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How to pick promising stocks amidst bad news

Bad news can cause fundamentally sound stocks to fall. Here is how you can spot such opportunities

How to pick promising stocks amidst bad news

At Value Research Stock Advisor, we bring to you outstanding stocks that you can hold for the long term. But outstanding companies generally trade at high valuations. In the normal course of events, you are not likely to get them at a reasonable price. There are times though when you can, as happens when these companies hit a speed bump.

These speed bumps often come with bad news. Bad news can take the form of disruption of production (raw-material constraints, labour unrest, other supply issues), fall in demand (cyclicality, price inflation, changing trend) or other factors (external action, lawsuit, change in policy, etc).

Why look for bad news?
Looking for bad news can be very profitable. The only time you can get your hands on outstanding companies at reasonable prices is when they are down on bad news. It is not uncommon for prices to go down by 50 per cent or more.

At Value Research Stock Advisor, here's the process that we use to spot opportunities amidst gloom:

Keep your eyes open for bad news: Bad news is good news for stock pickers. Where do you look for bad news? Your first stop is business papers. That's your hunting ground.

Would you invest in the company at all? The first thing to ask is if you would buy the company at all. You only want to invest in outstanding businesses. That way, even if you need to hold the stock for a long time - a situation that occurs fairly often - you can sleep peacefully. Look for stable or growing businesses with high returns on capital, little to no debt, and those that clear the following tests: C-Score (for any creative accounting), F-Score (for financial health) and Z-Score (for any likelihood of bankruptcy). If any company fails to clear these preliminary quality tests, it is a good idea to drop it from consideration at this stage itself. All this data is available on the Value Research Stock Advisor website.

Stop if any development raises doubts about the management's intention. Ask yourself: is the management effective, transparent and would you trust it with your money? If not, it's not worth your time.

Understand the problem: If you are comfortable holding the company for a very long time, then dig deep to understand the problem. There will be certain problems you won't understand. That's okay. You just pass them up.

If you can understand the problem, you then need to ask if it is going to be temporary, or else it could be bad news for a long time. A strike or lockout at a factory is likely to be a temporary phenomenon. A default on a loan or interest payment is likely to get a lot messier. What you want is a temporary situation likely to get resolved at some point in the future.

Weigh in the possible downside: expect to spend the most time here, since the kind of negative impact a company is susceptible to will vary based on the type of business and the particular problem it is facing. For instance, in the case of a lockout or labour problem, many companies will tell you about its impact on production.This will give you an idea of how big the problem could become. Another example is a construction company which has a lawsuit filed against a particular project. Here, you go about assessing how big the stuck project is to the company's total business and what the legal case is actually about.

There will be times when it will be difficult to assess the impact of a problem as may happen for instance when a slowdown in the economy leads to a fall in sales. In such cases, find out how dominant a company is in its industry. Maruti Suzuki, the country's largest passenger carmaker with over 50 per cent market share, could be down on sluggish demand. You may have no idea when demand is going to pick up. But what you know is that when it does, the company that sells one out of every two cars in the country is going to be among the first to gain.

If you cannot assess the impact just yet, it makes sense to sit back and wait for more information. Ideally, you want all the negatives to come out in the open. You want the stock to take all the beating there is to take before you step in. This is tough though. You will likely never catch a stock at the very bottom.

Start investing in small instalments: A stock that is down 50 per cent can fall by another 50 per cent. Therefore, do not put the entire amount you have allocated to the stock at once. Stagger it in small instalments. If the stock takes a further hit, you benefit in two ways. First, a smaller investment will not hit you that hard. Second, a further stock fall will give you exactly what you want - a cheaper price.

The mindset required
Investing in companies with problems is not for all investors and especially not for novices. An investor in such companies doesn't follow popular stocks or those that are lifted by a trend. Instead, the stocks he is interested in will include those that many fund managers would be selling and which come with more negatives than positives. You will not find comforting news before you invest and sometimes not for a long time after.

To be able to pick such stocks, at Value Research Stock Advisor we believe in developing a mindset with the following characteristics:

Independent thinking: the crowd is generally right; sometimes though, it is just short-sighted. In its predictions, it extrapolates the current situation well into the future. When a pharma contract manufacturing company had a run-in with the USFDA, the stock lost 35 per cent. A little digging would have revealed its track record of clearing these observations in a very short time. This time was no exception and it went on to clear the latest observations in a record time and the stock zoomed thereafter.

Ability to understand the business and evaluate the competition: investing in companies with problems requires an understanding of the business, its industry and peers. If you don't really understand what's happening with these companies, you should not invest in them.

Keep calm even if your stock falls further: Just because you bought a stock doesn't mean it won't go down. On the contrary, most of these stocks will fall just after you buy them. You need to accept this reality and still stay calm.

Here's what to do if the stock falls further.

Keep calm: Keep a cool head. Acting under panic leads to wrong decisions.

Evaluate the event: Evaluate the event that caused the fall. Does it change the fundamentals of the company? Is it a one-time or recurring event? Was the fall factored in, in your initial analysis? Doing this takes you back to understanding the problem and weighing its impact all over again.

Re-evaluate the management: Attend conference calls or look up interviews the management has given to consider its argument. Then check with peers or look up sector developments to see if what the management is saying is corroborated by others. Go back to previous communication to see if what they said earlier materialised or not. This will tell you if the management is trustworthy.

Buy/hold/sell decision: If the event that causes the stock to fall further changes a fundamental characteristic of the company or puts it at an extraordinary earnings risk, you should consider exiting the company, even at a loss.

If it doesn't, you have to decide whether to hold or buy more. This will also depend on your existing exposure to the stock, the sector and any other compelling investment ideas on hand.

Thus, investing in companies with problems, if done right, promises to give you great results. The process is simple, but not easy. There are many pitfalls along the way that only experience will teach you how to avoid. Even then you will make new mistakes.

Since picking good stocks for the long term is the very objective of Value Research Stock Advisor, we have developed the right process and frame of mind to invest in promising stocks that are available cheap. Our subscribers regularly get such stock recommendations, along with updates on how the underlying story has been unfolding.

Mohammed Ekramul Haque is a Senior Equity Analyst at Value Research Stock Advisor.

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