Tuesday, January 06, 2009

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.

19 comments:

PanzerGrenadier said...

Hi Musicwhiz

Stock valuation is as much an art as some see it as a science.

I'd like to think it reflects the market participants expectations of the future coupled with their hopes, fears and greed all mixed up and reflected through the transacted prices.

Ultimately, no-one can second guess the market all the time but enough trends up and down do make some traders richer (and others poorer).

I have a proposal to you help monetise your blog better. Would you be open to listen to it?

If you are, please email me at rod.loh at gmail.com and we can take it offline.

No obligations.

Be well and prosper.

musicwhiz said...

Hi Panzer,

Yes thanks for your comments, and I agree with them.

Will email you in a few days time as I am currently very tied up with personal matters. Thanks for your good offer to help maximize my monetization.

Cheers,
Musicwhiz

patrick ho said...

Hi MW,
was trying to think about valuations, and I believe it's a little tricky to base valuations on trailing PER as the 'E' part isn't exactly v reliable.

I do also think that factoring in an earnings drop/rise based on historical figures might be good? Not about chasing up earnings. Would pay to find out what the price behind a stock reflects. That's why MOS works so well:)

Brendan Lee said...

I think we should avoid stocks altogether. Stock investment is simply too risky in current economy environment.

Anonymous said...

Although you sound impressive citing items from financial statements and speaking like Buffett (Mr Market etc etc.. haha..)

However, you have a problem. You have an EGO. Not admitting people is right when they are. Putting on a brave front in front of people who gives you reasons not to go against crowd behaviour in investing.

From reading some of your blog post on companies, I noticed that you do not understand what value investing is about.

Please go read up more instead of thinking you are Buffett when you read only some books written by people who claim they know how Buffett invest.

musicwhiz said...

Hi Patrick Ho,

Yep I think it's good to factor in earnings disappointments when we think of investing in a company. This will temper expectations and prevent us from experiencing negative surprises.

Thanks,
Musicwhiz

musicwhiz said...

Hi Brenden Lee,

Of course you are entitled to your opinion about equities, since I am aware you are a currency trader. However, I am staying vested in equities for the long run as I believe they can help me overcome inflation and give me a decent return on investment.

Cheers,
Musicwhiz

musicwhiz said...

Hmm Anonymous again,

I just find it strange that most of the negative comments are from "Anonymous". It would certainly be nice if you could leave a nick so I can at least respond, instead of being a faceless criticizer.

I think the problem with your comment is that it is so unspecific ! Everyone has an ego (name me people who don't, unless they suffer fro depression), and I would also think that in order to analyze financials one has to use some of the jargon which goes along with financial statements. If you think crowd behaviour is so important then you can jolly well join the crowd; but I dare not guarantee you will get results which will please you.

And if you feel I do not understand what value investing is about, you should also be more specific and define what it IS about, right ? It's easy to criticize and point fingers but much harder to provide evidence to support your criticisms. If you think you are an expert in value investing or WB, please do share your insights and profound wisdom so that everyone can benefit from it in this comments box.

Otherwise, if you do not like my blog, just avoid visiting it in future.

Thanks,
Musicwhiz

PanzerGrenadier said...

Dear Anonymous January 9, 2009 1:44 PM

Please lah... If you want to comment at least leave a nick that we can refer to... Your comments are totally typical internet troll behaviour. You mean YOU DON'T HAVE AN EGO?!

Puh-lease... everyone has an ego, it's either big, medium or small.

I'm not sure what did Musicwhiz do to you in his past life to make you so critical. Why do you seem to hate him so?

Be well and prosper.

patrick ho said...

Hi MW,
anyhow, I believe that it's fine to value the company acordingly, and to adjust the valuations of the company from time to time, as the intrinsic value of a company changes all the time. I'm not too sure whether this might work or not, but am willing to try things out.

Cheers, don't be affected by cynical remarks:)

musicwhiz said...

Hi Patrick Ho,

That's a good idea, and sounds like something I am willing to adopt for myself as well as time goes by. All part of fine-tuning our investment process to make sure it gets better over time, and to learn from mistakes.

Thanks,
Musicwhiz

Brendan Lee said...

