It’s Time To Exit From ‘Those’ Stocks!

Were you among the investors who sold stocks during the recent market panic, or shouldn’t you have followed the herd mentality? In the unpredictable world of stock markets, recognising the opportune moment to sell can be as crucial as identifying the right time to buy. Mandar Wagh delves into the concepts of intrinsic value and overvaluation, offering insights into strategies investors can employ when their stocks are deemed overvalued 

What an exceptional fiscal year it has been for the domestic stock markets, wouldn’t you agree? With the Indian benchmark indices BSE Sensex and Nifty 50 surging by around 30 per cent, and broader indices experiencing an astounding growth of over 60 per cent each, the pervasive investor optimism was unmistakably evident throughout the preceding financial year. In March 2024, significant selling pressure was observed across the broader markets, notably affecting power, energy, real estate, railway, and PSU stocks. This could be attributed to profit booking following sustained strong rallies or could reflect a cautious response to remarks from the SEBI chief warning about market bubbles and stock overvaluations.
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While some market experts concurred with these concerns, others like Uday Kotak, Founder and Director of Kotak Mahindra Bank, expressed a different perspective. Kotak stated that he believes the market is not approaching the bubble territory. He acknowledged the presence of some frothiness, but emphasised that it is not yet out of control. Nevertheless, as informed investors, it’s prudent to re-evaluate our portfolios to safeguard against potential bubble bursts and mitigate potential losses. Let’s begin by comprehending the necessity of selling ‘those’ stocks at this moment! 

Understanding Intrinsic Worth and Market Evaluations 

In the realm of stock valuation, the term ‘intrinsic value’ denotes the estimated true worth of a stock, grounded in a variety of fundamental factors including the company’s earnings, cash flow, growth prospects, dividends, and relevant financial metrics. It embodies the theoretical worth of the stock, irrespective of its prevailing market price. Meanwhile, ‘overvaluation’ and ‘undervaluation’ serve as descriptors for the perceived relationship between a stock’s market price and its intrinsic value. Overvaluation arises when the market price of a stock surpasses its intrinsic value, signifying that investors are paying more for the stock than its fundamental worth. 

This can result from speculative buying, market exuberance, or flawed assessments of a company’s future outlook. When a stock is overvalued, there exists a risk of its price declining over time to converge with its intrinsic value, potentially leading to losses for investors who acquired shares at inflated prices. Conversely, undervaluation manifests when the market price of a stock falls below its intrinsic value. In this scenario, the stock is trading at a discount relative to its true worth based on fundamental factors. Investors may perceive undervalued stocks as promising opportunities for capital appreciation, anticipating that the market price will eventually ascend to reflect the stock’s intrinsic value.
 

How to Check the Worth of a Stock?

You might find it necessary to assess whether the stocks in your portfolio are overvalued or undervalued. To understand this, it’s advisable to scrutinise the company’s financial statements, encompassing earnings, revenue growth, profit margins, and cash flow. Additionally, consider evaluating the company’s competitive standing, industry outlook, and potential growth prospects. One approach to reaching a conclusion involves calculating key valuation ratios such as the price-to-earnings (PE) ratio, price-to-book (PB) ratio, and price-to-sales (PS) ratio. 

Analysing these ratios in comparison to historical averages, industry benchmarks, and the performance of the company’s peers can provide valuable insights into whether the stock is trading at a premium relative to its underlying fundamentals. Furthermore, estimating the intrinsic value of the stock through discounted cash flow (DCF) analysis is advisable. It is essential to consistently monitor the stock’s performance and stay informed about any developments that could influence its valuation. Regularly reviewing financial news, company announcements and economic indicators can assist in making well-informed investment decisions.
 

What if Your Stock is Overvalued? 

In the unpredictable world of stock markets, recognising the opportune moment to sell can be as crucial as identifying the right time to buy. While investors frequently receive guidance on which stocks to purchase, the decision to divest is equally significant, particularly when confronted with overvalued stocks. Divesting from overvalued stocks is often the initial strategy investors contemplate, yet this decision should not solely rely on the stock’s valuation metrics. Given the substantial upsurge in stock prices across the board in recent months, it’s not surprising that many stocks have become overvalued. 

However, it’s important to recognise that certain stocks, despite their overvaluation, may possess strong fundamental underpinnings and deserve ongoing investor interest. Therefore, opting to sell such stocks could prove detrimental in the long term. Therefore, we present a comprehensive table delineating key and simple financial metrics pivotal for informed decisions. We have organised BSE-listed companies into three distinct categories based on market capitalisation: those exceeding ₹50,000 crore, ranging from ₹20,000 crore to ₹50,000 crore, and falling between ₹10,000 crore to ₹20,000 crore. 

Furthermore, we have compiled a roster of companies exhibiting elevated valuations, surpassing industry averages, yet experiencing declines in revenue, operating profit, and net profit either on a quarter-on-quarter or year-on-year basis. This discernibly illustrates that these stocks are trading at inflated values without substantial fundamental support in terms of financial growth. Individuals may opt to divest from such stocks in alignment with their financial objectives and risk tolerance thresholds.
 

What Additional Strategies Are at Your Disposal? 

◼ Trim Positions — When you trim positions, you sell a portion of your holdings in the overvalued stock. This allows you to lock in profits and reduce your exposure to potential losses. By selling some of your shares, you can capture gains while still keeping some exposure to potential upside if the stock continues to perform well. This strategy helps you strike a balance between realising profits and managing risk. 

◼ Consider Hedging — Hedging involves using options or other derivatives to protect your portfolio from potential losses due to an overvalued stock. For example, you can buy put options to profit from a decline in the stock’s price or implement collar strategies to limit downside risk while still participating in potential upside. Hedging strategies help you manage risk and protect your portfolio against adverse market movements. 

◼ Diversify the Portfolio — Diversification is a strategy where you spread your investment across different assets to reduce risk. By reallocating the proceeds from selling overvalued stocks into other investments that offer better value or diversification opportunities, you can spread risk and improve overall returns. Diversification helps you mitigate the impact of individual stock performance on your portfolio and enhance long-term stability. 

◼ Seek Professional Advice — Consulting with a financial advisor or investment professional can provide valuable insights and recommendations on managing overvalued stocks. They can offer personalised guidance based on your financial goals, risk tolerance, and investment timeframe. Professional advisors have expertise in analysing market trends, assessing risk, and identifying suitable investment strategies to help you navigate through market uncertainties effectively.
 

Conclusion

In the current unpredictable market environment, it is imperative for investors to recognise overvalued stocks to protect their investment portfolios and attain their long-term financial objectives. By comprehending the signs of overvaluation and implementing suitable strategies, investors can adeptly manoeuvre through market volatility. 

Similar to the meticulous scrutiny of a company’s financial performance, operational prowess, market standing, industry outlook, and growth catalysts undertaken during the investment phase, these same factors should be weighed when contemplating divestment. Rather than succumbing to panic over inflated valuations or hastily seeking to capitalise on profits, it’s crucial to understand that fundamentally strong companies have the potential to experience exponential growth even after divestment. Certainly, exiting investments with excessively high valuations lacking strong fundamentals or growth drivers is a prudent decision.

Click here to download list of Stocks that seem to be overvalued based on their fundamentals

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