Stockpicking in a bear market using cash bailout potentials

Medium-term horizon
Long-term horizon
Cash bailout potentials
Fundamental strength of the business
Dividend
Capital appreciation potential
Privatisation potential

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Stockpicking in a bear market can be a hazardous business. Picking bottoms is not easy. Beware of intermediate bottoms and long-term bottoms.


One strategy during the bear market is to avoid risk and not hold stocks altogether. This is also the reason why we have a bear market at all --- risk aversion leads to lower volumes and the stock prices drop by gravity due to lack of support.


But yet, if we define risk* as the potential loss on investment over say 3-5 years, then buying stocks during a bear market could be a low-risk proposition indeed (because you are buying at a lower base and hence risk of losing is lessened over the long term), assuming that the bear cycle reverses in several years.

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A good model for picking stocks in a bear market would be to examine the cash bailout potential of a stock over the medium to long term. The general idea is to view a stock with regard to its potential to allow the holder to eventually bail out. Under this umbrella of "cash bailouts" are:

• selling in the open market for capital gains
• dividends and
• privatisation.

This way of viewing a stock is especially useful in a bear market where most small-cap stocks may be thinly-traded and selling out of them may be difficult. Yet, illiquid small-caps often offer the best potential gains.

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Two-horizon approach to picking these stocks in a bear market are:

• the medium-term horizon (6-12 months) and
• the long-term horizon (3-5 years).

Under each of these horizons, examine the cash bailout potential of the stock.

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Medium-term horizon

One should expect a lower potential returns for the medium term as opposed to the long-term horizon. Under the medium-term horizon, two main factors to look out for are

• privatisation potential and
• dividend yield.

These are the two main cash bailout avenues in a recession/bear market where liquidity and capital gains opportunities might be limited.

Dividend streams tend to be more easily predictable especially for older companies, and high dividends, perhaps in excess of 5-10% yield, would be a good clearing mark for potential stockpicks.

Privatisation potential is harder to judge. Companies with the following:

• the usual "good earnings/business" criteria
• tight ownership under a strong cash-rich owner,
• an operating niche or desirable brand name and
• steady free cashflows (operating cashflow minus investing cashflow)

would attract potential privatisation offers from parties such as the main shareholder, business competitors or private equity funds.

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Long-term horizon

Under the long-term horizon, capital gains look like a more viable, and probably the most profitable, cash bailout avenue. This is of course the preferred bailout avenue of the long-term growth investor.

Two main issues must be considered with respect to stockpicking for this horizon:

• firstly, how many times can the stock price appreciate;
• secondly, can the company's fundamentals survive the recession unblemished.

For those targeting 3-5 years down the road, aim to pick a stock with the potential to be at least a 4-5 times multibagging potential. That would translate to about 30-40% annualized gains. This is quite ambitious but is also a good way to filter out the real bargains among the many cheap pennies floating around in a bear market. Of course, the devil is in the details: the judgment of appreciation potential is critical and clearly the selected stock might not fulfil its hoped-for potential.

For the second issue, it boils down to an examination of the company's accounts and operating business. The balance sheet (complete with footnotes) is the single most important source of information to make the judgment. Things to look out for would be:

• heavy debt,
• contingent liabilities (under footnotes),
• consistently negative operating cashflows and
• insider selling.

As Warren Buffett says about car racing, to finish first, you must first finish.

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Ideally the selected stock would be satisfactory on all counts, both medium-term and long-term. Of course, it may be difficult to find one has multi-bagger potential and yet has clear indications of being taken over. Or it might pay miserly dividends.

The dividends and the fundamental strength of the business to negotiate through the recession override the other two factors, privatisation or capital appreciation, in terms of importance.

Dividends and fundamental strength of the business are the ones that are most easily judged from current and past data. These can be judged objectively, and provide a clear operating basis to fall back on should privatisation or capital appreciation not work out. In short, they provide a floor for the stock price. Look out for these two parameters most of all.

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*Risk

For long term investors with a longer investing horizon, we define risk as the potential loss on investment over say 3-5 years.

The standard definition of risk as price volatility is more appropriate for short-term leveraged players.

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Reference: http://mystockthoughts.blogspot.com/2008/11/stockpicking-in-bear-market.html