Trading Rule – “Don’t be in a hurry to bottom-fish stocks”…

There is something seductive and buffettian about bottom fishing for stocks. It is the dream of every trader to buy at the bottom and sell at the top. In practice, though, it rarely happens. P/E and valuations are just a plain theoretical approach to buy stocks of deep value. In reality, the time for bottom fishing is when the last optimistic bull has been squeezed out of the markets.

THE DOWNSIDES OF BOTTOM FISHING

The former head of Fidelity Magellan, Peter Lynch, famously said, “I do not believe in bottom fishing”. Coming from an inveterate value investor, it does sound a little weird. But, probably, what Lynch meant was that it is impossible to catch the bare bottom of a stock price. Therefore it makes sense to accumulate stocks in a range, from the point when value is clearly visible.

The problem that normal traders and investors face is actually twofold. The first challenge is to know whether a particular price is the bottom or it is a temporary respite before falling further. The second challenge is how to avoid the notorious value trap, where investors try to bottom fish but end up accumulating low quality stocks sinking into a bottomless pit.

While there are no hard and fast rules, there are 2 thumb rules that investors can apply. Any stock that falls with extraordinary volumes and is accompanied by institutional selling is not a candidate for bottom fishing. Also, remember that market bottoms are never made in a single day. It is a gradual and grinding process of falling interest and falling volatility.

3 QUESTIONS TO BE ASKED BEFORE BOTTOM FISHING

IS THERE A STRONG STORY FOR A REVERSAL?

There are a lot of sub-questions in this. Is the stock in a buoyant industry? Is the stock outshining peers within the industry? Does the company have growth and ROI to justify a serious bounce? These are the building blocks.

DOES THE CHART HISTORY SUPPORT A BOUNCE FROM THESE LEVELS?

Much as we may deride the downsides of charting, the truth is that it captures the gist of market sentiment. If the stock is in uncharted territory, avoid bottom fishing. If critical exponential averages are broken, stay away!

HAVE THE WEAK HANDS BEEN SQUEEZED OUT?

Normally markets bottom out when the last optimist is squeezed out of the market. Then the volatility ebbs and disinterest builds up. If the above two conditions are met, this is the time for bottom fishers to enter the fray.

“Price is what you pay. Value is what you get in the bargain” – Warren Buffett 

FIVE SITUATIONS WHEN BOTTOM-FISHING WARRANTS CAUTION

  1. Are the yields on debt higher than the earnings yield? Let me explain! The earnings yield is the reverse of the P/E, so when the P/E is 20, the earnings yield is 5%. If yield on debt is 8%, then debt is going to be preferred vis-à-vis equity for a higher risk-free yield. In such cases, bottom fishing will always be a disappointing exercise. Just avoid!
  1. Is gold on an upward march globally? This is an interesting indicator, because gold is the preferred asset in times of global panic. Sudden spurt in gold prices, backed by bulk buying is not a great indicator for equities. It typically signifies that the market prefers a risk-off trade. The safety of gold takes the sheen away from equities. Watch gold closely!
  1. Avoid bottom fishing when there is a larger issue with the industry in general or the stock in particular. Since 2009, Airlines have been a losing proposition. Kingfisher, Spicejet, Jet Airways are all bad candidates for bottom fishing. Within stocks Suzlon, Educomp are tragic cases. The retracement continues to be elusive!
  1. The markets never bottom out in a V-shape. If it happens, then it is most likely a false bottom. Be extremely sceptical. Markets never bottom out in the midst of high volatility. Wait for the price range to narrow, the volatility to fall to low levels and the buyers to lose interest in the stock. Absence of volatility and investor indifference can be sure shot market bottoms. Look for them!
  1. Look at the color and nature of buyers at the bottom. This is again a reliable indicator. Too much retail interest never signifies the bottom, it normally points towards a top. HNI buying, Long-only funds accumulating, promoters raising stake, plethora of buy-back and delisting offers are classic indicators of a bottom. Trust these indicators more!

CLASSIC EXAMPLES OF BAD BOTTOM FISHING

A volatile market like India is normally replete with stories of cases where bottom fishing failed. Stocks like Himachal Futuristic, Global Tele, and Pentamedia in the tech boom were classic cases! These were shell companies to ride a trend and not a veritable business model at all. Also take the case of Unitech, Ansal and DLF in 2007. Those who bought at high levels may never again see those levels, but those who went bottom fishing, were well and truly wiped out.

As long as bottom-fishing is restricted to quality stocks with quality business models with robust cash flows, it can still work in the long run. But where bottom fishing becomes an extension of your misplaced conviction or an unwillingness to let go, it can be disastrous. And therein rests the key to success in bottom fishing.

TAKEAWAYS FROM THE “BOTTOM FISHING” DEBATE

In the equity markets there is a very thin line separating expectation, hope and wishful thinking. As long as bottom fishing is not based on wishful thinking, you stand a good chance of striking a good stock at a reasonable price. Buying a good stock lower is always economically more sensible. But you need to be very clear on how to sidestep the value trap.

In a way, bottom fishing for stocks is like trying to find gold in El Dorado. The Europeans learnt it the hard way, after a stupendous cost, that easy money is always made the hard way. Have you ever imagined what it would be like to have bottom fished in Lehman, Enron, WorldCom or RadioShack. It would have been absolutely disastrous, to say the least.

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