What’s your story?
Approximately two months ago, on June 19, 2015, we discussed the Philippine stock market in this column. At the end of the piece, I mentioned that my favorite investment advisor, Philinvestor, suggested taking a less aggressive position in equities. Less aggressive, of course, is investment speak for reducing exposure. On that day, the market closed at 7,601.
For investors, this week opened with some anxiety. Over the three-day weekend, stock markets around the world had tumbled. Thursday this week, the market closed with the PSEi (the key index for the local stock market) closed at 7,022--welcome news for those who saw it dip to its one-year low of 6,603 Tuesday of this week.
Many questions have been posed concerning tis recent volatility in markets and they fall into three categories: What is causing this? What will happen next? What should we do now?
To the question of what to do now, one my friends rightly pointed out that if your basic investment theory is sound, a market dip is not necessarily reason to flee. This, actually, is good advice in many areas, not just in investments.
In management class and in planning meetings, I often say that at the heart of every strategy is a hypothesis: “If we as a company do this, then this will happen.” This is true, in fact, of most plans. We decide to take certain paths or directions because we believe they will take us where we wish to go. We believe this because we have a theory about things. So let’s begin with what individual investors would need to think about when they invest.
First, people generally put money in the stock market in order to earn a return. As investing in equities is generally believed to be riskier than putting money in a time deposit or in bonds, the target returns for stock market investments would generally be higher than those on corporate bonds. In turn, most corporate bonds have returns higher than rates on government debt. This week, national Treasurer Roberto Tan told reporters that the government plans to issue new debt with rates at a minimum of 3.625 percent for 10-year bonds and 4.625 percent for 25-year bonds. Now, a data set from NYU dated January 2015 shows an estimate of the equity risk premium (ERP) in the Philippines to be about 8.6 percent. The ERP is the amount by which returns on the stock market, on average, outpace returns on government bonds. This explains why target stock market returns are typically in the double digits.
Second, an investor makes money two ways from investing in the stock market--one is dividends and two is capital gains. In the Philippines, with very few exceptions (e.g. telcos), returns from dividends are generally negligible. What this means is that investors generally look to increases in stock price to drive investment returns. This means that Filipinos who invest in the stock market invest because they believe that the price will go up. The key to making money in this market is to buy low and sell high.
This means that the question of what to do is based solidly on the question of price.
One easy way to evaluate price is to look at the ratio of share price to earnings per share, what is commonly called the PE ratio. Theoretically, the earnings or net income of a corporation belong to the shareholders who are, after all, the owners of the corporation. If the company were to pay back all dividends to shareholders then earnings would represent the annual investment return and the PE ratio would be an estimate of the payback period of investment in the stock. Seen from this point of view, all things being equal, a low PE would signify a cheaper stock.
Note that PE is not the only indicator. Consider two companies with the same PE of 10. If one company were not growing at all, then ten years of earnings would represent 100 percent of the investment in buying the stock. However, if earnings were growing, clearly payback would be reached at an earlier time. In fact, at 20 percent growth, the investment would pay back in about 6 years. This explains why most analysts will look at an indicator called PEG, which is the ratio of the PE to annual growth.
The Philippine market has had its ups and downs. Prior to the 1997 Asian financial crisis, at the end of 1996, the PSEi was at 3,171. At the end of 1997, the PSEi was at 1,869. By the end of 1999, the PSEi climbed to 2,143, only to drop to 1,495 at the end of 2000. Local political volatility plus the dot com crash combined to a steady decline to 1018 at the end of 2003. Finally, by the end of 2003, the market had risen to 1,442. Steady increases continued to the end of 2007, which saw the PSEi at 3,622. By the end of 2008, the global credit crisis pushed the PSEi down to 1,873. The local market quickly recovered and by the end of 2010, the PSEi was at 4,201. In fact, year-end PSEi levels have risen steadily since 2008, hitting 7,231 at the end of 2014 and hitting a historic high of 8,137 in April of this year.
Now, consider that on June 19, when PhilInvestor called for caution, the PSEi was at 7,601 and the market PE was at 21.6x at prospective 2015 earnings. Recall that the 21.6x pricing of the PSEi in June was called “priced for perfection.” Now let’s look at current rates. Using the closing PSEi for Thursday of this week, the market is trading at 19.5 PE. Assuming that earnings will grow at 14 percent and with no change in prices, the PSEi will be trading at 17x by end of 2016.
By contrast, using Bloomberg estimates, the Shanghai composite (China) trades at 15x, the Han Seng (HK) trades at 9x, the Singapore Index trades at 13x, and KLCI (Malaysia) trades at 16x. Of course, JCI (Indonesia) trades at 23x, Sensex (India) trades at 21x and the FTSE (UK) trades at 22x. However, we should also recall that many of these markets are now tumbling.
PhilInvestor declares that a fair price for the local market would be 15x. If that is true, then we are still in high price territory. Major multinational analysts declared in the first half of the year called the market “priced for perfection.” What we have been seeing in the last week and this week shows is that the global situation is not perfect.
What remains to be considered is this. What is your story? When you bought the particular stocks you bought, you had some theory. Maybe you believed that the price at which you bought had not taken into account penetration into a new market space. The key question is this, does that story still hold? Because if not, then the plan needs to change.
Readers can email Maya at [email protected] Or visit her site at http://integrations.tumblr.com.