Published August 24, 2011
MONEY MATTERS
Beware - while value-investing may seem easy, human frailty often turns it into 'unconscious speculation'
By WILLIAM CAI
IN THE third quarter of 2010, a slew of positive economic data was evident in the media. The idea of investing for the long term - by picking Singapore's 'solid' dividend-paying blue-chip stocks - became an attractive proposition in a low-interest-rate environment. Coincidentally, this was also when the Singapore Investor Confidence Index Poll reached a high. From a contrarian perspective, that's when one should worry.
A 'death cross' occurred when the Straits Times Index (STI) fell to 2,797. It's a term used when a security's 50-day moving average price line crosses over its 200-day moving average line from the top, generating a long-term bearish signal which suggests that investors should adjust their bullish view to bearish.
While 12 out of 18 'death crosses' resulted as false signals (whipsaws) over the past 30 years for the STI, investors should still take the bearish signal seriously. Firstly, as a lagging indicator, the signal usually occurs after the STI has fallen by 10 per cent or more, and only to be compounded by further losses if a severe bear emerges. Secondly, six out of the 18 signals resulted in losses ranging from minus 22 per cent to minus 54 per cent. Thirdly, it is worrying that more than 60 per cent of the STI constituents, which are classified as 'blue-chip' stocks, have generated the 'death cross' signal.
More importantly, the 'death cross' has also occurred for various other global markets, increasing the odds of a full-blown bear market.
The definition of an 'investment', as offered by Benjamin Graham in 1934, 'is an operation that promises the safety of principal and satisfaction of return. Operations not meeting these requirements are speculation.'
Contrary to popular belief, Warren Buffett is a great market timer. He plays the game well by raising cash when he cannot find attractively-valued stocks. He waits for opportunities to pick up stocks at fire-sale prices, especially when there's blood in the streets.
The biggest mistake an investor can make is to focus only on the idea of getting stable dividends, with disregard to price. For example, when investors buy blue chips at a high price during the mature stage of an economic cycle, this increases the possibility of seeing their stock value fall 50 per cent or more in the next economic slowdown.
Despite the potential poor risk-adjusted ratio, investors stick to the concept of buying blue-chip stocks as they harbour the hope of capital appreciation which bonds may not match. This does not make sense as corporate bonds can do the job of providing a steady income better without similar risk to equity.
Untrained investors would focus on buying blue chips with the highest reputation, quoting their good management and their ability to continue to deliver profits for the long term as reasons for investing in them. Such investors do not wish to engage in market-timing activities as they equate these to speculation. Therefore, they pay insufficient attention to prices given their assumption that well-chosen blue chips would recover from an economic downturn. Ironically, that is a speculative assumption as many of today's blue chips could become tomorrow's losers.
For example, an investor who bought SGX shares at $14.40 on Oct 2, 2007 would have seen the price fall 53 per cent as at Aug 22, 2011. Assuming dividends reinvested, the loss would be large at minus 46 per cent. Investors who bought stocks like Cosco, NOL and Yangzijiang at their peak in 2007 would still be nursing losses of between minus 50 per cent to minus 84 per cent.
Contrary to popular belief, Warren Buffett, the famous value investor, is a great market timer. He plays the game well by raising cash when he cannot find attractively-valued stocks. He waits for opportunities to pick up stocks at fire-sale prices, especially when there's blood in the streets. As the key to long-term investment success is to first avoid losing big, a true long-term investor should do the same and wait for a market crisis to buy stocks at attractive prices. Then, they can ignore the madness of short-term volatility and sell the stocks when they become overvalued. Over time, this strategy can substantially increase the wealth of investors.
For most investors, professionals included, qualitative factors like good management are difficult to deal with intelligently and such an evaluation can be clouded by an investor's own confirmation bias. Quantitative factors, like the continued ability for a business to deliver steady earnings growth, would need investors to have a considerable amount of investigation and business acumen.
Savvier investors could argue that Singapore stocks are now reasonable, based on their current price ratios and forward-looking evaluations. This requires the calculation of the intrinsic value of a business as determined by its future earnings. However, history has repeatedly shown that during the good times, many analysts become over-optimistic and assume a sustainable earnings trend. In reality, the concept of intrinsic value is arbitrary at best. It is elusive and hard to determine, due to the uncertain future and the irrational market.
In addition, few analysts dare to offer views different from the herd as it is often safer to err with the masses. For an analyst to be wrong alone, it can lead to the demise of his reputation and career. Even if the trend of earnings and intrinsic value can be determined reliably, it does not sufficiently provide a safe basis for investing, especially during a bear market.
Currently, the price-to-book (P/B) ratio for the STI stands at 1.3 times and history has also shown that since 1994, whenever the P/B ratio drops from 1.5 times, its downward momentum would bring it to lower levels. This assigns a high probability that the STI could have more to fall as it just breached its 1.5 times P/B level this month.
Unfortunately, during a mature economic cycle, undervalued blue chips are uncommon and many investors end up investing without sufficient regard to price. Investors should focus on value investing as it helps investors invest better by selecting stocks based on the margin-of-safety principle. This means that one buys undervalued stocks at a price lower than their intrinsic value.
This helps to prioritise the safety of capital while dividends are viewed as of secondary importance. While dividends come in handy as a 'cushion' to effectively lower losses when stock prices fall, dividend yields are lower when blue chips are bought at higher prices. Furthermore, during an economic downturn, companies do slash their dividend payouts to preserve cash holdings. This was true during the last crisis for blue chips like SIA, NOL, SGX, CapitaLand, DBS, UOB and ComfortDelgro, as their earnings fell.
While value-investing may seem easy, human frailty often prevents successful implementation. It is hard to prevent human emotion from corrupting an investment framework. Even if the necessary fundamental analysis is used to scan for value stocks, investors may end up with a handful of stocks from boring industries which are not what he initially deemed as blue chips. More importantly, it is hard to be fearful when others are greedy, and vice versa. It is hard to think independently and go against the herd.
Nevertheless, I hope that this article has helped instil a new level of consciousness to replace unconscious speculation. When the stock market enters a bear phase, extreme fear rather than fundamentals rules the day. Even the bluest of blue-chip value picks can fall by a considerable amount. Dividends are often insufficient to cushion a market bloodbath. How much more refuge can an expensive blue chip provide? Investors who buy stocks at a high premium during a stockmarket high unwittingly end up as 'long-term investors'.
With the current global economic slowdown, coupled with the lingering US and European sovereign debt crisis, the recent market carnage could be the beginning of something worse. Buying blue chips based on dividends alone while ignoring price, potentially deteriorating fundamentals and the economic cycle can be disastrous. It's never too late to avoid unconscious speculation and to invest wisely.
The writer is vice-president & deputy investment head at GYC Financial Advisory
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