Hi MW,

I did not make negative statement because I am a currency trader. As a matter of fact I am a solid stock investor.

In 2007, I had participated in a 1 year stock-pick competition organized by Zacks.com in America.

At the end of the competition, I was ranked 407th out of 27,700 participants, hence this makes me top 1.47% of the competition.

I had achieved 32.67% return on the competition portfolio, for the same period S&P was only up 6.99%, and Dow Jones was only up 4.16%, hence I had outperformed the broad market by a wide margin.

But since stock market is not going to do well, I had switched to currency trading in my career.

Regards
Brendan
http://www.forexandbinary.com/

Ricky said...

Hi MW,

perhaps you'll like to toggle the option of disallowing Anonymous comments. May not stop the unconstructive comments but at least there's a nick to refer to.

BlackCat said...

Hi MusicWhiz,

If I may go back to the topic of valuations and PEs, 3 things are in my mind:



First:
For traditional cyclical industries (eg: airlines, shipping, oil rig operator, steel), trough PEs are often high and peak PEs are low, as the market often correctly predicts the cycle. From Peter Lynch in 'One up on wall St'. Not sure if the companies you listed are cyclical? (I dont follow them).


Second: (unrelated to the first point)

In a bear market, valuations can truly , unbelievably, ridiculously low! In 2001/02, the trough valuations of many good, well run, small/mid caps was 7 or 8. Examples are comfort, Robinsons, unisteel in my previous blog post:
http://profithunting.blogspot.com/2008/10/how-low-can-market-go.html




Third:

*Expectations* of earnings works both ways.

I think the best time to buy based on PEs is when past earnings have been compressed (usually by a recession) and the earnings are increasing, due to the recovery, and due to the intrinsic growth of your carefully analysed company. In 2001/02, you could often see PE *expansion*, as the company grew and analysts get more and more excited over it as time goes by, it gets 're-rated' with a higher PE. Examples were OSIM, unisteel.

Now we are seeing the opposite: PE contraction.

Agree that the best time to purchase is a bear market. But right now, compared to what I saw in 2001/02, I believe stocks are still too expensive after the (mini) rally in Dec. And I cant see the conditions in place for PE expansion. Personally I cant decide what to do... neither here nor there. :(

Regards
BlackCat

Brendan Lee said...

Conclusion: Keep away from stocks.

Anonymous said...

Great job! BlackCat and Brendan.
These people know more about value than Mr Market Whiz.

musicwhiz said...

Hi Brenden Lee,

I am sorry but stock competitions do not factor very highly in my assessment of one's investing ability as they are under controlled conditions and their time horizon is usually too short to determine if one can obtain a decent return. 3 to 5 years is the minimum period of time required for an investor to generate decent returns.

As for your comments and remarks so far, they all point to you being very averse to equity investing and promoting your forex trading, despite all that you claim.

My advice to you would be to contibute constructively to the post by commenting, instead of doing self-promotion.

Regards,
Musicwhiz

musicwhiz said...

Hi Ricky,

I have taken your advice and turned off Anonymous comments, most of which add no value whatsoever and include people trying to take a pot shot at me (for whatever reasons).

Initially, I was hopeful that this world would contain people who are less malicious and spiteful, but apparently I was sadly mistaken.

Cheers,
Musicwhiz

musicwhiz said...

Hi Blackcat,

Thanks, very relevant points you brought up, let me address them in turn.

One, yes you are right for cyclical companies. Of the companies I listed, I would say Tat Hong is pretty cyclical as they are more or less pegged to the construction cycle, though they are modifying their business model to do more rentals instead of equipment sales. As long as their cash flow is sound, I have no worries.

Two, yes apparently Mr. Market can get amazingly depressive ! These are opportunities for investors to purchase shares of sound companies for long-term wealth.

Three, yes I also agree 100% with this. The time to purchase stocks is when they are unpopular and no one is inerested. You cannot buy what is popular and expect to do well as it may very well be over-valued, and over-hyped. I recall Cosco at S$8.00, was it really worth that much in terms of value that people will pay such a high PER ?

Hope you can come to a decision soon on whether you want to purchase or not ! I think valuations have become even more compelling in the recent January 2009 sell-down.

Cheers,
Musicwhiz