Chemical Stocks Bottomed Out?

What if I told you the stock market of a country whose currency depreciated by 25% over the past one year, has an inflation rate of 55% per annum, has delivered a 115% return.

Also worth mentioning is that the country has been hit by a devastating earthquake.

Well, the country is none other Turkey, or as it's now known, Turkiye.

The stock market is indeed a strange place. But when it comes to the stock market, the problem lies with collective thinking.

Here's something my father once told me...

'When markets stop falling despite bad news, the bottom is more or less made and when markets stop rising despite good news, the top is more or less made.

The market is much smarter than you think. Bottoms and tops are made when information becomes news.'

History points out to many such instances. People thought that post 9/11 attacks in America, markets would sink.

Well, the bottom was made immediately less than few weeks after the markets opened.

In case of 2008, the global markets were falling six months prior to the Lehman and Bear Sterns bankruptcy.

However, once the Lehman bankruptcy was declared, contrary to expectations, the market soon made a bottom.

If you take Covid as an example too, global markets along with India, bottomed out in the last week of March when strict lockdowns were imposed.

In fact, Covid cases in March were hardly anything to begin with, however the market had already discounted the worst and declined by 40% from the top in a few weeks.

In hindsight, this obviously seems easy to understand. But in reality, seldom can one catch the bottom or the top.

The prime reason is our own emotions. The problem with humans is that we are programmed to buy the greed and sell the fear. People who can master this impulse, can make a fortune.

The past one year has been extremely painful for smallcap and midcap investors contrary to what the benchmark index Nifty and Sensex have done.

No major global event has happened like the ones mentioned above. But if we look at certain sectors, an average of 30-50% has been lost over the past year.

While the Nifty has barely fallen by 7% from the top, the fall in small and mid-cap stocks has been brutal.

BSE Small Cap Index

BSE Mid Cap Index

Now, the problem is that the street is divided what strategy to follow for small and mid-cap stocks.

Both the smallcap and midcap indices are down by 10% and 8% respectively over the past three months. So the question to be asked is have they bottomed out?

If we go by empirical evidence as well as history (above examples), stock price bottoms are made much before the actual numbers start turning around. I believe talking about small and mid-cap stocks and forming an opinion about the index is too generalised.

Why not focus on sectors?

There will always be some sectors which will have tailwinds and will outperform.

I ran a screener to see where the carnage has been. The chemical sector has fallen the most over the past one year and rightly so.

If investors pay FMCG valuation multiples to buy commoditised chemical companies, this is what will eventually happen.

Post Covid, due to a sharp increase in chemical prices, some chemical stocks jumped 5-7 times in one year. I'm sure when stocks rally, some narratives must have been peddled around.

The hottest topic was China plus one. While China plus 1 could be a reality, it is a gradual process and did not reflect in earnings of any company. The assumption which people made was to extrapolate inflated earnings into the future.

A combination of mistakes led to wrong pricing for the sector. These were assigning a high valuation multiple and making wrong assumptions of sustainable earnings.

Obviously, the bubble has burst resulting in a sharp correction in most of the chemical stocks.

So now the question is...

Should You Buy Chemical Stocks?

While majority of chemical companies have fallen by 30-50% from their peak, looking at price action alone is not sufficient to indicate a bottom.

Just because a stock halves it does not become a value buy and just because a stock triples in a year it doesn't become a sell.

What must be seen is the valuation multiple in conjunction with future earnings potential.

A lot of investors mistake bottoming out as 'price bottom'. However what must be seen is the 'earnings bottom' and the triggers for a rebound.

From the face of it, stocks like Balaji Amines and Alkyl Amines have halved in a year. However from a long-term valuation standpoint are still above their mean P/E ratio.

However, if you look at GNFC, the stock has corrected 38% from the peak and is also trading 25% below its 5-year average P/E ratio.

Does that mean GNFC is a better bet than Balaji and Alkyl Amines?

Certainly not.

While Balaji Amines and Alkyl Amines are trading above their 5 year valuations, they have corrected significantly as earnings slowed down over the past 3 quarters.

If the earnings are likely to turnaround, these companies will look compelling even though they are trading higher than their 5-year valuations.

For GNFC too, if the earnings have bottomed out, there is not much to lose at this price. However if earnings fall further, then even a P/E multiple of 5 can also look elevated.

In a nutshell, chemical sector after the steep fall looks attractive.

However, it's pertinent for investors to find the companies in which earnings have bottomed out and only then, after doing the necessary due diligence, consider making an investment.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com