Are We Mistaking A Bull Market for Brains?

Clearly, the title above may elicit some gasps of astonishment and surprise amongst readers, as the thought may not have crossed their minds that this is a “bull market”. However, during the last few months, it has become more noticeable that share prices have, in general, been moving upwards. Despite the gloomy and often depressing news, there were also bits and pieces of positive “green shoots” peppered in between which would make one smile and feel optimistic. Overall, the feeling is one of general caution and most investors would feel some measure of trepidation and would hesitate before jumping in. Or perhaps I am wrong? If one observes the recent Top 30 volume, one will notice that they are mostly made up of penny stocks, and these are businesses which frequently need to raise cash and are at most worth a punt. However, they continue to dominate the Top 30 Volumes listing with a very high churn rate, and supposedly are being traded in large volumes by large institutional players and small-time retail speculators.

This all sounds well and good, or does it? The general sentiment is that things will begin to improve, but how does that factor into our analysis of the businesses we hold? In order to answer that, one must constantly and consistently take a close look at the business to ensure everything is proceeding as planned, and that the numbers still look respectable. There have been many cases of “buy and forget”, which have resulted in an initial investment dwindling to 10% or less of its value (and in worst-case scenarios, the company goes bust and the investor loses everything). If one has taken a close hard look and is assured that all is well, the next question to ask would be – should I continue to add to my position at current valuations or should one adopt a “wait and see” attitude? Clearly, there is no definitive answer to this million-dollar question, and one must use one’s professional judgement as well as experience in reviewing business affairs to make an informed decision.

All is made much more difficult in the case of a bull market, where “a rising tide lifts all boats”. In the last 2-3 months, it has been observed that valuations had risen steadily as economic conditions reverted closer to the long-term average, and when a strong rebound in the economy and growth was anticipated. On April 14, 2010, the STI finally crossed the 3,000 psychologically important mark, its highest level since June 2008. An investor has to do double work in such cases – firstly to ascertain if business conditions are indeed improving and will positively affect the business in which he is invested in, and secondly to determine if valuations are still fair or excessive (they can’t be “low” because the bear market has long passed us). This may be one of the most “objective” methods I can suggest to review and see if it makes prudent sense to continue investing, or to hold and wait; as other methods may hinge too much on price levels and general sentiment and be unable to stand up to close scrutiny when called for. However, this method is far from simple and requires quite a bit of research, reading and delving into numbers, as well as the use of assumptions. Let me elaborate a little more.

The first step an investor has to take to distinguish between a bull market and brains is to assess the business climate affecting the company in question, and to determine if it has indeed improved or remains subdued or in the doldrums. For example, if you are invested in a high-end watch retailer (e.g. Hour Glass, Cortina), you could check out news articles on consumption spending of luxury items, and also how the industry as a whole is faring (e.g. are competitors expanding or lying low for now). Next is to examine the business model and numbers belonging to the company you are invested in and to sieve out any plans or intentions they may have to expand or grow. For example, a mass market food retailer may start expanding a chain of food courts because the middle class pool has grown larger in a developing nation, or a property company decides to go ahead with property launches as compared to 6 months ago when they laid low. All these signs point to heightened economic activity pertaining to the company you are scrutinizing, and these signs, coupled with a strong Management Team, usually indicate decent growth ahead in top line and perhaps bottom line as well. Cost control is another aspect one can assess, and this is by observing the quarterly gross margins which a firm enjoys. A recent example I can think of are Swiber and Ezra, whose gross margins seem to be shrinking even though oil prices seem to be rising. This either portends weaker rates, higher costs or more competition. Either way, one has to take note of all these and factor them in accordingly in order to make an informed judgment call.

The paragraph above briefly describes how to assess a company and weigh its fundamentals and prospects, and also to observe how it executes its plans. Track record also counts a lot when assessing companies, as some relatively new companies may have Management which are inexperienced and who have not gone through crises. Finally, a conservatively financed company with a strong Balance Sheet and consistent free cash flows also has a better chance to grow strongly once the economy bounces back, and there is even a chance of them increasing their dividends (which would count as a bonus) if revenue and earnings are lifted.

The second part is, admittedly, a lot more difficult to assess, and involves reviewing the current and expected future valuation of the Company to ascertain if it is still a bargain, or if it may exhibit signs of being over-valued. The difficulty here is one of future expectations, uncertainty over earnings (which is always the case) and most importantly, what is deemed to be “reasonable” in terms of valuations. If we take the first two items aside because we are not astrologers and cannot predict the future, that leaves us with the definition of “reasonableness” when it comes to valuations. Recall that during the brutal bear market, valuations of 1-2x PER and 0.4-0.5x P/B were extremely common, and many companies traded lower than their NAV. By contrast, bull market valuations (to take a leaf from late 2007) average anything from 15x to 30x for extreme cases. Thus, the long-term average is probably somewhere around 7-12x, and many pundits have stated that the index is fairly valued at about 13-15x PER. If we also account for the fact that we are in the midst of a slow recovery from a brutal recession (the worst since the Great Depression, apparently), then valuations should begin to normalize and a region of around 5-8x would be deemed reasonable.

By no means should readers take this as the gospel truth, as there is no way to determine what stage of the market we are in at any one point, and in fact it is always hindsight which tells us if a company was under or over-valued. Therefore, the conclusion is that even if one were to expect decent growth (not explosive), one should ensure a margin of safety by not purchasing a company whose historical PER exceeds 10x, and whose earnings growth rate averages 10-20% in the long-term. Since valuations are a tricky business, it is entirely up the individual investor to comfort himself that a margin of safety exists in his purchase based on all facts present, and he has to ensure he has covered a broad enough spectrum of variables to give himself the confidence to purchase a stake in the company for the long-term.

To end this article, to differentiate between a bull market and brains, all one needs to do is to analyze and focus on the business, and ignore the stock price unless it becomes so painfully obvious that we are in a runaway bull market and that valuations are unsustainably high; then it may make more sense to sell to Mr. Market!