Stock Selection Part 4 2 comments

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Previous parts: Part 1; Part 2; Part 3

When I hear analysts start to talk about the recent market weakness as being the start of a bear market and no longer a correction --- and people starting to believe in it, I know that the market has normalised from its heady days of early 2006 when anything goes. Of course, the conventional wisdom is that the stock market is a leading indicator of economic performance, which means we can't really tell if it is now predicting a declining global economy until on hindsight after the event, but it is difficult to see a decline when central bankers in China and the US are trying to control liquidity to moderate overheating/inflation.

Anyway, I never believe in market timing or trying to macroeconomically time market entry and exits; it has been statistically proven to be futile and satisfies one's ego rather than one's wallet. I just thought in this period of continually falling prices it'd be interesting to discuss what sets a bottom to prices --- what will stop a stock price from falling further ie. what is the support point?

My belief is that stock valuation is an art, and a dynamic one at that. It is a function of so many factors, the two main ones being fundamentals and market sentiment/perception, but also of intangibles like market investing horizon, insider transactions, general sector movement, frequency of corporate newsflows and perceived shareholder orientation etc. As such, it is difficult to ascertain that a stock price has "bottomed". As it is, the current "correction" has shattered some "bottoming price" myths.

One of them must be that the NTA (Net Tangible Asset) would be the anchor point for the share price. A look across the plastics sector, for example, would reveal quite a number of companies trading way below their NTA eg. Meiban, Fu Yu, Fischer, as are many other manufacturing plays eg. Kingboard, Amtek, Surface Mount, Seksun, Magnecomp (today). Another prime example would be the shipping plays. Most of these are still profitable, so what gives? Well, the NTA provides a clue to the liquefable value of the company's assets should it become insolvent, but note that the company assets (especially fixed assets) may not be saleable for the same price as recorded on book --- equipment may be obsolete, inventory ASP (average selling price) may have collapsed etc. A look at how the manufacturing plays have to heavily re-invest in capital equipment every year and one can realise that the NTA for these companies, in particular, can only be just a reference point, but never a price anchor point. Any drop in sentiment and outlook (eg. plastics sector) can easily bring the P/NTA ratio below 1.

The second would be a sufficiently low PE serving as anchor. The first question must be: what PE is "sufficiently low"? Some put it at <10, some <5 and so on. One should note that in most private acquisitions the PE seldom goes above 5, very rarely above 10. People are attuned to the idea of higher PEs for listed companies because it has always been so; they are actually paying a premium for the listed status and its liquidity (ie. easy to exit the investment). So a PE<10 might not be too "cheap" after all. And one just wonders about stocks with PE<5; they almost always have issues eg. Ace Achieve, Sinobest, United Food, China Paper, even NOL (cyclical). There is perhaps a "fair-value" PE, but one has to consider the company's track record, sector prospects, shareholder orientation ie. the whole fundamental works. So again, there is really no "silver bullet" PE that can cushion and anchor any share price drop.

One myth worth debunking is that a good buying/support price is the IPO price of the stock. Considering that the stock probably IPOed on the back of an above-average year and that management and underwriters must have optimised the pricing to capture maximum funds, the "anchor price" should probably lie somewhere substantially below the IPO price. If the IPO was a long time ago, then of course there is no point comparing as well, as the company's business would have evolved since then.

Considering that the purpose of investing is to participate in the company's earnings flow, and also considering the theoretical valuation of a stock being the sum of all cashflows to the investor, it makes sense that dividend flows have to be one of the most important factors in arresting the decline. I actually find that stocks with high dividend yield survive a market decline best, and provide the best kind of anchor. There are no actual calculations but I think a dividend yield of >4-5% provides the best support. But again, no point establishing hard and fast rules; steady and sustainable growth has to be there otherwise the dividend payouts won't be sustainable.

If we were to compare investment science with conventional hard sciences, it may be useful to draw some lessons from the latter. There are standard solution methods for certain forms of mathematical equations, but I have learnt that more often than not one utilises computational methods to calculate via "trial-and-error" and "convergence" --- such numerical methods offer the best general solution methods. A well-known method is the Monte Carlo method, which solves a problem with many variables by simulating numerous scenarios through continuously throwing random inputs at the problem, and then analysing the output. It is effectively an empirical (experimental) method of solving a complex problem where there are no easy general solutions. Investment is probably the most complex problem of them all, and one can hardly conceive of a simple failproof way to "solve the problem" ie. predict the bottom. Instead, it may be better to do it the experimental way, through observation of the tendencies and dynamically shifting one's position, that will best allow one to determine when the selling momentum might just be starting to fade. Think about it.