Thursday, October 16, 2008

Stock Markets - Predictors of the Future ?

As I was journeying on the bus and the MRT, I was thinking of how accurate the stock market is as a predictor of things to come. The market started its bear run in Oct 2007, and now Singapore is in a technical recession because of 2Q and 3Q 2008 GDP. So in a way, the stock market decline was able to "predict" the recession coming up and price it into share prices. This must be why people say that the stock market is a leading indicator, as it tends to react to future news and expectations even before they materialize and become apparent to the man on the street.

The reason for this uncanny ability of the stock market to anticipate economic slowdowns and recessions is due to the fact that most forward-looking news is incorporated into the price through investors/traders expectations of the future. Of course, there are some who argue that it might be a self-fulfilling loop created, whereby people's expectations of others' expectations forms either a positive feedback loop to push prices up or a vicious cycle (like what we are witnessing) to force prices lower. The analogy which Benjamin Graham used of Mister Market is extremely apt as stock markets are the collective actions of millions of participants, al trying to maximize their own gain and all thinking that they are (somehow) smarter than the guy next to them.

Normally, all this frenetic activity prices stocks very reasonably and fairly; and on "normal" days the market price can be said to be an accurate reflection of a company's intrinsic value. However, during periods of economic prosperity or depressive gloom, there is a tendency for the market price to over-shoot and land up too high or too low. Let me elaborate on this with respect to the current prevailing sentiment in the world. With the USA in constant fear of being "in a recession" and the rest of the world also afraid of tumbling into a long, deep recession; this has caused market prices to reflect the most pessimistic scenario, whereby many companies are priced as if they were better off dead than alive (below NAV !). This kind of weird asset pricing occurs in extreme conditions (admittedly, current conditions are unprecedented) and acts as a barometer of sentiment about the future (or the lack of one !).

The fear and trepidation is quite apparent in the last 3 weeks as the crisis has spiralled into something of an avalanche instead of being just a tiny snowball. On my blog alone, the number of visits has increased to more than 300+ daily (compared to 100-200 during the bull market and on normal market days). There are also seemingly more people acting sarcastic or cynical, which I may attribute to acute stress as a result of the sudden plunge in the value of their shareholdings. After some thinking and reflection, I realized that this is the PERFECT opportunity to purchase more shares in companies which I am confident in, and which can emerge from this crisis stronger. As a value investor, the idea is to own shares in good and growing companies, instead of relying on hindsight investing to tell if one should sell at the peak and buy back at cheaper prices (incidentally, anyone can be a hindsight investor by looking at a historical chart and sounding intelligent when they point out when you should have bought and sold; but try doing that in real time hehe). So the crux of the matter is to own shares in companies that will do well 3-5 years from now; the short-term price fluctuations do NOT matter as there is no intention to sell anyway.

Based on the above observation of the predictive abilities of the stock market, what I can say for sure is that the market will almost ALWAYS start moving up about 6 to 12 months from the recovery of an economy. This means that almost no one can accurately time the bottom as no one will know how long or deep the current recession will last. Stock prices are useful future indicators of how the economy will turn out; and investors who wish to own a piece of a great company should make use of this rare window of opportunity to purchase to his heart's content. Just make sure you leave enough funds for emergencies !

41 comments:

Simon said...

i see u r blatantly starting to do some market timing

'should make use of this rare window of opportunity to purchase to his heart's content'

and quantitative analysis

the number of visits has increased to more than 300+ daily (compared to 100-200 during the bull market and on normal market days). There are also seemingly more people acting sarcastic or cynical, which I may attribute to acute stress as a result of the sudden plunge in the value of their shareholdings. After some thinking and reflection, I realized that this is the PERFECT opportunity to purchase more shares in companies which I am confident in

see! i was right.!
u can't rely on value alone. value is everywhere now. each stock is value. u need additional tools.
btw, u can sharpen yr skills even further with some technical analysis...

i'll be waiting for the day of your conversion, the day you admit u can't rely 100% on value investing alone..=)

Simon said...

how can i miss this piece written by you bearing all the hallmarks of market timing ..

market will almost ALWAYS start moving up about 6 to 12 months from the recovery of an economy.

i can't say the above is exactly correct. it's a crude observation, but u r getting there...just have to do more reading on bks that deal with mkt timing..=)

musicwhiz said...

