The ongoing pandemic is responsible for massive losses in the stock market. Note that the PSEi index is down 24 percent year-to-date and most stocks are trading significantly below their year-ago prices. Because of this, a lot of investors have become fearful of buying stocks, and this is evidenced by the diminishing value turnover in the Philippine Stock Exchange.
However, as Albert Einstein said, “in the midst of every crisis lies great opportunity.”
Because of various reasons such as poor earnings growth, larger number of sellers compared to buyers and weaker investor sentiment, it is normal for stock prices to go down sharply during a bear market. Even good quality stocks trade at much lower prices during bear markets.
However, it is important to remember that although stock prices go down during a bear market, the drop is only temporary. Corporate earnings eventually recover when economic activity picks up, and this drives share prices higher. When this happens, investors who were brave enough to buy stocks at depressed prices during bear markets make a lot of money. Admittedly, overcoming the fear of losing money and buying stocks is very difficult during bear markets. After all, just because a stock is cheap, does not mean it cannot become cheaper. It is also normal for buyers to suffer from short-term losses and this could cause some investors to regret buying stocks and cut losses at even lower prices.
Investors can also make the wrong choice and buy stocks of companies that fail to survive the crisis, making their investment worthless.
Rather than avoid buying stocks, here are some tips that I hope will help you invest successfully during bear markets.
Manage your size. As I have mentioned earlier, a cheap stock can become cheaper during bear markets. To strengthen your ability to withstand any possible drawdown, manage your size. This should be an amount that you can afford to keep for a very long time since nobody knows when the bear market will end. Recall that the bear market triggered by the Asian Financial crisis lasted for several years. Although we are hopeful the stock market will recover next year as the government slowly reopens the economy, we can also be wrong, especially if the government fails to control the spread of the virus.
Buy slowly. The trend is not your friend during bear markets. Nobody knows when the market will bottom. Because of this, you should buy stocks slowly so that you can average down and reduce your buying price.
Don’t overpay. The reason why you want to buy stocks during a bear market is because they are cheap. As such, do not rush into buying stocks that are still expensive.
Aside from measuring how much a stock has dropped from its high, there are other measures you can use to value stocks such as the price to earnings ratio (P/E) or the price to book value ratio (P/BV). I tend to use both ratios in evaluating the attractiveness of stocks during bear markets. Earnings temporarily weaken during times of crisis making the P/E ratio less meaningful. In contrast, book value measures what is left to shareholders assuming that a company needs to sell all its assets and pay all its debts. A lot of stocks trade at a discount to their book value during bear markets.
You can also study a company’s dividend payment policy and measure a stock’s dividend yield based on its current price. A stock that pays cash dividends is more attractive because shareholders are paid to wait for prices to recover. It also increases your level of indifference between keeping cash in time deposits or bonds and holding on to stocks.
Is the company suffering from a cyclical or secular decline? When picking a stock to buy during bear markets, you need to make sure the company you buy will survive the crisis. Although most companies will suffer from weaker profits during times of crisis, profits of companies that are suffering from a cyclical decline will rebound immediately when the economy recovers.
Do not buy stocks of companies that are suffering from a secular decline caused by changes in consumer preference or technological disruptions. Even if the economy recovers and the bull market returns, profits of these companies will stay weak and their stocks will most likely stay depressed.
Avoid companies with too much debt. Another factor that can hurt a company’s ability to survive the crisis is the amount of debts in its books. Although sales of companies go down during difficult times, their interest expenses stay the same. If the crisis lasts for a very long time, companies with too much debts might not have enough resources to meet their obligations and eventually go bankrupt.
Diversify. Despite careful due diligence, there is still a risk that the stock you pick will not do well. Therefore, it is better to diversify by buying several stocks. You can do this by buying several individual stocks. Or you can buy a few stocks that you really like and mix it with an equity index fund which is a diversified basket of stocks. If one of the stocks you own does not do well, the impact on your portfolio will be reduced.
With these tips, I hope you will be more confident in buying stocks during bear markets. After all, bear markets provide a rare opportunity to buy stocks at bargain prices, preparing you to earn a lot of money when the bull market returns.