A low PE portfolio beats the index hands down

IN the last article, we discussed one of the measures used by the market to value stocks – the price-earnings, or PE, ratio. We noted that the market likes high-growth companies and accords them a higher PE ratio.

The higher the price a stock trades at relative to its current earnings, the more difficult it is for it to meet the market’s expectations and the higher the probability its share price will underperform.
In one of my finance courses years back, the lecturer told us that we should distinguish between a growth stock and a growth company.

Most times, growth companies are not growth stocks, because the hype of the growth has been factored into the share price.

Growth stocks, on the other hand, are stocks whose price will grow because they have unappreciated value or business fundamentals. We want to buy growth stocks but not necessarily growth companies.
Using a hypothetical example, we showed how a 21% downgrade in earnings can potentially cause a 62% plunge in stock price in a high PE stock, and how a 10% to 15% upgrade in earnings can lead to a 150% jump in share price for a low PE stock.

So what proof is there that this is actually happening in the market, that buying low PE stocks pays?
Well, I carried out a study of the stocks listed on Bursa Malaysia in the last 24 years.
I ranked all the stocks listed here based on their PEs every year, from stocks with the lowest PE to the highest. The ranking is done at the end of March so as to capture companies with financial year ending Dec 31.

I then clustered them into 10 groups with equal numbers of stocks. Decile 1 is made up of stocks with the lowest PEs. Decile 2 has stocks with the second-lowest PEs, and so on. Stocks with the highest PEs go into Decile 10. I then tracked the performance of these stocks a year later.
Let’s assume that I started with RM1mil in 1990 – RM100,000 to be allocated to each of the 10 baskets of stocks. After doing the ranking on March 30 that year, I used the first RM100,000 and split it equally into all the stocks in Decile 1. The next RM100,000 is allocated equally to stocks in Decile 2 and so on.

At the end of March in 1991, I liquidate all the stocks bought a year ago. Money obtained from the Decile 1 stocks – calculated based on the share price on March 31, 1991 plus the dividends received in that past year – was redeployed into the Decile 1 stocks in the second year. Money from Decile 2 in the first year would be rolled over to the Decile 2 stocks the following year. Similarly for Decile 3 till Decile 10. I keep doing this for the next 23 years.

The accompanying chart shows the performance of the 10 baskets of stocks with the return rolled over for 24 years.

The RM100,000 put into the lowest PE stocks every year would have grown to RM4.3mil. That’s a compounded return of 17% a year. Guess what the bonus is? Low PE stocks on average also have higher dividend yields.

The second basket of stocks, those with the second-lowest PEs, returned 15.7% a year. Not too bad. It grew the original RM100,000 to RM3.3mil. (Please note that all the calculations exclude transaction costs, and yes, a small difference in growth rate translates into a big difference if compounded over the long term.)

How would someone who consistently goes for the high PE, glamour stocks have done? Well, they managed to grow their original RM100,000 to just RM128,600 for a compounded annual return of a mere 1%. That doesn’t even beat inflation and when transaction costs are factored in, he/she would have lost money.

In comparison, buying and holding the FTSE Bursa KLCI from March 1990 until March this year would have yielded you a capital appreciation of about 4.9% a year. Add in dividends of say 3.5% a year, and your RM100,000 invested in the Malaysian stock index would have grown to about RM2mil over that time, with dividends reinvested in the market.

In other words, buying a basket of low PE stocks would allow you to vastly outperform the KLCI.
But note: Some stocks trade at low PEs for a reason. They could be value traps, in that their stock prices would go lower as the company’s operations continue to deteriorate.

Many of the S-chips, or China stocks listed in Singapore, were trading at very low PEs. And as some of you may know, many of them have bombed. Those still listed are trading at very low PEs because the market doesn’t quite trust the numbers due to the poor corporate governance issues of their peers.
Meanwhile, some stocks trade at PE of 100 times or 200 times because they are transitioning from a loss-making patch to profitability.

So when we look at PEs, it is also important to look at the quality of earnings, and the sustainability of the earnings. But all things being equal, holding a basket low PE stocks beats holding a basket of high PE stocks.

In the next article, we will look at another valuation metric used by the market to value stocks – price-to-book value – and we will see how it performs vis-a-vis the low PE strategy.

The author is a partner in Aggregate Asset Management, manager of a no-management fee Asia value fund.

Source : The Star Online

Pump and Dump

If you've ever researched stocks, you've almost certainly come across a "pump and dump" scheme.

It works like this...

Some person or some group either acquires shares of a company, or is paid to promote a penny stock by someone who already owns shares.

The idea is to give publicity to the stock, thereby attracting other investors to buy.

This is the pump.

If the pump is effective, the amount of new buyers attracted to stock makes the share price start to rise, because there are more buyers than sellers.

But this is only temporary... The dump hasn't come yet.

Once the share prices starts to rise – and enough buyers have been attracted – the original person or group starts selling their shares.

They are selling their cheaply acquired shares at a higher price to those buying during the pump.

Some people make a lot of money from pump and dumps. Others lose it all.

