How to find buying opportunities in a stock market sell-off

Periodic sell-offs are an undeniable fact in the stock market, and they range in severity from occasional-but-savage bear phases to much more common one-day setbacks.

Not only are these events hard to predict but they can also have miserable consequences. Even a brief pullback of just a few percent can be enough to cause panic if you’re unprepared. In these moments, the human instinct is to fight or flee. But when you’re scared out of your wits it’s not always easy to make solid financial decisions.

At worst, the emotional turmoil results in selling and taking a loss on the way down and then being psyched out of buying back (and missing the gains) as the market recovers. Timing trades in and out of the market can be a humbling experience when you’re acting on instinct.

The unforeseeable size and duration of market dips - and the uncertainty they cause - is generally why most investors are urged to think long term and have a plan for all events.

Multi-year time horizons and good planning can help smooth the impact of bear markets and make the intermittent single-figure “corrections” easier to live with.

In fact, with the right plan, a correction can offer the chance to buy positions that might otherwise have been out of reach. In this article we’re going on the offensive by looking at the factors to think about when it comes to finding opportunities in a sell-off.

Grappling with the bear

On most measures, stock markets reach ‘bear territory’ when they fall by 20 percent or more. These kinds of major pullbacks are rare but inevitable.

In the US, which accounts for more than 50 percent of the ‘global’ equity market, there has been a bear market every 3.6 years on average since the late 1920s. Those gut-wrenching phases each lasted an average of 9.6 months, but the timings vary a lot.

For instance, both the dotcom crash of 2000 and the financial crisis of 2007-2008, led to bear markets lasting longer than a year. It took another 11 years for the next one to come along, which was the Covid-19 crisis. Unlike its predecessors, that crash was followed by a recovery that only took a few months.

While bear markets are perilous, a much more common challenge for investors is dealing with “corrections”. Technically, corrections are when the market falls between 10 - 20 percent. But after long periods of relative stability, daily drops of just a few percent are often classified as corrections, and are just as capable of stirring unease and even panic.

These kinds of sell-offs can happen for a variety of reasons - ranging from macro economics and geopolitics to very specific country, sector or even single-stock shocks. Journalists and analysts like to draw conclusions, but the fact is it’s not always clear what the cause is and how long a rebound might take.

What is undeniable though, is that even modest market corrections can cause a spasm in prices, which in places can be severe. For the unwary, it’s painful watching. But if you’re prepared for these events when they occur, corrections can actually present opportunities.

Arming yourself with a long-term outlook and a screen or watchlist of stocks of interest (if they were cheaper) could give you a useful point of reference when the market feels chaotic and others are losing their heads.

If you don’t have a checklist or watchlist to hand, one option to get you started is a screen that looks for good quality stocks with a recent track record of positive momentum. Here’s why...

Good stocks on a solid trend

High quality and improving momentum are characteristics of stocks that, generally speaking, the market tends to rate highly (they’re good and they’re on an uptrend). Some come with full or above-average valuations, while others have more of a contrarian ‘recovery’ feel to them, where the price has been starting to move higher.

In the context of a sell-off, these stocks are interesting because they are a test of market fear. In general terms, the combination of quality and momentum means that they’re the kinds of shares that investors may be less willing to give up as easily as others. And if they do get marked down, it may only be for a comparatively short time. So there can be opportunities here, as well as a useful reference to how the market is behaving towards its favourite shares.

Theoretically, because of their quality and recent strong momentum, you might expect shares with this profile to recover quicker when market confidence returns - but there are no guarantees. In extreme conditions, everything can be marked down and no-one knows what the future holds. But with this approach, at least you’ll have a compass.

What to look for in quality and momentum

In company shares, quality can be measured in many different ways. Typically, the best quality companies have strong, defensible profitability and are very efficient at making money. They have solid, improving balance sheets and no accountancy red flags. Crucially, you can easily find clues to these kinds of traits in a company’s financial reports...

Two factors you might consider are positive earnings growth and double-digit return on capital employed, which are both commonly reported. They offer a view on whether the company is growing its profitability as well as how efficient it is as recycling profit in order to grow and generate more profits. Companies that are good at putting their capital to work are often good quality businesses.

In terms of momentum, again there are multiple measures you can use. Academic research suggests that over a 12 month period, stocks with the strongest momentum tend to get off to a bad start, with the first month being negative. However, in this context, looking for positive 1-month, 3-month and even 6-month relative price strength is a technique that will pinpoint stocks that are consistently ahead over the recent term and are perhaps well-placed to maintain that trend.

Constructing the screen

With Stockopedia you can construct a screen to do this by starting here. Alternatively, you can Copy and Save (and then Edit) this screen, which gives you a starting point.

To get started, click Add Rule to launch the Rule Picker. Here you can see that selecting “Quality” and then “ROCE” will give you the option to select a timeframe to use. Selecting TTM (trailing 12 months) will give you the ROCE over the past four reported financial quarters. Then click Save.

The main quality rules in this screen are ROCE and Earnings per Share Growth (which you can find in the Growth section of the Rule Picker). It also includes Stockopedia’s own Quality and StockRank measures, which do a great deal of heavy lifting in lasering in on good quality and solid overall quality, value and momentum factors.

The price strength measures - using 1, 3 and 6 month relative price strength can be found as a single “Relative Strength” rule in the main Rule Picker. In this screen, all we’re looking for is a measure better than zero, or flat. But you can make this much more demanding.

Here’s a snapshot of what the overall results table looks like:

A plan for volatile days

Faced with a sea of red on volatile days when the market is in correction mode, it’s easy to feel helpless. For many investors, it can represent a rapid undoing of weeks or months of progress. The behavioural risks - the chances of making rash decisions - are significantly heightened in these moments, which is understandable. Human nature means it’s much more comforting to take some sort of defensive action - so having a plan can be helpful.

Over time, bear markets and corrections are on average far less frequent than long periods of stability and positive momentum. So for investors with a longer-term outlook, having a pre-prepared screen or watchlist of stocks for bad days could be worth thinking about. At the very least, a wishlist of stocks that you’d buy if they were cheaper might offer a different perspective when markets sell-off and help you pinpoint potential opportunities in the recovery.