Sunday, October 12, 2014

Market fluctuation

When there is market fluctuations or consolidation as experienced in recent times, it is time to revisit some of the best advice out there. This is from Berkshire Hathaway's Annual Report in 1997 at a time when there were some market challenges. Remember our "Tom Yam effect"?

How We Think About Market Fluctuations 

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
     
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
      
For shareholders of Berkshire who do not expect to sell, the choice is even clearer. To begin with, our owners are automatically saving even if they spend every dime they personally earn: Berkshire "saves" for them by retaining all earnings, thereafter using these savings to purchase businesses and securities. Clearly, the more cheaply we make these buys, the more profitable our owners' indirect savings program will be.
      
Furthermore, through Berkshire you own major positions in companies that consistently repurchase their shares. The benefits that these programs supply us grow as prices fall: When stock prices are low, the funds that an investee spends on repurchases increase our ownership of that company by a greater amount than is the case when prices are higher. For example, the repurchases that Coca-Cola, The Washington Post and Wells Fargo made in past years at very low prices benefitted Berkshire far more than do today's repurchases, made at loftier prices.
      
At the end of every year, about 97% of Berkshire's shares are held by the same investors who owned them at the start of the year. That makes them savers. They should therefore rejoice when markets decline and allow both us and our investees to deploy funds more advantageously.
      
So smile when you read a headline that says "Investors lose as market falls." Edit it in your mind to "Disinvestors lose as market falls -- but investors gain." Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: "Every putt makes someone happy.")
      
We gained enormously from the low prices placed on many equities and businesses in the 1970s and 1980s. Markets that then were hostile to investment transients were friendly to those taking up permanent residence. In recent years, the actions we took in those decades have been validated, but we have found few new opportunities. In its role as a corporate "saver," Berkshire continually looks for ways to sensibly deploy capital, but it may be some time before we find opportunities that get us truly excited. 

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The recent consolidation is hardly a time to think about opportunities yet, but would be good if it is to deteriorate further taking a cue from the above.

Wednesday, October 8, 2014

Quite interesting times

Should one catch a falling knife? I would not especially when we have seen that the knife is already been held high up. In recent times, useless stocks have reached all time high. The usual lesson is that if one is to hold on to those stocks, be afraid as we would never be comfortable with those companies. It may be a one time wonder. Good stocks would however pick itself up. I have seen that in old old stocks like Genting, BAT, Nestle etc. and they would reach all time high again and again.

Not for those useless ones as chances are some of these companies financials are tweaked to accommodate the good times. When it is bad times, no point for these companies to show good results right?

Good companies however would not need to tweak their accounts. They will perform and pick themselves up usually (not always). Anyway, the market has only been down for few days. I am not sure whether how far more it will deteriorate.

Globally, stocks are not performing as well with some fear that China and Europe will be slowing down again. As mentioned, commodities are taking a hit and that may impact our country as well being one country that is quite dependant on petroleum related and other types of agri products. Things are not well it seems now.

It should be interesting to see what Bank Negara and government will do if the fall is continuing... 

Monday, October 6, 2014

Financing: Why government and banks may have gotten it all wrong

We are pretty good at encouraging Malaysians to borrow more for homes, cars, other consumption purposes but probably not in the areas where it is probably more beneficial to the nation.

How much is my flexible rate loan from a bank if I am to borrow RM1 million? I can get as low as BLR - 2.5%. At the current BLR rate of 6.85%, my effective interest rate is 4.35%. That is historically very low although BLR is not at its lowest. It was as low as 5.5% back in 2009. Bank Negara is trying very hard to regulate interest rates and that in itself is only helpful towards owning a home or a car, which is why consumption loan is at its highest ever, EVER.

Now turn this around? If I am a business owner, and I need a term loan from a bank. What is the interest rate I am paying? I would still be charged something like BLR + 1.5% or even more. That translates to around 8.35% - a whopping 4% higher than if I am to get a housing loan. Would this be friendly towards business? Or would this action be friendly towards the property sector only?

With the differences in rate, if I own a property, I would probably be refinancing my home by taking opportunity of the lower rate (by 4%) to fund my business.

Banks would act upon where it stands to make from the most and it is not surprising that they have been focusing on home loan or other consumption loans such as automotive, credit cards and personal loans recently. Lending for these purposes however is less productive as compared to lending for businesses, which is also why Malaysia has not been very successful in churning out entrepreneurs.

If I am an young entrepreneur, one whom most probably would not be owning many assets, I would be probably be turning towards business loans with little collateral. That is expensive comparatively against buying a home where the collateral is the house. Where as a young person should I be looking at? That young person would probably be less inclined to startup his own business, but ended up investing in a home.

This to me is a move towards wrong direction where as a country, we should be more friendlier towards business entrepreneurship. Is there a reason why we are not entrepreneur friendly, but the type of corporations we have been attracting are only large ones who are able to get loans (non BLR) at much lower rates unlike the smaller corporations.

