Wednesday, March 28, 2007

Defensive way of investing

In view of the uncertainties of the stock market outlook, how to invest now?

Even though the market rebounded lately, a lot of retailers are still cautious. They still recall clearly their bad experience on how the market wiped out all their gains within a short period of time.

Despite the Government’s efforts to make Malaysia a better place to invest, our market cannot escape from potential negative external risks like the yen carry trade, the threats of possible US economic recession or the volatility in the US or Shanghai markets. Thus, retailers need to adopt a more defensive way of investing amid the current market situation.

Benjamin Graham developed a method called defensive value investing, which uses a few strict quantitative guidelines for the stock-screening process.

According to Graham, a defensive investor is one who places great emphasis on avoiding serious mistakes or losses. As he explained in his book The Intelligent Investor, the serious investor is someone who is looking for “safety and freedom from bother”. This approach emphasises the avoidance of serious mistakes but, at the same time, provides satisfactory returns.

Graham’s defensive investor screen

Adequate size of the enterprise
Graham considered this the most important factor. He recommended [in 1970] that an industrial company should have at least US$100mil of annual sales and a public utility company should have no less than US$50mil in total assets.

This was because smaller companies tended to have a more volatile performance compared with bigger corporations. As a result of the adjustment on inflation and the different industry structures of different countries, we think selecting large companies that have a market share of at least 10% in the industry should be a fair guide today.

A sufficiently strong financial condition

Graham proposed that we should select companies with a sufficiently strong financial condition – with a current asset ratio of more than two times. Also, the company’s long-term debt should be less than the net current assets (or working capital), and the debt-to-equity ratio should be less than 0.5 time.

Cash-rich companies with little borrowings would be able to fulfil these requirements. Graham’s student, Warren Buffett, did mention in his 1987 letter to shareholders that “Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage”.

Earnings growth and stability
The company should not have incurred any losses over the past 10 years and its earnings per share should have grown by one-third in the same period. Hence, companies in cyclical business may find it difficultto meet these requirements.

Dividend growth
The dividend returns are always the most important form of reward for an investor. According to Graham, the company should have a continuous record of dividend payments for at least 20 years. In Malaysia, only a handful of companies can fulfil this requirement.

Moderate price-to-earnings ratio (PER)
To safeguard investors from paying too high a price, the current price of a stock should not exceed 15 times of its average earnings for the past three years. Based on our estimation, the current market PER is selling about 15 times. There are still a lot of good fundamental stocks selling at PERs of less than 15 times. Nevertheless, they may not be able to match the above earnings and dividend requirements.

Moderate ratio of price-to-assets

Graham suggested that a defensive investor should not pay more than 1.5 times of the company’s net asset value. This acts as a safeguard against overpaying for a company. Most property companies may be able to meet these criteria, however, they may find difficulties in fulfilling guideline 2 (strong financial condition requirement) as most of them have high financial gearing.

Even though Graham did warn that many of the above might become obsolete with the passage of time, I believe some of the principles can still be applied today, given the high uncertainties in future market movements.

Source: TheStar

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Wednesday, March 14, 2007

To buy or to sell stocks?

WHY did our stock market crash?

Investors need to understand that the stock market normally takes a longer time to go up than to go down,

When the market drops, as a result of fear and panic, it just cannot move down gradually.

In the recent market crash the KL Composite Index (KLCI) tumbled from a high of 1,283.47 on Feb 23 to a low of 1,110.69 on March 5, plummeting 173 points in six trading days.

The reasons behind the crash were attributed to the sharp drop of 8.8% on the Shanghai Composite Index, the unwinding of the yen carry trades as well as worries over a rapid slowdown in the US economy.

In addition, our own market correction after the KLCI's sharp rise of about 400 points without any major pullback – from 886.48 points on June 15, 2006 to the recent peak of 1,283.47 – also contributed to the downturn.

Hence, we should be aware that the KLCI took 8 months to put on 400 points, but needed only six days to lose 44% of those gains.

Apart from the China market, other regional major stock markets like Hong Kong, Japan and Singapore as well as the US market also made big losses over the past two weeks. We are not surprised by the losses, given that these markets have been making large gains over the past 8 months.

Rachel Campbell, Kees Koedijk and Paul Kofman in their research titled Increased Correlation in Bear Markets, found evidence of significantly increased correlation in international equity returns during the bear markets.

As a result of the international contagion, a big crash in any one market could lead to major crashes in other financial markets.

Hence, apart from monitoring changes in our KLCI, retailers need to keep track of movements on other major indices like the Shanghai Index, Hang Seng Index, Dow Jones Industrial Average Index and Nikkei 225.

Some traders even track the movement of the yen versus the US dollar in view of worries over yen carry trade.

Should I cut my losses now?

Some retailers tend to invest at the wrong time. Every time there is a bull market, the moment they start getting excited about the stocks and start to invest, the market collapses a few weeks after that.

In this recent market rally, we believe that a lot of retailers only started to invest one to two weeks before the Chinese New Year (CNY).

As a result of the market crash one week after the CNY, most retailers gave back all their gains while some even incurred losses.

According to Benjamin Graham, the word “intelligence” in intelligent investor “is a trait more of the character than of the brain”.

It has more to do with how investors control emotions when investing.

They must have the courage to take profit in a bull market and have the discipline to cut losses when the investment drops below a certain acceptable level.

At the beginning of the market crash, most retailers were reluctant to sell their stocks because the prices went below their recent highs.

For example, even though their cost of stock A was only at RM1.00, they did not want to sell the stock at RM1.70 because the stock's recent high was RM2.00.

To them, selling at RM1.70 means they are incurring a “loss” of 30 sen. In actual fact, they have already made 70% profit, given that their original cost was only RM1.00!

These investors, however, panic and want to sell when the market crashes further and when the stock price trades nearer to their original cost of RM1.00.

As a result, most retailers were unable to make money from the stock market because they bought and sold at the wrong time.

Is it a good time to buy now?

After a market crashes it needs to go through a period of consolidation before gathering the momentum to turn around.

Nobody can tell when the consolidation period will be over. In our local market, the recent low of 1,110.69 on March 5 may be the lowest level of the recent pullback. Ooi Kok Hwa, a licensed investment adviser and the managing partner of MRR Consulting, gives some advise on buying and selling of stocks

If the market goes against our view and starts to move up, we should not continue to be bearish if we have sold out all stocks. We must be then be prepared to buy them back.

Hence, we need to constantly monitor our country's economic development as well as the global economic outlook.

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