Homepage
PR Newswire
25-09-2011, 07:41 AM
The Straits Times
Sep 25, 2011
SMALL CHANGE
S'pore equities not undervalued - yet
Wait for pessimism to set in deeper, analysts to lower forecasts before wading into market
By Andy Mukherjee
A weak and nervous stock market brings out the worst in brokerage analysts and strategists.
The common refrain in the e-mails I get from some of them nowadays is: 'Look, equities are so cheap. How much more can they fall?'
Well, there is cheap, and then there is cheaper.
Is the Straits Times Index (STI) cheap, after its 16 per cent decline so far this year?
One of the silliest ways to answer that question is to rely on easily available indicators such as price-to-earnings (PE).
The fatal flaw of the PE ratio is that it tells you nothing about where we are in a business cycle when company earnings are evidently cyclical - they ebb and they flow.
A different way to analyse whether a market is trading at a fair value is to follow the advice of Mr Benjamin Graham, the father of value investing and Mr Warren Buffett's guru.
Following Mr Graham's exhortation, one should think of an equity share as nothing but a series of future dividends which will be paid out to shareholders. Obviously, $1 in future is worth less than $1 now. And $1 invested in a risk-free 10-year bond is a hurdle that we would require equities to beat. Otherwise, why bother to take the extra risk?
So dividend expected in future must be appropriately discounted, taking into account the real, risk-adjusted cost of making an equity investment. The sum total of this discounted dividend stream is the fair value of the company's share today.
Typically, analysts' forecasts for dividends are available for only a couple of years. So the valuation formula makes an assumption about the 'terminal' rate of growth at which we can expect dividends to grow in perpetuity after the initial two-year period.
Following this approach, one can get a relative measure of overvaluation or undervaluation. Assume that today's price for the STI is its fair value; then apply the dividend-discount formula described above to get an implied value for the terminal rate of dividend growth beyond this financial year and next, the period for which explicit forecasts for dividends are available.
A low value for this number means investors are pessimistic about the ability of companies to enhance profits and payouts. A high rate of future implied dividend growth indicates investors are bullish on this count.
Conducting this exercise on the STI, my estimate of future dividend growth is 10.6 per cent for the index as a whole. The absolute value is unimportant - you may arrive at numbers that are different from mine, based on your own assumptions. What is more interesting is how this number has behaved.
There were 12 occasions in the past three years when this expected rate of terminal dividend growth fell below 10 per cent. These were buying opportunities, because the market was too bearish. Most of these opportunities came in the second half of 2009, but there were a few last year as well.
You should have bought the index every time this dividend signal flashed green and liquidated all these investments on Sept 21 last year. Why that date? That was the first time in three years that investors got so bullish they started assuming future dividend growth of more than 13 per cent.
Such high dividend growth rates in future were unrealistic hopes, which needed to be dashed. The volatility that we have seen in equity prices since then confirms the hypothesis.
If you had followed this investing approach, your average return would have ranged between 5 per cent and 46 per cent without a single loss. (See chart.)
On an annualised basis, even the single-digit returns would have been mouthwatering.
So what now?
The present assumption of 10.6 per cent dividend growth in future is still not low enough. It is not a fail-safe entry point to get into the STI as a whole through an exchange-traded fund. You will have to wait for pessimism to set in deeper and for analysts to lower their expectation of earnings and dividends more meaningfully.
By all means hunt for bargain stocks if you can find them. The STI is not cheap - yet.
andym@sph.com.sg
Sep 25, 2011
SMALL CHANGE
S'pore equities not undervalued - yet
Wait for pessimism to set in deeper, analysts to lower forecasts before wading into market
By Andy Mukherjee
A weak and nervous stock market brings out the worst in brokerage analysts and strategists.
The common refrain in the e-mails I get from some of them nowadays is: 'Look, equities are so cheap. How much more can they fall?'
Well, there is cheap, and then there is cheaper.
Is the Straits Times Index (STI) cheap, after its 16 per cent decline so far this year?
One of the silliest ways to answer that question is to rely on easily available indicators such as price-to-earnings (PE).
The fatal flaw of the PE ratio is that it tells you nothing about where we are in a business cycle when company earnings are evidently cyclical - they ebb and they flow.
A different way to analyse whether a market is trading at a fair value is to follow the advice of Mr Benjamin Graham, the father of value investing and Mr Warren Buffett's guru.
Following Mr Graham's exhortation, one should think of an equity share as nothing but a series of future dividends which will be paid out to shareholders. Obviously, $1 in future is worth less than $1 now. And $1 invested in a risk-free 10-year bond is a hurdle that we would require equities to beat. Otherwise, why bother to take the extra risk?
So dividend expected in future must be appropriately discounted, taking into account the real, risk-adjusted cost of making an equity investment. The sum total of this discounted dividend stream is the fair value of the company's share today.
Typically, analysts' forecasts for dividends are available for only a couple of years. So the valuation formula makes an assumption about the 'terminal' rate of growth at which we can expect dividends to grow in perpetuity after the initial two-year period.
Following this approach, one can get a relative measure of overvaluation or undervaluation. Assume that today's price for the STI is its fair value; then apply the dividend-discount formula described above to get an implied value for the terminal rate of dividend growth beyond this financial year and next, the period for which explicit forecasts for dividends are available.
A low value for this number means investors are pessimistic about the ability of companies to enhance profits and payouts. A high rate of future implied dividend growth indicates investors are bullish on this count.
Conducting this exercise on the STI, my estimate of future dividend growth is 10.6 per cent for the index as a whole. The absolute value is unimportant - you may arrive at numbers that are different from mine, based on your own assumptions. What is more interesting is how this number has behaved.
There were 12 occasions in the past three years when this expected rate of terminal dividend growth fell below 10 per cent. These were buying opportunities, because the market was too bearish. Most of these opportunities came in the second half of 2009, but there were a few last year as well.
You should have bought the index every time this dividend signal flashed green and liquidated all these investments on Sept 21 last year. Why that date? That was the first time in three years that investors got so bullish they started assuming future dividend growth of more than 13 per cent.
Such high dividend growth rates in future were unrealistic hopes, which needed to be dashed. The volatility that we have seen in equity prices since then confirms the hypothesis.
If you had followed this investing approach, your average return would have ranged between 5 per cent and 46 per cent without a single loss. (See chart.)
On an annualised basis, even the single-digit returns would have been mouthwatering.
So what now?
The present assumption of 10.6 per cent dividend growth in future is still not low enough. It is not a fail-safe entry point to get into the STI as a whole through an exchange-traded fund. You will have to wait for pessimism to set in deeper and for analysts to lower their expectation of earnings and dividends more meaningfully.
By all means hunt for bargain stocks if you can find them. The STI is not cheap - yet.
andym@sph.com.sg
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/