21-04-2008: Prices more volatile than value

21-04-2008: Prices more volatile than value

Following the subprime woes, stock prices in the world have fallen sharply. Asia-Pacific markets fell more than the US although the subprime problems originated from the US. Dow Jones fell only 4.7% in the fourth quarter last year. Countries that fell more include Japan down 8.8%, Singapore fell 6% and China dropped 5.2%. The downtrend not only continues into 2008, in fact, the fall accelerated further. While Dow Jones gave up 7.9% in the first quarter of this year, Japan plunged another 18.2%, Singapore dipped 13.9% and the China market collapsed by a whopping 34%.

The sharper drop in the Asia-Pacific markets was due to withdrawals by foreign funds on concerns of possible impact by US recession on the export-oriented Asian economies in the immediate future. The sharp fall in Asia-Pacific markets demonstrates the increased financial integration among various economic blocs in the world. On the other hand, growing domestic economies of emerging markets over the past few decades have enabled many developing economies to gradually de-couple from the US and the reliance on US exports has decreased gradually.

Concern of a recession
With the collapse of the housing market in the US leading to default on subprime mortgages and spreading to quality mortgages, liquidity crunch has started to affect the nerve of the US financial system. The concern of a recession is so strong now that investors sold down their shares and many would-be-buyers stayed away from the market.

Unrecognisable prices
Some of the stocks were so badly bashed down that their prices went beyond recognition. It is undeniable that economic slowdown in the US has its impact on the fundamentals of global economy and also stock prices.

But for every company, it is a challenge to cope with the potential global economic slowdown. Even if the world economy is down for the next two years, most well-managed companies will ruffle through the storm water and emerge leaner and fitter to face the new competition ahead.

Basic fundamentals remain
A well-managed company should prepare for the up and down of an economy as they experienced good time as well as bad time over the years. During the period of economic slowdown, consolidation will be the preferred strategy to preserve capital and trim cost. When the economy recovers again, these companies will be there to reap the fruits of expanding economy again.

Graham: Price value
The relationship between market price and value of a stock is best studied by Benjamin Graham. He commented that “stock prices fluctuated widely while the underlying value of the businesses was far more stable”. Graham and his student Buffett observed the regular irrational behaviour of investors who always over-react both in a bull market in over-pricing a stock and in a bear market in over-selling the same stock.

A stock selling at 20x PE in a promising economy may just fall by 50% to trade at 10x PE in an uncertain outlook. When the economy was good, the management did not promise or guarantee the robust economy will continue. The economic outlook is an external environment independent of the management. As such, when the economy cools down, it is unfair to punish the management by pushing down the share price.

When the economy is doing well, analysts and fund managers should look out for possible economic reversal. On the other hand, when a stock is bashed down due to a possible recession in the US, the economy will eventually recover partly due to the various actions taken by the US government to save the economy.

Prices trade around fundamental value?
Under normal circumstances and especially if the market is efficient, the price of a stock should trade around the fundamental value. Although the fundamental value of a stock may change over time due to changes to the business condition, prices should theoretically track the fundamental value or intrinsic value of a stock most of the time.

From time to time, the price may depart from the intrinsic value due to market uncertainty or when sentiment over-rules the fundamentals (see Fig 1). When senses are back to normal, the price will quickly converge back to the intrinsic value. Whenever, the price moves too far from the intrinsic value other investors will notice it and they will take advantage of the price discrepancy. An over-valued stock will be sold down by other shareholders and an under-valued stock will attract buying interest from other investors.

Prices always over-shoot
In reality we notice prices always tend to stay around the intrinsic value and seldom at the intrinsic value (see Fig 2). In the first place, it is very difficult to pinpoint the exact value of a stock. Different research house has different value of a stock. The value is very much dependent on the earnings growth outlook and the business risk of a stock. Even investment duration whether it is for short-term or long-term investment will affect the valuation of a stock. As a result, the intrinsic value of a stock should not be viewed as a magical absolute figure, where anything above is considered over-valued and prices below it as under-valued.

Intrinsic value can be seen to be a range of prices (eg RM 5.00 +/- RM0.50) or an absolute price +/- certain percentage (eg RM 5.00 +/- 10%).

Components of intrinsic value
The value of a stock is the ability of the company to generate a stream of future earnings or cash flow for shareholders. The earnings machine of stock is basically the on-going business of a company which will comprise the plants and equipment, the system to produce goods and services, its customer base, its pool of employees etc which allow the company to operate as an on-going concern. Because it is an on-going business entity, it has certain business goodwill which encompasses the network of suppliers, its array of customers and the team of employees who know how to conduct the business. A newly established company will not have such goodwill as it may not know the capabilities of its suppliers, it will not have ready customers, neither will it have a team of capable employees who know exactly what to do to avoid or tackle a problem. The operating system of a business is also a valuable asset without which the business will not be able to operate smoothly.

Imagine a fund management company without its proprietary trading system will not be able to pick the stock to invest. A profitable building material trading house supplying solely to its parent building contractor may run into losses if it is sold off and have to look for customers all over again. A construction company with most of the key engineers leaving will not be the same again. A stockbroking firm with most of its remisiers joining another firm will have a much lower value.

In certain companies especially smaller firms, the key management is instrumental in setting strategies of the company and lead the company in terms of getting contracts, providing motivation to staff and strategic planning. Without such key management, it is like a tiger without its teeth. Without them the value of the company will not be the same again.

From business perspective, we can say,
Intrinsic Value= Book Value + Business Goodwill + Management Goodwill (see Fig 3).

Price affected by short-term setback
From time to time, a stock is hit by adverse news or adverse business setback which could be temporary in nature. Examples of short-term impediment are hike in raw material prices, a fire which destroy part of the building but not the main production lines, technical problem which needs a month to rectify, a delay in the expansion plan and a flood which impact on its transportation. To avoid the risk, some panic investors exit the stocks. By selling aggressive they are also taking the risk that stock price may rebound when it becomes clear that the problem is only temporary.

Price drops but fundamental intact
There are many instances where the price of a stock fell due to certain changes but the fundamentals of the company ie its earnings capability, remain fairly intact. The company may have some setback in earnings but it is only temporary as the main structure of company ie its plants and equipment, its operating structure and its management are still intact.

As such, a temporary drop in earnings due to difficult business conditions is not a major issue. A more crucial concern is the permanent loss in value if the control system of the company deteriorates or the management’s focus to grow the company has mellowed down.

Crisis — A window of opportunity
Whenever there is a crisis, like the present subprime woes in the US, there are always investment opportunities. Presently there are many financial institutions in the US battered by provisions on CDO (collaterised debt obligations) and as a result their share prices have fallen by 50% or more.

However, if the losses are not too severe, the fundamentals of the banks may not be very much affected. If the bank can secure capital injection either by way of rights issue or subscription of shares from third party, then the capitalisation of the bank will be restored back to the capital adequacy requirement, the bank will be able to operate as normal again.

It is important for a bank to quickly restore market confidence to avoid a run. So long as depositors do not run away and the bank still has its loans in place, the main fundamentals of the bank are still intact. Whatever losses due to provision of subprime mortgages are not recurring in nature.

If these problems were seen as temporary setback and the company is expected to be back to normal again, then the selldown on the stock can be a window of opportunity to invest. Without which the stock price may not be trading at such a low level. This is especially so for solid company where the share price is normally very firm. A temporary setback or a small mistake is seen as entry opportunity to acquire good stock on dip.