Want to pick stocks in a falling market? Remember these 5 golden rules

India plays the T20 World Cup later this year. Some of the leading and established players should not or may not make the squad in their current form.

The dilemma here is whether to trust the often quoted saying in cricket “Form is temporary and class is permanent” and give them another run or look elsewhere.

We would have to wait and see how this pans out on the cricket field and how the team is built. As investors, we are also faced with a similar dilemma especially when the markets are in a free fall.

Which stocks should we back or pick – ones that have been consistent performers and wealth creators but are currently in the grip of a downward spiraling market or are they past their sell-by date?

Going back to the cricket analogy. History has shown that the team was always built around or had an element of class or quality.

Whether one believes in this or not in cricketing terms is a matter of debate.

In investing what is generally not a matter of debate is that class or quality almost always bounces back.

So, what it essentially means is that look for quality while picking stocks in these turbulent times. Here are some rules to follow:

1) Earnings Stability
Look for companies that have shown a trend in earnings growth with profits regularly improving over a period.

This means that the company will have far greater financial and operational stability. When sentiments improve stocks of such companies quickly appear on the radar of investors. The markets and investors love stability and earnings visibility.

2) Valuations Matter
Invest in companies that are available at a decent valuation. Not all stocks with a high Price / Earnings (P/E) ratio are bad and not all stocks with a low P/E ratio are good.

There are many companies that do not actually have a real business that justifies their valuation.

Similarly, there are many good businesses run by good management that can be available at attractive valuations.

As an investor, you have to determine whether the stock deserves that valuation.

In a falling market, valuations become a buzzword and a big factor because it is a safe zone to stay in.

Avoid companies where valuations are excessive. But also watch out for value traps, not all stocks available at low P/Es are necessarily value buys.

3) Good Management
This is a qualitative call. Good management with a proven track record will steer a company out of troubled times faster.

A good management keeps the company ahead of the curve in terms of products and technology. Such stocks tend to have a faster recovery rate when sentiments improve.

4) Avoid High Debt
All companies have debt. It is an important indicator of the health of the business.

If a company has a high debt/equity ratio in a challenging business environment it may find it difficult to meet its debt obligations.

A company with strained and stretched financials is a risky bet. Valuations and sentiments are bound to nosedive sooner than later.

5) Shareholder Friendliness
One of the ways in which a company can be shareholder-friendly is by rewarding the stakeholders with regular dividend payments.

Stability and reasonable dividend payments over the years mean that the company is fairly sure of its business. When capital appreciation is challenging dividends are another source of income.

When looking for stock picks in a falling market, a bottom-up approach to investing is preferred. Evaluate each company you want to invest in based on the broad parameters mentioned above.

Compare them with their peers. Most importantly, maintain an asset allocation based on your risk profile and investment objective.

(The author is Chairman, TradeSmart)

(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)

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