Hi Simon,

Was a bit confused on your comment. You said I am blatantly asking people to do market timing ? In case you have not noticed, the market is currently at such valuations because of external economic conditions. If I had forseen this coming, and asked people to buy 6 months ago, then I would consider it market timing. If I just based on valuations alone, there would be attractive companies out there with long-term prospects. Problem of course is a lack of cash to swoop up all the bargains. Thus, I do not agree with your definition of market timing as I feel that valuations are good currently; so it's purely based on valuation alone.

I don't understand the point about quantitative analysis. What has the number of unique visits to my blog have to do with timing the market ? I can't see the association or connection. All I am saying is that with valuations at such depressed levels, it's a golden time for value investors to pick the companies they want to own for long-term. Such valuations do not come by often.

I am also not sure why you would be interested in my "conversion" as you call it. Thus far since late 2006 I have relied solely on value investing without any form of market timing. So far I don't see any problems with this method, and will continue to use it to the best of my ability.

Regards,
Musicwhiz

musicwhiz said...

Simon,

Incidentally, that was an observation made by me that the market is forward looking, rather than looking at history. You seem to be confusing it with market timing yet again. As I said in my post, no one can predict when markets recover; in fact it is the recovery of the stock market which signals that the economy is healing and will be back on track.

Thanks,
Musicwhiz

patrick ho said...

Hi MW,
haven't been reading ur blog recently, busy with school and everyth... The velocity of the decrease in prices is catching everyone unawares...So for me, what I'm doing now is increasing the margin of safety of close to 75%, and averaging my way down if even this safety level doesn't hold...averaging only if it falls by more than 15%...

The markets are starting to punish the companies which are in net gearing, so I guess for now, cash is king...I personally find it rather difficult to determine which business models can still survive net gearing through cash flow generation, so I'm trying my best to stay clear of these companies for now...looking at others with visible earnings ahead instead...

Down the road, only time will tell whether these companies with high debt levels can sustain their organic growth through cash flow from their operations...But I'm not taking any risks here, I mean, isn't value investing all about doing something u're confident in?:):)let's all stick to something we're confident in, and learn from our mistakes...Our mistakes are not going to surface now, they will only surface months or years down the road, so let's all hold our comments till then...

Patrick Ho

patrick ho said...

Hi Simon,
I believe MW has mentioned his views about market timing, or more aptly, NOT timing the markets.

I believe that for value investors, market sentiment will affect our buying decisions...when market sentiment starts to get poor, we increase our margin of safety...is that market timing? that's up to u to decide...wat we're trying to do here is to catch the companies only when they enter our alert radar on valuation grounds...and possibly averaging down if valuations get even more compelling...market timing? i don't think so...calling for a bottom isn't that easy, Henry Paulson got it wrong, many other Wall Street execs got it wrong...

As for any conversion, I guess it's up to MW to decide on it himself...watever is his own decision, he is going to be basing it on his confidence and competence level...if he ever swtiches an investing style, it might only be because he is very confident that that particular style will work for him...

investors, no matter wat style they adopt, should be confident of wat they're doing...wat MW and other investors like me are doing is to find out our confidence level...and, the only way to find out is to tide through this bear market...let's wait before passing our judgements...

patrick ho

Simon said...

mw, im not passing any judgment here...
the gist is, i feel u r using market timing and quant without realising it.
for e.g., yr no. of visits up to 300+ daily would be a good time to buy stocks. or even the no. of ppl acting sarcastic or cynical. these can be used as tools. of course it could be due to some other factors, but these r signals we can pick on to see buying or selling opportunities.
it's ok, if u disagree with it, im totally cool.

and patrick, increasing yr margin of safety when sentiment is poor...that doesn't make sense to me. this reeks of market timing, or even trend trading and momentum trading instead of value investing.
wat has yr margin of safety has anything to do with market SENTIMENT? shouldn't yr margin of safety hinge on the company's fundamentals?
moreover, i presume u increase yr margin of safety during bad market sentiments becos u r cautious. shouldn't u do the opposite instead? remember the greed fear thing that ppl endlessly quote from buffett?

Anonymous said...

Hi Simon,

Firstly, I don;t believe in technical analysis. What we mean by increasing tools: is to increase our understanding in business through a framework, simply a filter mechanism.

