How to Identify Quality Stocks in a Market Crash

The stock market witnessed one of its biggest falls ever and the carnage is not yet over. Volatility is the name of the game right now and investors should brace themselves for the worse. In times of such uncertainty, an investor has two options; either to panic sell good stocks or stay calm and look at this crash as an opportunity to invest in more quality stocks. However, given the situation all the stocks in market is falling, making it difficult for the investors to differentiate quality stocks from fundamentally weak stock. 

An investor who looks at this crash as an opportunity can be tempted to invest in stocks, which have fallen the most, in the hope that when the fall is over he or she will make money. This strategy might work for some stocks and generate returns in a very short period but the downside of using it is that such strategies are based on luck and thus investor can never be sure of generating good returns, also such strategies can work only for a short term not the long term. A smart investor should try to identify quality stocks in the given market condition simply because those stocks are falling due to volatility in the market and when the volatility ends such stocks will generate returns not only in the short-run but in the long-run as well while generating capital returns for the investor.

So let’s look at some important ways to identify quality stocks: 

• PROMOTER HOLDING: Promoter holding is the percentage holding in the business by the promoter of the company. A high level of promoter holding depicts the promoter’s confidence in the business and ability of the business to generate good returns. However, some businesses should not be looked through the prism of promoter holding like Banks, NBFCs and professionally managed companies. Investors should also look for promoter pledging while looking at a promoter holding because there are companies with high promoter holding but at the same time they have high levels of pledging.

What should an investor do: Investors should look for companies in which there is a high level of promoter holding or promoters have increased their holdings in the past 1 year. Investors should avoid companies with high pledging.

• DEBT: Companies take debt for a variety of reasons and no matter the reason the company has to pay interest on that debt. In good times a company can manage its debt but in bad times (or worse times like this) debt hurts the financial stability of the company. Debt is a fixed obligation that the company has to pay irrespective of the market situation thus companies should avoid high levels of debt. 

What should an investor do: While going through company financials, investors should check the levels of debt the company has and the ability of the company to meet its obligations. Investors should avoid companies that have a high level of debt while look for companies with a low level of debt or companies that are virtually debt-free and should check Debt to Equity Ratio and Interest Coverage Ratio to know whether the company can meet the debt it has taken. 

• RETURN ON EQUITY AND RETURN ON CAPITAL EMPLOYED: These two matrices help the investor to assess the ability of the company to generate profits from shareholder’s investment in the company and how efficiently is the company is using its capital employed, i.e debt + equity. A high percentage indicates that the company is generating good amounts of profit from its capital employed; however different industries have different levels of return on equity and capital employed

What should an investor do: Investors should check the industry the company is operating and then compare the company’s return on equity and return on capital employed with the industry average. A company of different industries should not be compared. The investor should not just consider the two matrices for just one year but should be seen over a period of years to have a more clear idea about the functioning of the company.

• SALES GROWTH AND PROFIT GROWTH: As mentioned above these two matrices are also important for an investor to analyze the company. Both sales growth and profit growth show how much the company is selling year on year and how much profit these sales are generating year on year. Every company needs sales and profits to survive in the market and a growing sales percentage and profits percentage indicate that the company can capture more market share or grow in new markets while improving efficiency to carry out its operations.

What should an investor do: Sales and profit are important indicators for the investor to focus on. An investor should consider taking an average to know whether the company is consistent in increasing its sales and profits over the years. While checking both the factors, an investor should take note that the company doesn’t have a high level of other item sale or unusual gains and profits, as such items are a one-time event and can lead to error in judgment.

While choosing the company, the investor should use a combination of all the above factors and not just focus on mix of some factors or a single factor. The above-mentioned factors also should not be the sole criteria to invest, the investor should understand the business model of the company first and look out at other criteria before investing. 

Due to coronavirus pandemic, some stocks are affected temporarily and will rebound in a few months as soon as the impact of the virus is subdued. Here at Finology we have identified a few quality stocks that have been impacted due to coronavirus. 
To know about them, click here.