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Sunday 30 November 2008
Questions to Ask When Shopping for Stocks
That said, certain equities, those that survive, will outperform cash over the next five to 10 years, and by a significant margin. There will be winners and losers from this crisis. The trick in part will be to avoid the losers.
Some equities will win, others will lose from this crisis; the trick is to avoid the losers
Hugh Young 30 November 2008
We have reached that point in the bear market where some analysts point to low price-to-book ratios - currently around 1.2 times for the Asia ex-Japan universe - as representing a good buying opportunity.
It’s difficult to disagree, but the time to buy on such a formulaic basis will be when price-to-book ratios look expensive, following a couple of years of losses and write-downs that eat into equity.
That said, certain equities, those that survive, will outperform cash over the next five to 10 years, and by a significant margin. There will be winners and losers from this crisis. The trick in part will be to avoid the losers.
The eventual winners may well have further to fall, but the truth is that one will never be able to pick the bottom. Anyway, since certain equities are very good value at current prices, there is no point in worrying too much about timing.
But what are these “certain equities” that will do well over the next five to 10 years? Before we tackle that question, let’s go back to basics and remind ourselves what an equity is.
An equity is a share of ownership in a company that entitles one to whatever is left after everyone else has staked their claim. These include suppliers, employees, banks, tax collectors, directors, even local communities. In normal circumstances, there is plenty left over for dividends and some capital appreciation.
But these are not normal times. The root problem of this crisis is too much debt.
It follows that balance sheets must shrink to reflect lower levels of growth and cheaper assets.
Companies that have borrowed too much could be fighting for their existence. Some will fail. The situation is obscured because our reflex is to consider companies in aggregate - what the market is doing or what the markets are worth.
So, with that in mind, back to the question of which companies to buy.
The first check is to make sure that the company will survive the worst-case scenario, whatever that might be. This check involves asking a number of questions.
The first is: does the company make products or provide services that people need, as opposed to just want? Examples of the former would be utilities such as CLP Holdings and Tenaga, or mobile phone operators such as China Mobile and Taiwan Mobile, or consumer-staple-related companies such as Dairy Farm, Indonesia’s Unilever and Malaysia’s BAT, or banks, such as Singapore’s UOB and OCBC.
All the above-mentioned companies do things that people need. There will always be demand for electricity and communicating with others, for food and tobacco, and for somewhere to put your money.
In the case of banks, you must make sure that you stick to the ones that have followed a traditional deposit-taking model and have not done anything “exotic”.
Companies that may see demand for their products plummet as a result of belt tightening by consumers include carmakers, luxury property developers and tour operators.
Think about what would be (or perhaps are) the first expenditure items to be cut from your own budget and ask which companies would suffer if everyone did the same.
The second question is: does the company have sufficient control over its supply chain? Examples where this is the case would include commodities companies such as Rio Tinto, whose essential inputs are land, labour and power. All three of these inputs the company has a sufficient degree of control over. It owns the land it is mining, or at least has secured long-term leases. Labour is an input whose supply is relatively secure. Power is a captive resource.
Another input for all companies is capital, which brings us to the third question: how geared is the company? In the current deflationary environment, companies with low interest coverage ratios are likely to struggle. Cash flow is king.
Once you have asked these three questions and determined that the company will survive the worst-case scenario, you can move on to the next issue: valuation. Even if the company can survive, you want to be sure you are buying it below intrinsic value.
In normal circumstances, determining the intrinsic value of a company involves an assessment of what earnings are likely to be in the next few years, then assuming a certain rate of growth thereafter. But, again, these are not normal circumstances.
The problem is that, even for companies that have, historically, had the most stable revenues and margins, earnings in the next few years could see a sharp decline, making near-term, profit-based valuation methodologies redundant.
At present, analysts are back- pedalling fast on their forecasts as the news turns gloomier. But while that is overdue - and will surely lead in time to the other extreme of excess pessimism - markets’ lack of direction is already generating anomalies.
Let’s take, as an example, China Mobile. This is a company whose potential domestic client base is the best part of a billion people.
It has leading market share in a low-penetration market with average revenue per subscriber of just US$12. If one uses the experience of mobile operators in developed Asia as a yardstick (where penetration rates are nearer 90 per cent), but allows for a decline in market share and higher acquisition costs, and hence lower profit margins - a decline from 25 per cent to 20 per cent, say - what could it be making then?
Well, a rough, ready and conservative assumption would be the company’s potential net profit down the road reaching US$30 billion, substantially more than last year’s US$12.8 billion. This makes the current market cap of US$180 billion look well supported in the long term.
Now, the above method is very simplistic and is meant to provide an indication only of whether one is getting reasonable, long-term value at the current price.
It can also only be applied to companies with simple businesses. But then that’s always been my mantra: to invest only in companies that can be both understood and valued. That way, I sleep better at night.