1. Buy business that are simple and you can understand
2. Sustainable competitive advantages
3. Able and trustworthy managers
4. Valuation and margin of safety


Fundamental analysis plus some common sense will do the trick.

Some common senses:
On Market timing -> To be greedy when people are fearful, be fearful when people are greedy. Don't have to depend on technical tools!


Market Sentiment ->

One can buy great companies at fair value (70-80%) in bull market.

One can buy great companies at discounted value (40-60%) in bear market.

One can buy great companies at extremely discounted value (80-90%) in depression.

regards,
Ryan

hilltop said...

MW said "There are also seemingly more people acting sarcastic or cynical, which I may attribute to acute stress as a result of the sudden plunge in the value of their shareholdings."

That is simply not true. If you go over all the comments posted on your blog this month, you'll realise the converse is much closer to the truth. Don't believe me? Take a quick count on the number of positive post vs negative ones in your previous update - positive defenders outnumber critics by at least 4 to 1.

Everytime anyone dares express negative outlook on the market, he/she is immediately flooded with a long list of "value investors" who trip over one another to defend their value strategy.

Such behavior is seldom seen during bull markets and to me just indicates the lack of confidence and probably the need to seek mutual reassurance from one another during such trying times. I won't deny there might be a couple of genuienely calm fellows out there, but the majority of them...

Exchanges here are almost becoming like those seminars in MLM companies whereby anyone who puts up a less than rosy picture is immediately shouted down by the crowds.

Ricky said...

Hi hilltop,
If it was true that you're commenting on the market, it would be fine. The outlook for the market is indeed bad like what you said.
But take a look at your recent post. Are you commenting on the market or the people's behavior/comments?
And if the exchanges here are beneath you, why are you even here reading it?

nhyone said...

I'm curious. Do you try to estimate the earnings for the next few years to do the value analysis?

The data for the past few years may no longer be valid.

Anonymous said...

Safest way:

Buy great company with discount to present value. (share price < NTA)

In this way, you earn future cash flow for free!

Ryan

harsha said...

I've been investing in the market for last 5 years solely based on fundamentals, out of the 20 quarters, i've outperformed broad market in just 4 Qs, this leaves me in a fix, and slowly moving towards accumulating ETFs as a 20% of my portfolio.

musicwhiz said...

Hi Patrick Ho,

Thanks for visiting. Frankly, I agree it's not easy to sift out the good companies from the bad either, because of the credit crisis screwing everything up and many companies may be having short-term debt obligations. One method I use is to to evaluate Management quality to see if they had survived previous crises before and how they coped. Admittedly, some of the newer companies I invested in have not been through a severe and prolonged downturn, so it remains to be seen if they can survive unscathed.

Ultimately, one has to have faith in the companies he chose to invest, or it would mean you have to screen more carefully the next time. All the homework should have been done at the point of purchase, the rest is just keeping up and monitoring the company's progress.

I personally think margin of safety should not depend on bull or bear market; but on the industry and company characteristics. If the company is in a risky and volatile industry, then one should demand greater margin of safety from errors.

When valuations are good, I will buy. There is no point in trying to time markets and using hindsight investing to say I could have bought/sold at so-and-so price; it's all academic I feel. One should be happy owning good companies even if the stock market closed down for the next 3-5 years.

Cheers,
Musicwhiz

musicwhiz said...

Hi Simon,

I disagree with your view that it's market timing and "quant" (whatever that is). It's just the simple matter of buying when valuations are depressed with respect to the prospects of the company. These are companies I wish to own for quite some time, so my intention was not to sell them off anyway.

And I agree with your point that margin of safety should be based on the company and industry, rather than market sentiment.

Regards,
Musicwhiz

musicwhiz said...

Hi Ryan,

Yes, those are very good screens ! They are what I use too to guide me in my investing decisions. A lot of it is also intangible and qualitative; not just purely about the numbers.

Thanks !

Musicwhiz

musicwhiz said...

Hi hilltop,

Very interesting view you have but I must say that it's flawed. In the first place, I am not comparing the number of "good" comments versus "bad" comments. What I am saying is that the number of bad comments has increased over say, last year during the height of the bull market. So it's a comparison more of the volume of "bad" remarks then and now; rather than good comments against bad comments.

