Wednesday, January 31, 2007

Fundamentals key to sustain share price

Retailers are tempted to lock in their gains following the recent run-up in stock prices. They should not worry that higher prices would mean the stocks are due for a fall. It is the fundamentals of a company that determine the sustainability of its share price, writes Ooi Kok Hwa of MRR Consulting.

I have made very good returns on certain stocks. Should I lock in my gains now?

When to sell is always the toughest decision to make in investing.

Over the past week, as a result of some pull-backs on Bursa Malaysia, investors have started to wonder whether this is the right time to lock in their gains, given that the market has surged by more than 30% since the low in the middle of June 2006.

Most investors will have a sense of regret when the price of a stock that they have just sold goes up further.

To an investor who has sold Genting Bhd at around the RM25.00-level versus his original purchase price of only RM15.00, a return of 67% is supposed to be considered as a very handsome one. However, instead of feeling good about it, he may feel the other way around if the stock is currently selling at the RM38.00-level.

To him, he has missed an opportunity gain of 52% if he compares the current price of RM38.00 with his disposal price of only RM25.00. He would have earned an extra 52% if he had continued to hold the stock.

Do not sell just because the stock price has gone up

In his letters to Berkshire Hathaway shareholders, Warren Buffett said: “We need to emphasise, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time”.

He would only recommend a sell if the stock’s quality deteriorates or if the price rises far above the demonstrable value, or when a better opportunity arises. Except for the above three reasons, he would never sell a business whose intrinsic value continues to increase at a satisfactory rate and the current price is only temporarily above intrinsic value.

According to Buffett, the maxim that “you can’t go broke taking a profit” is a foolish premise on which to sell a good company’s stock.

Investors may miss out on the potential of greater gains if they do not have the patience to hold on to their winners for a longer period of time, as a good stock can sometimes increase 10- or 20-fold in value.

Investors get worried when there is a drop in the stock market. As they follow closely their winners’ stock prices, the chances are high that they will regret selling the stocks too early.

Sometimes, certain investors who seldom follow stock prices can sell at a better price than active investors who closely monitor the market's movements.

Hence, we should always remember that “just because a stock price has increased, does not mean it is due for a fall – the fundamentals are the determining factor, not stock price history”. (Peter Lynch)

Need to know the intrinsic value of the company

Nevertheless, it is always not easy to determine the intrinsic value of a stock.

Normal investors with limited financial training will find it difficult to determine the point at which a stock becomes fairly valued.

John Neff in his book entitled John Neff on Investing said: “Successful stocks don’t tell you when it’s time to sell them”.

In order to judge the intrinsic value of a company, investors need to know the earning power and the sustainable earnings of the company. We need to check whether the current market price has gone far beyond the company's fundamentals.

Some investors have tried to predict short-term price movements. They sell a good stock when the price appears to be too high with the expectation of buying it back at a cheaper price later.

Instead, the stock price goes up even higher after the disposal. If the fundamentals of the stock remain intact and promising, they should buy back the stock.

Unfortunately, in most instances, investors seldom buy back at a higher price when they realise that their prediction did not come true.

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Wednesday, January 17, 2007

Check risks and returns at current level

The KL Composite Index's current level of about 1,120 points poses a higher market risk than when it was at the 880-level seven months ago. Investors will face higher market risk if they decide to invest now. They need to check if the potential returns commensurate with the risk that they will take writes OOi KKok Hwa, an investment manager licensed by the Securities Commission and managing partner of MRR Consulting.

Since I missed the good opportunity to invest last year, should I invest now?

Since the low of 886 points on June 15, 2006, the KLCI has surged by 26% to the recent high of about 1,120. There had been no major pullback over the past seven months.

Investors who were not in the market last year will be wondering whether it is still not too late to invest right now.

However, investors who have invested since June 2006 are getting uneasy with the current market level and are tempted to lock in their gains.

“Buy from pessimists and sell to optimists”are investors more optimistic or pessimistic now?

Benjamin Graham said we should “buy from pessimists and sell to optimists”. We should buy stocks when nobody is interested in buying them and sell them when everyone in the stock market has become excited.

The market's recent strong gains coupled with the high trading volume of more than one billion shares per day imply that retailers are getting excited and have more confidence in the market outlook.

Obviously, if we were to follow Graham's advice, we should be selling as investors are more optimistic now compared with seven months ago.

Risk is higher if you invest now

Any investor who decides to invest at the KLCI's current level will be at a greater disadvantage compared with those who invested earlier at the 880-level.

If there is any major market crash, investors who invested at current levels will face potential selling pressure from investors who have invested earlier at the 880-level because the latter can still sell their holdings even if the market were to drop below 1,000. Investors who had bought at the 1,120-level would have to face the pressure to cut their losses.

Most investors always find it difficult to cut losses as they prefer to gamble than to recognise a sure loss. In behavioural finance, we call it “loss aversion”, whereby a sure loss is worse than the risk of losing a little bit more with the gamble. Investors feel bad when they lose money, but twice the loss does not make them feel twice as bad.

Potential 7% gain versus potential 21% loss

At the beginning of 2007, some fund managers predicted that the KLCI would touch 1,200 this year.

Assuming that their prediction is correct and the 1,200-point level is the maximum level for this year, there is only a 7% difference between 1,120 and 1,200 points.

However, if there is a major market pullback and the market gives back all its earlier gains, the KLCI can retreat by 21% to 880 points from the present 1,120 level (although the market may not tumble as much as 21%, a 7% drop is more likely than a 7% gain, given that the market has gone up 26% within seven months without a major pullback).

Hence, investors need to decide whether it is worth taking the risk on a potential 7% gain versus a potential loss of 21%.

The above calculation is based on the assumption that the maximum movement of the KLCI this year is 1,200 points, whereas the maximum pullback is at the 880 level.

Nevertheless, we would not be surprised if the KLCI went beyond 1,200 points, given that the stock market is always a place with irrational exuberance and can be a haven for speculation.

Consider the timing and the value that you pay

Although the index has surged by 26%, not all stocks have increased at the same percentage. There are still a lot of laggard stocks that are selling at low prices.

Philip A. Fisher in his book entitled Common Stocks and Uncommon Profits said: Don’t fail to consider time as well as price in buying a true growth stock”.

Some of the good and promising companies might have shown good results lately, but investors should also pay attention to the price they are going to pay.

Stocks with low prices are not necessarily cheap and vice-versa.

We need to make sure there is enough margin of safety, which means we should not invest in a stock unless there is sufficient basis for us to believe that the price being paid is substantially lower than the value being delivered.

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