Saturday, October 4, 2014

Price-to-earnings ratio and its use as an investment strategy

by KC Chong

“The key to successful investing is to relate value to price today.”

PE ratio is the most widely used metric as a measure of how expensive or cheap a stock is. Analysts and investment bankers use this valuation metric in their valuation reports all the time.

Price-earnings ratios vary across sectors with stocks in some sectors consistently trading at lower P/E ratio than stocks in other sectors. It is generally acknowledge that stocks that trade at low P/E ratios relative to their peer group must be mispriced.

P/E = Market price / Earnings per share (EPS)

The widely used of P/E ratio to gauge the attractiveness of a stock is often justifiable as given below:
  • ·       it is an intuitively appealing statistic that relates the price paid to current earnings.
  • ·       it is simple to compute for most stocks, and is widely available, making comparisons across stocks simple.
  • ·       it is a proxy for a number of other characteristics of the firm including risk and growth.


One big problem with P/E ratio is which “EPS” is used.
  • ·       Is it the EPS of the most recent financial year?
  • ·       Is it an undated measure of EPS by adding up the latest four quarters results?
  • ·       Is it the expected EPS for the next financial year?
  • ·       Is it before or after the extra-ordinary items?
  • ·       Is it based on the outstanding number of shares or all shares that will be outstanding when all warrants or ESOS are converted (fully diluted)?

Consider this case of internet stocks at the end of the 20th Century. All telecom and internet stocks were trading at P/E multiples of high tenths or even more than hundred. If a particular internet stock is trading at a P/E ratio of say 50, was it considered cheap? I don’t.

Besides that, all companies, even those in the same industries, contain unique variables - such as growth, risk and cash flow patterns. Surely a company which has poor operating efficiencies, no potential growth, a poor balance sheet should not be accorded a similar P/E ratio with one which has superior earnings and cash flow growth, and a healthy balance sheet. A company with strong market position in general generates more stable earnings should be accorded with higher P/E ratio.

P/E ratio is hence more likely to reflect market moods and perceptions but this can be viewed as a weakness, especially when markets make systematic errors in valuing entire sectors.


Figure 2 above shows the PE ratio distribution of S&P500 stocks on 31st December 2013.

As you can see above, most stocks are now trading above a PE of 16. Hence a PE ratio of less than 16 may be good, below 8 will be fantastic, but above 20 may be too expensive.

Estimating fair PE ratios from fundamentals
One way for the practitioner to do to solve this problem is to use the Katsenelson’s absolute P/E method to find a fair value of P/E ratio for a specific firm which we will discuss further later.  
Here we will look into a theoretical view of how P/E ratio is related to metrics such as return on equity (ROE), dividend payout, growth, cost of capitals etc.

P/E ratio: Theoretical background
The financial theory postulated by John Burr Williams in his “The theory of investment value” says the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. The simplest model for this purpose would be the Gordon constant dividend growth model for a stable firm.

P0 = DPS1 / (r-g)                     Equation 1
P0 = Value of equity
DPS1 = Expected dividends per share next year
r = Required rate of return on equity
g = Expected growth rate in dividends (forever)
Divide both sides of Equation 1 by expected earnings per share next year, EPS1
P0 / EPS1 = Forward PE = (DPS1 / EPS1) / (r – g ) = Expected payout ratio / ( r – g )                           

Equation 2
Equation 2 shows that:
·       A higher growth firm should  have higher P/E.
·       A higher risk firm having a higher cost of equity, r, will have a lower P/E ratio
·       P/E should increase when the payout ratio increases.
·       Firms that are more efficient about generating growth by earning a higher return on equity will trade at higher multiple.

Note that the above equation 2 is the fair PE ratio for a stable growth phase. For a high growth company, you would have to estimate the payout ratio, cost of equity and the expected growth rate in the separate phase of high growth and the stable growth period, and summing up the value in these two phases taking the time value of money into consideration. This approach is general enough to be applied to any firm, even one that is not paying dividend right now.

Investing using the low P/E ratio strategy
Tons of research has shown that investing in low P/E ratio stocks have yield extra-ordinary returns when compared to the broad market. However just basing on P/E ratio alone is not a desirable way as P/E ratio theoretically depends on a number of factors. It is possible that these low PE stocks are riskier than average and that the extra return is just a fair compensation for the additional risk, low future growth rates and poor quality earnings. One can improve the strategy tremendously with some screening works based on the discussion above as below.

  • Low P/E ratio with respect to the prevailing market, say not more than 12
  • Low idiosyncratic risk as measured by debt/capital ratio, of less than 0.6, current ratio of more than unity, and interest coverage ratio of more than 3.
  • Reasonable expected growth in earnings of more than 5%
  • Historic growth rate in past 5 years of more than 5%
  • Good quality of earnings with reasonable cash flows