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Buying more shares in a falling market a good way to cover losses

Buying more shares in a falling market a good way to cover losses

Buying more shares when the market is falling is a good way to cover losses. Averaging works best when a company's fundamentals have not worsened but its stock is not doing well due to poor market sentiment or industry-specific conditions.

A key principle of investing is 'buy low and sell high'. But the volatility of stock markets makes this difficult. One way to deal with the sharp ups and downs in the stock market is averaging.

This entails buying more if the stock falls below the purchase price so that the average holding cost comes down, says Dipen Shah, head, private client group research, Kotak Securities.

Let's assume you buy 100 shares at Rs 300 (for Rs 30,000). If the stock falls to Rs 200, you lose Rs 100 per share or 33 per cent of the investment. At this stage, you can do two things-wait for the stock to bounce back or invest Rs 30,000 more at Rs 200 and buy 150 additional shares. The latter will bring down your average holding cost to Rs 240 (Rs 60,000/250 shares).

This can work in both rising and falling markets. "In rising markets, averaging reduces the cost of purchase of new units, while in falling markets it reduces the loss as the average purchase price falls," says Anil Rego, chief executive and founder, Right Horizons, a wealth management firm. However, in certain circumstances, it may not be the best strategy.

NOT FOR ALL SEASONS

Rego says averaging works best when a company's fundamentals have not worsened but its stock is not doing well due to poor market sentiment or industry-specific conditions. Take airlines. Burdened by huge costs and debt, the sector was an underperformer until recently. The easing of foreign direct investment rules in aviation in September gave a push to most airline stocks. But Kingfisher Airlines is still 30 per cent down this year. Now, the question is, should you average a stock like Kingfisher? No, says Rego, adding that the company faces an existential crisis and its stock has turned purely speculative.

Another sector embroiled in controversies is telecom. The fall in share prices over the last few quarters encouraged some to invest more at the lower levels, only to hit further lows. Tulip Telecom, for instance, has fallen 63 per cent in the last one year. Subex Ltd, a leading provider of management services to telecom companies, is trading at Rs 14, down 43 per cent from Rs 25 at the start of the year. Rego says telecom and information technology sectors are facing global headwinds and it may be pre-mature to invest more in telecom stocks at this moment. Also, Tulip's margins have been under pressure and are likely to remain so, says a report by IIFL, which has recommended 'sell' on the stock.

Now, take textile stocks, which have been under pressure for many quarters due to huge debt and falling demand. For instance, after its initial public offer, Koutons tried to expand but failed to get the desired results. The stock is down 39 per cent this year. Similarly, Alok Industries, among India's largest textile companies, is down 38 per cent this year.

GOOD BETS

Now, what should one do if the stock of a company with good potential is under pressure? Experts say in such a case there is high chance that averaging will work. Adarsh Shamdasani invested in Educomp Solutions at Rs 410. The stock has fallen 63 per cent since then and is now trading at Rs 155. Now, he is wondering if he should invest more. The company is after all a market leader in the digital education content business, though tough competition has ensured that the stock is down 20 per cent in the last one year. Although revenues have been growing, the pace of growth has slowed and profitability and return on equity have been under pressure. Despite this, IIFL is positive on the company due to its consolidation strategy and recent capital injection and has recommended 'buy' on the stock with a target of Rs 180. Those looking to average their losses can do so at the current levels, say experts.

Similarly, there are several stocks in real estate, construction, engineering and capital goods sectors that have underperformed the market of late. Shah of Kotak says economic reforms and rate cut by the Reserve Bank of India could benefit beaten-down investment-related sectors and rate-sensitive stocks. "One should invest selectively in these stocks after looking at the quality of the managements and balance sheets, apart from valuations," he says.

Sachin Shah, fund manager, Emkay Investment Manager Ltd, says averaging works best when the company is fundamentally strong. He says one must consider three factors for averaging. One, the company must have a strong balance sheet, that is, have low debt and high cash reserves; the management should be of good quality; and the company should have a solid unique selling proposition. Without these, cost averaging will not be fruitful, he says.

If one buys into a company which does not have a strong business model, the stock will not make a comeback easily. Take Moser Baer, once known for its technological edge. After touching new lows for the last few years, the stock of the country's largest disc (data storage and content) maker has fallen 57 per cent this year to Rs 6. Shah of Kotak says technology becomes obsolete quickly and so one has to be very nimble to succeed in this business.

IDEAL TIME TO AVERAGE

Shah of Emkay is not comfortable about averaging stocks that are not in Nifty 50 or BSE 100 indices.

One stock that investors can average is Infosys. The company's fundamentals are strong, it is trading at 15-17 times earnings (historical low), has low debt and huge cash, and pays good dividends. "Once the business cycle revives, growth will start looking up," says Shah.

Experts caution that stocks that are the flavour of the season and are not the top ones are risky and must not be averaged.

Also, one must consider averaging only if the stock has fallen less than 15 per cent. Rego says investors should revisit the risk-return profile at the time of averaging to see whether there are better opportunities with similar returns but lower risk.

Cost averaging is advisable for investors who have a long horizon during which the stock price may fall many times. "For others, because the time horizon is short, averaging may not be advisable in most cases," says Shah of Kotak.


THINGS TO LOOK AT BEFORE AVERAGING

  • The market cannot stay at the bottom forever. So, if a stock you have bought falls lower than the purchase price, do a fundamental check on the company - balance-sheet strength, valuation, management quality and the core proposition.
  • Study the fundamentals of the sector to see if there is any chance of a re-rating.
  • Look at the past performance of the sector concerned and the company in different difficult scenarios.