Buying stocks with unappreciated value in such a climate can pay off in the long run
06 Jan 2013 15:52 TEH HOOI LING
Back in October 2011, sentiment for the stock market was really bad. Concerns over the slowing growth in China, the sovereign debt crisis in Europe and the struggling US economy all weighed heavily on investors’ willingness to take risk.
At that time, I spoke to a friend of mine who, in his more than 40 years of stock investing, has ridden through a few bubbles and survived their bursts.
He shared some insights with me. He said there remained opportunities despite the very poor market sentiment.
“You can buy now if you can hold,” he said then. “There are always stocks out there with unappreciated value. Sooner or later, the market will realise their value.”
A way to identify stocks with unappreciated value is to look at their share prices relative to the value of their assets in their financial statements – a measure we discussed last week.
The bigger the discount of the market price relative to the book value, the more “undervalued” the stock is.
But as mentioned, sometimes there are valid reasons for the discount. So to minimise risk, my experienced friend says, first, ascertain that the companies are carrying the assets on their books at a fair and realistic value.
Second, it is better if these deep value stocks are also paying decent dividends.
It is anybody’s guess how long the market would take to recognise the companies’ value. So it will be good that you get paid while you wait.
Third, make sure that these companies have little borrowings.
Companies trading at low price multiples to their earnings are also underappreciated.
But the market’s underappreciation of them is not as great as that of those trading below their book value.
We showed in the last few weeks that consistently buying the 10 per cent of the market with the lowest price relative to their earnings (PE) would turn $10,000 into just under $200,000 over a 22-year period from March 1990 to March last year. That’s a compounded annual return of 14.6 per cent a year.
Meanwhile, buying the 10 per cent of the market with the lowest price-to-book (PTB) ratios would turn $10,000 into $355,000 for a return of 17.6 per cent a year.
What if we buy stocks which pay dividends and are trading at a low PTB ratio?
To rank the stocks, I take the dividend yield divided by the PTB ratios. So, say, a stock has a dividend yield of 5 per cent but trades at 0.8 times its book value. Its score would be 6.25. Again, I repeated my test of consistently buying the 10 per cent of the market with the highest dividend/PTB score.
What do I get?
Well, the strategy grew the initial $10,000 back in 1990 into $715,665 by March last year. That’s a compounded return of 21.4 per cent a year!
Few fund managers can boast of that kind of track record.
The accompanying chart shows the performance of the three strategies I’ve discussed so far in this column – the low PE strategy, the low PTB strategy and this week, the high dividend but low PTB strategy.
The third, I believe, allows one to screen for stocks that pay investors to wait.
I highlighted the strategy of combining these two ratios in late 2011 and again last year in my column in The Business Times. I churned out a list of stocks which fit the criteria. Then, a lot of real estate investment trusts showed up on the list.
A reader kept the list and tracked the stocks’ performance since then.
He wrote to me two months ago saying: “You concluded that investing in stocks with the highest dividend yield but lowest price-to-book ratios appears to ‘capture the cream of the crop’. How true it is!
“Just these two ratios alone would have filtered out most stocks and just leave the investors with a small number of stocks to choose from.”
In response to numerous readers’ requests last week for lists of stocks which fit the various metrics I have talked about in this column, this week I have tabulated lists of stocks which have high dividend yields relative to their price-to-book ratios.
I have three lists – one for companies with market capitalisations of above $1 billion; one for companies between $200 million and $1 billion; and finally one for those between $50 million and $200 million.
Just a word of caution. As you know, stock markets around the world have rebounded strongly since the US fiscal cliff has been averted – for now.
Thus, there is less value in the market at the moment than say, four or five months ago.
Also, there may be some errors in Bloomberg’s data. So readers who intend to take the lists one step further should do their own due diligence and please do tread with care.