Scattered Thoughts on Valuations

With the current bear market entering its 16th month (most generally acknowledge that the bear market began in October 2007 when the STI peaked back then at the 3,800+ level), it is interesting for me to note that valuations between bull and bear markets can have such a significant gap. I have put a lot of thought into this matter over the last few days and admit that the following post is merely the result of a thought process which had culminated into ramblings of a somewhat academic nature, and thus may not have practical value in determining valuations for subsequent bull and bear markets and how these may have an impact on margin of safety and one's investment decision. Still, I will provide some insights into the qualitative (and not just quantitative) process of selecting companies for the long-term and also how to be mindful of possible "value traps" while doing so.

With the benefit of hindsight (to be touched on in a future post under "Behavioural Finance"), we can all now look back at the roaring and overly-exuberant year of 2007 when the bull market was still charging ahead. It is with a somewhat reflective tone that I can state that valuations at the time did NOT seem excessive, purely because at the time the future seemed clear and prospects looked good for the companies I owned. Therein lies the basis for the higher valuations, due to increased visibility of earnings and clear growth prospects (due to stable economies and markets), higher valuations of price-earnings were assigned to many companies in general. A reasonable person would not consider such valuations excessive in light of developments which were going on at the time (before the eruption of the sub-prime crisis in the USA), and thus could not rationally and knowingly have argued that companies were over-valued based on future earnings. One must also be aware that future earnings are never clear and most of the time, higher PER valuations are accorded to companies with expectations of higher earnings and higher growth; notwithstanding the fact that this MAY NOT materialize even under the best-case scenarios.

I recall the valuations of the companies which I had purchased in my current portfolio (excluding FSL Trust and Tat Hong) back then in 2007:

a) Ezra - About 12-14x historical PER
b) Swiber - About 11-12x historical PER
c) China Fishery - About 8-9x PER
d) Pacific Andes - About 7-8x PER
e) Boustead - About 8-10x PER

These would not have seemed excessive as valuations then had incorporated all known information on proposed future growth potential as well as events which would play out as Management had expected, to give rise to the anticipation of higher earnings. Of course, when the crisis broke out, suddenly the future became much less clear and the original growth prospects were not as clear or obvious as before. The credit crisis had degenerated into a full-blown economic crisis and was creating uncertainty for every company.

If we now turn our attention to the present, valuations for the companies I own are currently at PER of 2-3x (historical), which would seem to represent "trough" valuations for a worst-case scenario situation for all companies concerned as to the opaqueness of future earnings and growth. Of course, one can also argue that the extent of the drop in valuation metrics is largely due to a depression-type scenario being factored into the prospects of all companies' growth plans and hence "disrupting" the original good intentions of the companies to grow as previously forecast. Hence, the original estimates which pertained to perceived growth rates for the companies concerned have to be abolished (in the worst case), or modified drastically (in the most optimistic case).

The point I wish to make here is that I've learnt (after going through this bear market which we are still in right now) that the uncertain future always means that an investor should accept a significant discount to perceived "superior" growth if one should consider purchasing shares in a company. This is of course linked to the concept of "Margin Of Safety" in that I have to modify my method of assessing what I deem as a reasonable margin of safety. During bull markets, when growth is clear, Mr. Market is happy to assign high valuations to companies that, on hindsight, apparently were too high for comfort. During bear markets, recessions and economic crises, Mr. Market will take a very dim view of the prospects of a company and thus assign a very low valuation for companies.

So the question to learn is not to be overly confident of a company's growth plans and overpay for its shares, even though things appear to be mapped out way in advance and nothing can be seen on the horizon to derail the company's plans. I've learnt the hard way that growth is never certain and one should always be prepared for nasty surprises, thus having a greater margin of safety is more important than ever. The bottom line is that one should always purchase as if one is expecting a bear market and economic crisis to hit, and accept valuations which are very low compared to the prospects of growth. The problem, of course, is that during bull markets such valuations are almost impossible to find, thus making purchase a problem. Which is why people say that the best time to purchase is during a bear market even though growth may be highly uncertain, as we should then turn our attention to qualitative factors (e.g. Management's track record through previous recessions) to justify purchasing a company.