You’ve likely heard of the Pareto Principle, more popularly known as ‘the 80/20 rule’, which suggests that roughly 80% of effects come from 20% of causes.

Despite being very simple (some might even say simplistic), this principle is quite well-known because it seems to hold true in a wide variety of domains.

And the 80/20 rule tells us something interesting about the stock market: 80% of “real” market quality comes from 20% of stocks.

In other words, if you put together all the stocks that have high earnings multiples and rich valuations, most of them (up to 80%!) don’t deserve such multiples and valuations.

But then how do they end up with such inflated valuations, and how can you take advantage of them?

Irrationality amplified

As you might expect, “valuation mismatches” mainly take shape during bull markets.

During such periods, companies that are of inferior quality in terms of earnings stability, growth, or capital allocation start commanding valuations similar to or even better than those of high-quality companies.

But why does this happen? Well, when a bear market is close to its bottom, most low-quality companies are priced under the assumption that they will either fail or end up delivering poor long-term value.

But when times change and a bull market takes hold, the rising tide ends up lifting all boats.

As a result, low-quality stocks start delivering extraordinary returns and profits, even though nothing has changed radically in terms of their fundamentals. And some investors end up making a fatal mistake by extrapolating such trends into the future.

What smart investors should do

How can you take advantage of some investors being irrationally optimistic about low-quality stocks during bull markets? Well, you can use the concept of ‘capitulation’ to identify periods when it might be a good idea to enter the market.

Capitulation refers to a point where investors give up and sell their stocks in a panic, often at steep losses. It is characterised by high trading volumes, extreme fear, and a sharp drop in stock prices. It often creates bargains and buying opportunities.

Now, history tells us that in a bear market, everything falls. But weaker firms, which are usually more in number (due to the 80/20 rule), fall especially deep.

So one sign of capitulation is when 50% of Nifty 500 firms fall more than 50% from their peak.

And as you can see from the chart below, we’re not there yet.

But if the thesis discussed above appeals to you, you should probably keep a close eye on this metric over the near term!

For more actionable insights backed by data and analyses, we invite you to read thelatest edition of Netra in its entirety.