There is no plethora of value investors trying to support one another. If you notice, it's just a bunch of people who invest based on a set of criteria and who are guided by a certain philosophy. It's surprising that you use an analogy to an MLM company, not very apt I must say.

As to the "reassurance" part, value investors come together to share ideas and opinions; rather than to seek reassurance. I have stated that upon reflection on my own companies, I have grown more confident of them and know that they are companies I can invest in for the long-term. I didn't need anyone here to reassure me of that; I thought of the issues myself and came up with the conclusion through objective fact-finding.

Musicwhiz

musicwhiz said...

Hi nhyone,

Yes, in a way I do project earnings to see if it will be higher or grow in the coming years. Though the future is never clear, I will invest based on a set of criteria which I have outlined on other sections of my blog. This is also supported by other empirical evidence which may be intangible (e.g. brand strength) or qualitative (e.g. experienced Management who are rational capital allocators).

Thanks,
Musicwhiz

musicwhiz said...

Hi Ryan,

Buying a company below NTA does not always work because the company needs to have growth prospects; otherwise it may not be generating FCF (to pay as dividends) and earnings will stagnate (meaning the company will trade below NTA for a long time to come). That's one reason why I don't always favour companies with market prices below NTA.

Regards,
Musicwhiz

musicwhiz said...

Hi harsha,

Actually, I don't think you should be using broad market as a comparison for your investment returns. As long as you get a decent and consistent return on your 5-year investment, you should be satisfied.

For myself, I only started serious value investing in the last 2 years, and have yet to accumulate a significant stake in strong companies over a long enough period to know whether I can get consistent returns. Perhaps if you revisit this blog 5 years later I can tell you my results, be they good or bad ! :)

Perhaps you can share more on ETF ? I am also curious as to how it works. I've heard it's not a very liquid investment though, care to comment ?

Thanks,
Musicwhiz

Anonymous said...

Hi MW,

Of course,in the first place, the company should generate fcf and maintain/expand her competitive advantages over long period of time.

The screen of buying under NTA (NTA = NAV - intangible assets - goodwill) is the safest way, which comes at the last stage of evaluating a company.

If one could buy such a business passing all the criterias, then it should be very safe.

regards,
Ryan

harsha said...

hi musicwhiz,
over the last 5 years, it is only occasionally that my returns (dividend yield + capital gains) beat the market.

In the local market scenario, over next 10-15 years, if my approach beats the market return or not is still a question mark.

The reason why I'm slowly turning into passive investment (ETF) is from the conviction that I might not beat the market in a long time frame (10 yrs), as my experience taught in the last 5 years that I might beat occasionally, but not always.

The illiquidity of ETF in local singapore market is a concern, though some say it is a misconception, at least i see, STI ETF is having good liquidity.

The other missing part which is never told is ETF dividend yield, which is index dividend yield, say 2%, is not insignificant in my opinion.

Coming back to Singapore local market, except the STI ETF(0.3%), rest of the ETFs have significant expense ratio (~1%), which make them unattractive, while the comparative ETFs in USA have 0.1-0.3% towards expenses.

Care to read the book, "the little book of common sense investing" from Bogle.

Anonymous said...

Hi mw,

with regards to fsl, do you loan to- market value covenant will be trigger?

jeflin said...

Musicwhiz,

I think you are doing fine with your due diligence and reading of Ben Graham's principles. Sometimes, when everybody agrees with you, it is not a good thing.

If there are disparaging remarks about your decisions, it could be a blessing in disguise... the more you should persevere.

patrick ho said...

Hi MW,
anyhow, just wanted to say, keep on going and do continue doing what u're doing. seems like thr's been a barrage of cynical remarks here and there, ignore them;)

Ken said...

MusicWhiz,

What actually happen to such a good company like Ezra to fall down till 50cents worth of sthares?

Believe you have a good impression on Ezra since the day you bought it..

Thanks.

Anonymous said...

Hi MusicWhiz and fellow investors,

I was looking through some penny stocks and one company caught my attention. I shall describe the situation the company is in and would like seek valuable opinions from all of you.

This company has been making consistent profits for the past couple of years with a net margin of about 14% in the past 2 years. Revenues growth has been slow and only picked up recently. Management has not been spending much on capex and as a result the company capacity is not expanding fast enough. Cash flow is strong with inflows from operation. Balance sheet is also strong with almost zero long-term debt.

