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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