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Sunday, October 13, 2013

Time the market based on valuations

Those entering market at current levels have good chance of earning satisfactory returns over next 5 years

By Teh Hooi Ling

One of the shrewdest and longest lasting market strategists on Wall Street, Mr Jeremy Grantham, has a bone to pick with some value investors who contend that bubbles and busts can be ignored. You don't have to deal with that kind of thing, they argue, you just keep your nose to the grindstone of stock-picking, said the founding partner of GMO who prides himself and his team as global bubble spotters. These value investors feel that there is something faintly speculative and undesirable about recognising bubbles.

The fact is, the mantra of staying invested, of not timing the market, is not the exclusive purview of value managers. That's the investment adage that most fund managers preach to the retail investors as well. In fact, in The Sunday Times Invest pages recently, the headline for one story is exactly this: "Don't try to time the market, says expert".

There are lots of merits to the "don't time the market" advice. The thing is, the average retail investor tries to time the market based on news flows, or the price movements of the market.

Will the US Federal Reserve start tapering next month? Is that company going to win that lucrative contract? Is there going to be a reverse takeover of this stock? I will only buy when I can discern a clear uptrend momentum, some say.

Let me tell you this. The chances of getting the timing of your stock purchases or sales correct based on news flow and price movements are not good. There are bigger players who can react faster to the news, more sophisticated investors with better access to the news, or can analyse the situations better although I won't place my bets on anyone being able to consistently do that. The modern economy is infinitely complex. And funds are flowing so quickly around the world that an uptrend can easily turn into a downtrend the next day. These are but market noise.

What Mr Grantham refers to in terms of spotting bubbles relates to recognising when markets are overvalued, or conversely, when it is undervalued. Bubbles happen because of investors' euphoria and greed, and the fear of career risks by people in the financial sector.

As the former chairman and CEO of Citigroup, Mr Chuck Prince, famously said: "As long as the music is playing, you've got to get up and dance." Such behaviours will bring market valuations to extreme levels in either directions.

But there is a central truth to the stock market: Underneath it all, there is an economic reality. There is arbitrage around the replacement cost. And the price of an asset has to be justified by the earnings that it can generate.

Say because of a bull market, the shares of a company that owns a factory are now worth $100 million. If somebody can build a similar factory with the same production capacity at $50 million, that somebody is going to do it.

The $100 million factory is going to face competition from the $50 million new factory, and its earnings will be affected. Shareholders, who bought the shares of the $100 million factory, will not see the return they expected when they bought their shares.

They will be disappointed, and they will sell the shares leading to a decline in the share price. The result could be that the $100 million company now has a market value of $60 million.

Now, let's say a third tycoon comes to town. Building and material costs have not risen. He discovers that he can build another factory also at a cost of $50 million. He does that and now there is even more competition in the market. The first factory may not be able to compete with the new factories, and it starts to make losses. Investors sell down its shares even more. Now the factory which used to have a market value of $100 million is worth only $30 million.

The owner of the second factory is thinking of expanding his capacity because he is able to capture an increasing market share due to better branding. But to build a new factory, it will now cost him $70 million because land cost has risen. He sees that his old competitor's factory is selling for only $30 million. He figures that he can buy that factory, upgrade it at a cost of $10 million, and it will be as good as new. So he offers to buy the first factory at $40 million. After the upgrading costs, he still gets the factory at a cheaper price than if he were to build a new factory from ground up.

So there you have it. Stock prices can't be so high that they are detached from market reality. Neither will they stay cheap for long if they are trading below the replacement cost of the assets they are holding.

Consider the price of the Singapore market, relative to the 10-year average of its earnings per share, as calculated by Thomson Datastream. This is measured by the so-called Graham and Dodd price-earnings (PE) ratio.

In the past 30 years, the highest the market price has gone up to was 33.5 times its 10-year average earnings. That was in August 1987 just before the October 1987 Black Monday crash. The lowest the market has plunged to was 10.3 times its 10-year average earnings. That was in February 2009, the darkest point of the recent global financial crisis.

In the past 30 years, when the Graham and Dodd PE fell below 16 times, the returns of the three portfolios five years later tended to be substantial.

They averaged 15.2 per cent a year for the entire market; 25.4 per cent a year for the low (price-to-book) PB portfolio; and 13 per cent a year for the high PB portfolio. The five-year period starting from the lowest point on our PE chart, i.e. February 2009, has not ended yet. But already, those who entered the market at that point are sitting on, or had made, outsized returns.

There was only one instance when buying into the market at the Graham and Dodd PE of 16 times or below did not pay off handsomely five years later. That was in July 1997, at the onset of the Asian financial crisis. Five years later, in August 2002, the market was still trading at similar levels as it struggled to climb its way out of the bust and the 2001 terrorist attacks in the United States.

The higher the Graham and Dodd PE, the lower the return five years later. Investors who entered the market at a PE of 26 times or higher had seen a miserable 1 per cent average return a year in the following five years for the market portfolio, 7 per cent for the low PB portfolio and minus 2 per cent for the high PB portfolio.

At that market entry level, chances of an investor suffering capital loss are also elevated. Based on monthly numbers in the past 30 years, the probability of loss five years later (at Graham and Dodd PE of 26 times and above) was 42 per cent for the market portfolio, 12 per cent for the low PB portfolio and a whopping 70 per cent for the high PB portfolio.

Finally, where is the Graham and Dodd PE for the Singapore market now? It's at 14.1 times as at end September. This compares with the average of 20.8 times in the past 30 years.

In the past three decades, there were 25 different months when the Graham and Dodd PE traded between 14 and 16.5 times. For those 25 different months, the market portfolio returned an average 15.5 per cent a year over the next five years. The low PB portfolio averaged 24.8 per cent a year, and the high PB portfolio 14.3 per cent a year. The probability of capital loss for those periods was 1-in-25 for the market portfolio, and 3-in-25 for the low PB as well as the high PB portfolios.

So based on patterns in the past, in so far as companies' earnings are not artificially propped up by low interest costs and barring any structural change in the economic environment, investors who enter the market at current levels have a good chance of earning satisfactory returns from the stock market over the next five years.

The writer, a chartered financial analyst, is head of research at Aggregate Asset Management, manager of a no-management fee value fund.

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