Picking stocks in a Bear market can be both rewarding (as in the long term you see spectular returns) but also tricky (if you don’t invest near the bottom, then you’re in trouble if the market falls aggressively. Here are some general rules of thumb when it comes to picking stocks in a bear market:

1. Large Blue chips: Go for large, well established blue chips rather than mid-caps or small caps. While these are the first to be beaten in a bear market, they are also the very first to recover. Smaller shares are more likely to be dependent on one industry, and will have less access / negotiating power with banks for access  credit - something that is absolutely critical in today’s environment of a severe credit squeeze.
    
2. Neccessity rather than luxury: Focus on buying stocks of companies that sell a product or service that is a neccessity rather than a luxury. The reason is simple: when people’s confidence in the economy, the stability of their job / business and therefore their future income is threatened (as it is in a bear market) they’re going to cut back on all their luxuries including designer clothes, watches, luxury cars etc. They cannot cut back (much) on medicines, food, water, electricity, petrol. Business will also cut back on what they may believe are luxuries - advertising, and expensive offices and furniture. Not only will companies cut back spending on real estate, but individuals and households will also avoid ‘large spends’ on new houses, cars etc.Sectors which have shown to have done well in past bear markets include major pharmaceutical, food producers, tobacco, telephone (now more likely cellular phone), basic household products, oil and energy and utilities companies. This is pretty much in line with what we’ve seen thus far - companies like Hindustan Lever, which is actually up since January, or GSK pharma, which has only lost about Rs. 20 since its January highs.Sectors which have shown to do poorly in bear markets are house / real estate builders, motor vehicle related businesses, industrial materials or machinery  / capital goods, advertising or advertising dependent companies, and financials. With real estate, most motor vehicle, and every financial stock suffering (financials are down between 70-90% from their January highs) this general rule of thumb seems to be highly applicable.
    
3. Domestic focus: Choose stocks that have a focus on the domestic economy and are not reliance on exports / foreign operations, especially outside of emerging markets and in the US / UK / Europe.
    
4. Low ‘beta’ - less than 1: Beta is a measure of how much the stock tends to move with a market move, or crudely, its relative volatility. For example, a stock has a beta of 2 then a 10% fall in the Sensex would typically lead to a 20% fall in the stock. Picking stocks with a low beta means that when the market recovers, your stocks may not ’soar’ but this certainly protects you if the market continues to fall. If you pick a stock with a beta, of say 0.5, then a 10% market fall is likely to only lead to a 5% price fall for that stock.
    
5. High dividend yield shares: Dividend yield is how much the annual dividend the company pays out divided by the current market price. So if the stock price is Rs. 100, and the last dividend that the company paid was Rs. 20, the Dividend yield is 20%. Buying stocks that have a high dividend yield is a useful way of protecting yourself against further falls in stock prices. If for example, the stock price falls by 10% and the dividend yield is 20% (provided you hold the stock long enough / at the right time to be eligible for that dividend) then the overall return is +10%.Of course, make sure that the dividend yield is over the prevailing (risk free) fixed bank deposit rate - you need to be compensated for the fact that while the fixed deposit rate will give you guaranteed returns, a company could cut its dividend as and when it feels like it.  Be careful however - high dividend yielding stocks can also spell trouble: very high dividends means that the company may be spending too high a proportion of its profits on dividends. If profits fall, the dividend will get suddenly cut, and the stock price will plummet because nobody likes a stock that cuts its dividends. In order to guard against such instances, trying buying a stock with a dividend cover of 1.8 or more. ‘Dividend Cover’ is Earnings per share divided by dividends per share. If the company’s profits are stable, and it has a dividend cover of 1.8 or more, you can be assured that the company is unlikely to cut dividends suddenly.When looking for dividend yielding stocks, also try to focus on well established, well known blue chip companies, because they’ll avoid cutting dividends in order to protect their name and reputation.
    
6. Stocks to avoid: Stocks with high PE ratios and low dividend yields are likely to see a price correction, and dividend payments aren’t going to be sufficient to protect you. Stocks with few or no tangible assets are also vulnerable. The lower the tangible assets, the lower the company’s ability to get access to cheap credit, especially in an environment such as this, where liquidity has dried up. At the same time, avoid companies that have a lot of debt (a debt to equity ratio of higher than 25%) - in a high interest rate environment such as this (even to interest rates are being cut), those companies saddled with a lot of debt are likely to default, and unlikely to be able to raise further credit.
    
7. Timing - carefully examine support / resistance levels: While a stock might be fundamentally a good buy, it makes sense to try and purchase it near its support (the price level that the stock falls but bounces back from) rather than resistance (the price level that the stock keeps rising to but falls back from). Determining support / resistance levels is not very difficult if you look at a company’s stock chart.

Tags: bear market, Defensive Stocks, Educational, Investor Education, Investor Essentials, Stock Picking, stock picks

This entry was posted on Thursday, November 6th, 2008 at 12:55 am and is filed under Educational, Forecasting, Stock Market, Trend Analysis. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.