move less than the market on the upside as well as the downside.

Further, the stock should have an attractive dividend yield (dividend yield is the current annual dividend divided by the stock price). It should also have a history of steady dividend payments. A dividend yield of greater than 3-4 per cent on a consistent basis is highly appreciable.

Although these stocks create long term wealth at a lower risk, in a sustained bull run these stocks will underperform the market. When the market recovers it is the cyclical and high beta stocks that tend to outperform. Also, many stocks within the defensive space are already trading at their fair valuations, given the steady increase in their price (e.g. FMCG stocks). The best time to buy defensives is when there is a gloomy picture on earnings for manufacturing sectors, higher crude prices and higher interest rates. As the defensive sectors are less prone to the risks mentioned above they offer value in times of uncertainty.

So, if one is convinced that the market is going to remain bearish for a long period of time, one can go ahead and buy good quality defensive stocks with low beta, low debt-equity ratios and high dividend yields.

Strategise your equity investment: Equity investment always needs certain strategic planning. Unlike bank FD or fixed income instruments, in case of equities you need to have a proper plan and need to stick to the plan unless there is valid reason to deviate from the plan adopted. Most investors exit during downturn and enter when the market has peaked. Due to this they are not able to maximise their gain from the equity market.

Look at large cap companies: It is now clear that the economy will take some time to regain momentum. Slower growth rates, high inflation, high interest rates and rupee weakness may stay on for some more time. Large companies will be in a much better situation to tide over the slower growth than the small or mid cap companies. It is best to stick to large-cap stocks in the coming months. Even within the large-cap space, you must be careful while picking stocks and sectors. Metal stocks for instance may be in for an extended downturn because of falling commodity prices.

Diversify: The infrastructure sector has been badly beaten, but analysts expect it to do well when the economy revives. It is a good time to start looking at infrastructure stocks at these beaten down levels. But spread your bets across a basket of stocks and sectors.

Have a Systematic Investment Plan(SIP): In case you have a SIP plan, do not think about terminating it at this point. If you stop now you will effectively turn down the chance to buy more at lower prices. The markets are down, but there is no knowing where the bottom is. Those who do not have an SIP, should go for the same. To avoid buying high, invest in monthly installments. In this manner, you will be able to gain the advantage of the rupee-cost averaging that the SIPs offer.

Defensive approach and adopting the right strategy can help cushion the impact of volatile market. Do invest in equities even during uncertain times, but with caution.

The author is a freelance writer