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Sunday 11 July 2021

Going Down The Quality Curve

We are in a bull market. We have been in one since the cataclysmic fall of March 2020. In the technical sense, markets have been making higher highs. Nearly all technical indicators are bullish, which is usually the case in a bull market. There are a large number of sceptics waiting for a market correction. The market is obliging them once in a while with some pause, sideways consolidation and correction for a few days. 

In the last one year, we have been seeing a very healthy sector rotation which has prevented any linear rise in any sector or a particular stock. The exception had been the Adani group stocks, which has also had their share of fall recently. 64% of stocks are still below Jan 2018 highs created by a booming mid & small cap bull rally.

Looking at the sectors which are rallying will give you a sense of the market. Commodity cyclicals like sugar, steel, cement have been at the forefront of the current rally. But other more "secular growth sectors" like IT, pharma, specialty chemicals have also participated in the rally in the last year. In such a market context, there are two completely divergent thought processes that run in the minds of investors. The first is the fear-of-missing-out. We want to be in the hot stock or the hot sector and ride the rally. We do not want to miss out on the rally that is happening where everyone else seems to be minting money. The opposite fear is that the market valuations are very high and makes us hesitate to deploy our capital fully. We are pulled at one time in two opposite directions and do not know what to do.

In a bull rally, the first casualty becomes the quality of the portfolio. Usually, the best quality companies rarely run spectacularly. They tend to be, what I call, "peaceful compounders". It is the companies a few notches below in the quality curve that runs the hardest. And people with FOMO gravitate towards that. As any market veteran will tell you, you end up with a clutch of poor companies in your portfolio when the ensuing bear market comes. 

So, the first and perhaps the most important thing to remember is to not dilute the portfolio quality. Does that mean you forego the rally and resign yourself to a more flaccid investment performance? Of course not. You can definitely participate in a sectoral rally but ensure that you are buying into the top one or two companies in that sector. And make sure you position size conservatively. Always, think of the downside first. Every bull market brings with it some narrative on why a particular cyclical industry has turned the corner and will henceforth be a secular growth story. Don't fall for that. You should be able to understand both the bull and bear case before you invest.

The second part of investment hesitancy can be avoided by two simple rules. This bull phase may end tomorrow and it may go on for the next five years for all we know. It is important to have a well thought out "systematic" strategy before we invest in a market like this. The first rule of investing in a market like this is by investing slowly, in tranches over time. Take a few months to deploy your capital. Keep nibbling at the stocks you have shortlisted and accumulate them. The second is to have an exit strategy ready. You need to know when and how much you will sell and where you will put the cash. You also have to plan for when and how to get back into the market subsequently. If all that seems very complex and difficult, just buy good quality businesses and try and ignore the short term market gyrations.

This post first appeared in https://economictimes.indiatimes.com/markets/stocks/news/how-to-survive-when-a-bull-market-takes-the-u-turn/articleshow/84256907.cms


  1. We need to be cautious while taking position in a bull market. However, quality companies with superior management quality can separate the chaff from wheat.