‘How low can a stock go?’ is the wrong question to ask; focus on these 4 fundamental factors instead

Benchmark indices broke below crucial support levels in a matter of days in July. The S&P BSE Sensex has fallen over 6 percent from its record high of 40,312 recorded last month and Nifty has plunged over 7 percent from the record high of 12,103.

The market has been on a losing spree since and the sell-off has only gotten worse since the Budget announcement on July 5.

Over two-thirds of Nifty stocks are trading at double-digit discounts to their respective 52-week highs, which has also pulled the index 5 percent lower in June-July.

Among the Nifty50 names, 28 stocks are trading below their respective 200-DMA. These include names like Maruti Suzuki, Bajaj Auto, Hero MotoCorp, Hindustan Unilever, Tech Mahindra, Mahindra & Mahindra, Sun Pharma, Zee Entertainment and ITC.

Most of the top marquee names are trading in a downtrend and it is difficult to gauge how low they'll go. Predicting top as well as bottoms is one of the toughest calls to make in trading.

Peter Lynch once said that “There is simply no rule that tells you how low a stock can go in principle.”

Empirical evidence is clear that it is practically impossible to gauge how low the stock price can go if it is caught in a vicious cycle of deterioration especially at a time when demand is falling, the economy is showing signs of a slowdown, negative news flow, corporate governance issues, and risk of default.

“Downtrends have cycles ranging from one year to three years. When sentiments become super bearish, stocks refuse to fall further despite negative news and valuations are at the lower end of the band, at such times a sustainable rally can emerge,” Umesh Mehta, Heard of Research, SAMCO Securities told Moneycontrol.

“Currently, valuations are still high but sentiments are severely negative so at best a bounce can be expected in the short term. There are no visible signs of a reversal yet and the market is expected to fall further. Hence, for now, investors should wait and watch before jumping into stocks and start bottom fishing,” he said.

ICICI Securities in a report said -- the right question to ask would be -- ‘Is the business model and long term growth outlook largely intact?’

According to the note, here are 4 fundamental factors which are possible to analyse:

(iv) Valuation stands at the lower end of the long-term range (10-year range).

Stocks which fulfil the above criteria according to the domestic brokerage firm include names like Tata Motors, Cadila Healthcare, Quess Corp, Ceat, and Greenply Industries.

Empirical evidence suggests very few stocks make it to earlier levels post a significant correction. Even if the stock bottoms out, recovery to a previous high has been rare, which is the main reason for buying the stock after a sharp correction in the first place.

“Our empirical analysis of sharp stock price corrections of more than 75 percent from their peaks during a two-year period since CY10 indicate very low probability of scaling back previous highs (eight out of 228 stocks, which fell more than 75 percent over a two-year period since 2010, have been able to scale back their previous high),” ICICI Securities note added.

Key reason for this behaviour is the adjustment to the new reality after original beliefs of the attractiveness of the business model and prospects are shaken. Resulting in permanent derating of stocks, the note explained.

Over the past two years the Nifty50, NSE Midcap and NSE Smallcap are down 6 percent, 25 percent and 40 percent, respectively, from their peak levels.

In contrast, in the BSE500 universe, 167 stocks (Large - 10, Midcap - 28 and Small - 129) have lost at least 50 percent from their two-year peak while extreme loss of more than 75 percent was seen in 41 stocks (Large – 2, Mid - 6, and Small – 33) during the same time.