Hugh Young is managing director of Aberdeen Asset Management Asia
1 comment:
Questions to Ask When Shopping for Stocks
Some equities will win, others will lose from this crisis; the trick is to avoid the losers
Hugh Young
30 November 2008
We have reached that point in the bear market where some analysts point to low price-to-book ratios - currently around 1.2 times for the Asia ex-Japan universe - as representing a good buying opportunity.
It’s difficult to disagree, but the time to buy on such a formulaic basis will be when price-to-book ratios look expensive, following a couple of years of losses and write-downs that eat into equity.
That said, certain equities, those that survive, will outperform cash over the next five to 10 years, and by a significant margin. There will be winners and losers from this crisis. The trick in part will be to avoid the losers.
The eventual winners may well have further to fall, but the truth is that one will never be able to pick the bottom. Anyway, since certain equities are very good value at current prices, there is no point in worrying too much about timing.
But what are these “certain equities” that will do well over the next five to 10 years? Before we tackle that question, let’s go back to basics and remind ourselves what an equity is.
An equity is a share of ownership in a company that entitles one to whatever is left after everyone else has staked their claim. These include suppliers, employees, banks, tax collectors, directors, even local communities. In normal circumstances, there is plenty left over for dividends and some capital appreciation.
But these are not normal times. The root problem of this crisis is too much debt.
It follows that balance sheets must shrink to reflect lower levels of growth and cheaper assets.
Companies that have borrowed too much could be fighting for their existence. Some will fail. The situation is obscured because our reflex is to consider companies in aggregate - what the market is doing or what the markets are worth.
So, with that in mind, back to the question of which companies to buy.
The first check is to make sure that the company will survive the worst-case scenario, whatever that might be. This check involves asking a number of questions.
The first is: does the company make products or provide services that people need, as opposed to just want? Examples of the former would be utilities such as CLP Holdings and Tenaga, or mobile phone operators such as China Mobile and Taiwan Mobile, or consumer-staple-related companies such as Dairy Farm, Indonesia’s Unilever and Malaysia’s BAT, or banks, such as Singapore’s UOB and OCBC.
All the above-mentioned companies do things that people need. There will always be demand for electricity and communicating with others, for food and tobacco, and for somewhere to put your money.
In the case of banks, you must make sure that you stick to the ones that have followed a traditional deposit-taking model and have not done anything “exotic”.
Companies that may see demand for their products plummet as a result of belt tightening by consumers include carmakers, luxury property developers and tour operators.
Think about what would be (or perhaps are) the first expenditure items to be cut from your own budget and ask which companies would suffer if everyone did the same.
The second question is: does the company have sufficient control over its supply chain? Examples where this is the case would include commodities companies such as Rio Tinto, whose essential inputs are land, labour and power. All three of these inputs the company has a sufficient degree of control over. It owns the land it is mining, or at least has secured long-term leases. Labour is an input whose supply is relatively secure. Power is a captive resource.
Another input for all companies is capital, which brings us to the third question: how geared is the company? In the current deflationary environment, companies with low interest coverage ratios are likely to struggle. Cash flow is king.
Once you have asked these three questions and determined that the company will survive the worst-case scenario, you can move on to the next issue: valuation. Even if the company can survive, you want to be sure you are buying it below intrinsic value.
In normal circumstances, determining the intrinsic value of a company involves an assessment of what earnings are likely to be in the next few years, then assuming a certain rate of growth thereafter. But, again, these are not normal circumstances.
The problem is that, even for companies that have, historically, had the most stable revenues and margins, earnings in the next few years could see a sharp decline, making near-term, profit-based valuation methodologies redundant.
At present, analysts are back- pedalling fast on their forecasts as the news turns gloomier. But while that is overdue - and will surely lead in time to the other extreme of excess pessimism - markets’ lack of direction is already generating anomalies.
Let’s take, as an example, China Mobile. This is a company whose potential domestic client base is the best part of a billion people.
It has leading market share in a low-penetration market with average revenue per subscriber of just US$12. If one uses the experience of mobile operators in developed Asia as a yardstick (where penetration rates are nearer 90 per cent), but allows for a decline in market share and higher acquisition costs, and hence lower profit margins - a decline from 25 per cent to 20 per cent, say - what could it be making then?
Well, a rough, ready and conservative assumption would be the company’s potential net profit down the road reaching US$30 billion, substantially more than last year’s US$12.8 billion. This makes the current market cap of US$180 billion look well supported in the long term.
Now, the above method is very simplistic and is meant to provide an indication only of whether one is getting reasonable, long-term value at the current price.
It can also only be applied to companies with simple businesses. But then that’s always been my mantra: to invest only in companies that can be both understood and valued. That way, I sleep better at night.
Hugh Young is managing director of Aberdeen Asset Management Asia
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