The low market capitalization means this stock is off the radar of funds and liquidity is low (high liquidity risk as it doesnt take much trading to move the price of the shares). As such, do you think it is a good idea to buy into this company if it is selling at less than its net cash holdings (ie cash minus all liabilities, a net-net company according to ben graham)? The problem is the company has not given any dividends for the past 2 years and share price has been declining despite the firm being profitable.

What are you views?

S.Jealousy said...

Hi MW,

Do you think you want to add more chips on FSL Trust? It's dividend yield is quite good.

I may want to buy in some... would like to seek for your opinion, is the price now consider as ok?

p/s: your analysis is very helpful.
i believe in value investment.

Anonymous said...

hello all fellow value investors and disciples of Buffet, there sure are a lot of negative remarks on musicwhiz's blog these days. Must be wetting their pants due to the recent market drop.

What all this people don't realise is that for long term value investors like us, this is the best thing to have happened! Lots of great companies at bargain basement prices.

Stay the course and do not be dettered by such negative thinkers. They probably dont have the guts and logicl head to go through such trying times and it just shows in their desperate attempts to put down others.

please keep up the good work and continue to stay the course. I'm sure all of us here who can stay above the greed and fear of the market masses out there will profit in time to come!

nhyone said...

Lots of bargain, but do you have the cash to pick them up?

Is it wise to keep a cash cushion? If so, how much? In good times, it feels silly to keep it.

musicwhiz said...

Hi Ryan,

Agree with you on that. Very safe as in cigar-butt safe. Hehe. Problem is whether you can convince them to sell off their assets and return you net cash per share higher than what you paid for. :P

Regards,
Musicwhiz

musicwhiz said...

Hi Harsha,

I personally think it's not too important to beat the market. As long as you have a decent return on your investment over the long-term, you are already doing better than most investors.

Of course, ETF is a safer way of just buying the Index, but this means you can only get market returns (no chance to surpass the index's returns).

Regards,
Musicwhiz

musicwhiz said...

Hi Anonymous,

With regards to FSL Trust, the market value of their portfolio of 23 vessels is 175% of their debt covenant, thus I do not forsee an issue with the loan-to-market covenant being triggered as requirement is at least 145%.

Regards,
Musicwhiz

musicwhiz said...

Hi Jeflin,

Thanks for your comments and thanks for visiting too. You have a very good blog as well !

Cheers,
Musicwhiz

musicwhiz said...

Hi Patrick Ho,

Thanks too for visiting. Yes, I will continue to practise value investing. It's a very fun way to invest though it takes a lot of time and homework. Hehe.

Regards,
Musicwhiz

musicwhiz said...

Hello Ken,

I can't really answer that question. Perhaps you may wish to ask Mr. Market. Problem is he's never really sure how to value a long-term business.

I look at the company and I see good and stable long-term prospects. I will not let short term events distract me from my long-term goals.

Thanks,
Musicwhiz

musicwhiz said...

Hi Anonymous,

You should ask Management why they are not expanding or paying out dividends but still sitting on a BUNDLE of cash doing nothing ! Cash erodes through inflation and the Management of this company obviously does not know what to do with it. Even though the factors you mention are very positive for the company, the way they deploy their cash is highly questionable. I feel this is one area you need to clarify before you decide to invest.

Regards,
Musicwhiz

musicwhiz said...

Hi S.Jealousy,

I will spread out my funds over my other companies. I plan to average down on several of my companies in the coming weeks/months.

Thanks for visiting.

Regards,
Musicwhiz

musicwhiz said...

Hi V,

Erm, which Mr. Chua are you referring to ? Thanks for visiting though.

Cheers,
Musicwhiz

musicwhiz said...

Hi Anonymous,

Didn't realize there are so many other value investors out there. Yes the current mood makes bargains out there aplenty. Let's just take our time to deploy our capital in the best way possible and take advantage of Mr. Market's moods.

Regards,
Musicwhiz

musicwhiz said...

Hi nhyone,

Yes I do have cash coming in every month from salaries and dividends, so I can slowly buy into the market if I see value.

One should keep cash buffer of about 6-9 months of expenses for emergencies. I do NOT use this for investment.

Cheers,
Musicwhiz