This article was originally written by Nicki Bourlioufas for Morningstar’s Australia website. It has been edited for an Indian audience.
The recent sell-off in share prices highlights an important point for investors -- prices can vary widely and it's all part of the ride, and the opportunity to buy at lower prices shouldn't be ignored by investors who are keen to build their portfolios.
If you have a long-term investment horizon, a short-term fall in prices or even a downturn in prices over the medium term isn't something that will hurt you. It's not nice, it doesn't feel good, but unless you sell your shares at the bottom of the market, then a price drop won't dent your wealth over the longer term.
So, how can an investor take advantage of volatile markets? While there's no way of knowing whether the stock market has further to fall, there's no point trying to pick the bottom, according to Morningstar head of equities research Peter Warnes.
The important point is that prices are much lower now than they have ever been for many quality stocks, and while the stock market might be correcting, we aren't experiencing a crisis.
"The key is to distinguish between a genuine economic crisis, which may depress share prices for many years, and a market correction, where prices may fall, but not necessarily for an extended period of time. What you are trying to avoid is catching a falling knife, which can happen when you have a crisis or a black swan event on your hands," Warnes says.
"But last week's sharp price fall wasn't a crisis, though it may be a correction. The world is in much better shape now than it was during the global financial crisis. The all-important US economy is growing and interest rates are heading higher, which is an indication of a stronger economy. While higher rates may precipitate another share market pullback, it won't trigger an economic crisis.
"Having decided that there isn't a crisis, this pullback, or correction, represents an opportunity for investors to build up their long-term portfolios."
But investors need to be picky about where they place their funds. While some shares might be cheap, they may also be risky. So how do you build your portfolio with quality stocks and avoid the duds?
Warne encourages investors to have a heavy bias towards stocks which have an economic moat or a sustainable competitive advantage, so the company will deliver excess returns to shareholders over the long-term -- companies that generate sustainable free cash flows, can pay dividends and reward shareholders.
If the stock is trading at an acceptable discount to fair value, then the time is right to buy.
Morningstar analyst Suruchi Jain suggests that investors look at IDFC, State Bank of India and ICICI Bank. All three are trading below their fair value estimate, or FVE.
Analyst Piyush Jain notes that the price of Ambuja Cements at Rs 212 is way below its FVE of Rs 280. He also recommends Tata Motors which is trading at Rs 325; the stock has a FVE of Rs 650.
Warnes recommends a gradual approach rather than going on a buying spree.
"Feed your money into the market gradually. We don't recommend you go at it all at once. Rupee cost averaging is always an effective way to invest and it's a good idea to keep some money on the sidelines for when markets correct," he says.
And once you're in, stick to your guns. Your asset allocation is a long-term position. As prices swing about, and perhaps sell off even more, it's important to stand by your purchases and not crystallise any losses by selling at the bottom of the market.
The share market over the long term is resilient, but over the short term it may well swing about some more.