The Art Of Cutting Your Losses

One of the most enduring sayings on Wall Street is "Cut your losses short and let your winners run." Sage advice, but many investors still appear to do the opposite, selling stocks after a small gain only to watch them head higher, or holding a stock with a small loss, only to see it worsen.

No one will deliberately buy a stock they believe will go down in price and be worth less than what they paid for it. However, buying stocks that drop in value is inherent to the nature of investing. The objective, therefore, is not to avoid losses, but to minimize the losses. Realizing a capital loss before it gets out of hand separates successful investors from the rest. In this article, we'll help you stand out from the crowd and show you how to identify when you should make your move.


Reasons Investors Hold Stocks With Large Unrealized Losses

In spite of the logic for cutting losses short, many small investors are still left holding the proverbial bag. They inevitably end up with a number of stock positions with large unrealized capital losses. At best, it's "dead" money; at worst, it drops further in value and never recovers. Typically, investors believe that the reason they have so many large, unrealized losses is because they bought the stock at the wrong time or it was a matter of bad luck. Rarely do they believe it is because of their own behavioral biases.

Let's look at a few of these biases:

 Stocks Always Bounce Back - Don't They?

 A glance at a long-term chart of any major stock index will see a line that moves from the lower-left corner to the upper right. The stock market, over any long time period, will always make new highs. Knowing that the stock market will go higher, investors mistakenly assume that their stocks will eventually bounce back. However, a stock index is made up of successful companies. It is an index of winners. Those less successful stocks may have been part of an index at one time, but if they've dropped significantly in value, they will eventually be replaced by more successful companies. The indexes are always being replenished by dropping the losers and replacing them with winners. Looking at the major indexes tends to overstate the resiliency of the average stock, which does not necessarily bounce back. In fact, many companies never regain their past highs and some go bankrupt.

Investors Do Not Like Admitting They've Made a Mistake

By avoiding selling a stock at a loss, many investors do not have to admit to themselves that they've made a judgment error. Under the false illusion that it is not a loss until the stock is sold, they elect to continue to hold a losing position. In doing so, they avoid the regret of a bad choice. After a stock suffers a loss, many investors plan to hold onto it until it returns to its purchase price. They intend to sell the stock once they recover this paper loss. This means they will break even, and "erase" their mistake. Unfortunately, many of these same stocks will continue to slide.

 Neglect

When stock portfolios are doing well, investors often tend to them like well-maintained gardens. They show great interest in managing their investments and harvesting the fruits of their labor. However, when their stocks are holding steady or are dropping in value, especially for long time periods, many investors lose interest. As a result, these well-maintained stock portfolios start showing signs of neglect. Rather than weeding out the losers, many investors do nothing at all. Inertia takes over and, instead of pruning their losses, they often let them grow out of control.

 
Hope Springs Eternal
 
Hope is the belief in the possibility of a positive outcome, even though there is some evidence to the contrary. Hope is also one of the primary theological virtues in various religious traditions. Although hope has its place in theology, it does not belong in the cold hard reality of the stock market. In spite of continuing bad news, investors will steadfastly hold onto their losing stocks, based only on the faint hope that they will at least return to the purchase price. The decision to hold is not based on rational analysis or a well-thought-out strategy; and unfortunately, wishing and hoping that a stock will go up does not make it happen.

Realizing Capital Losses

Often you just have to bite the bullet and sell your stock at a loss before those losses get bigger. The first thing to understand is that hope is not a strategy. An investor has to have a logical reason to hold a losing position. The second point is, what you paid for a stock is irrelevant to its future direction. The stock will go up or down based on forces in the stock market, the stock's underlying fundamentals and its future prospects.


Let's look at a few ways of assuring a small loss does not become "dead" money or turn into a much larger loss.

•  Have an Investment Strategy

Having a written investment strategy with a set of rules both for buying and selling stocks will provide the discipline to sell stocks before the losses blossom. The strategy could be based on fundamental, technical or quantitative factors.

•     Have Reasons to Sell a Stock

 An investor generally has quite a few reasons why he or she bought a stock, but typically no set boundaries for when to sell it. Don't let this happen to you. Set reasons to sell stocks, and sell them when these things occur. The reason could be as simple as: "Sell if bad news is released about corporate developments or a price target."

•     Set Stop Losses

Having a stop-loss order on shares that you own, particularly the more volatile stocks, has been a mainstay of advice on this subject. The stop-loss order prevents your emotions from taking over and will limit your losses.

•     Would You Buy the Stock Now?

On a regular basis, review every stock you hold and ask yourself the simple question: "If I did not own this stock, would I buy it today?" If the answer is a resounding "No", then it should be sold.


Conclusion

Taking corrective action before your losses worsen is always a good strategy. In investing, avoiding losses entirely may not be possible; successful investors accept this and try to minimize their losses rather than avoid them. Selling a stock at a loss and receiving a tax credit is one benefit you will receive. Selling these "dogs" has another advantage too - you will not be reminded of your past mistake every time you look at your investment statement.

Trade Stock At Bursa Malaysia

Start With A Financial Plan

Trading stocks should be treated as a business venture - it will require time, knowledge and money to succeed. Your Financial Plan represents your roadmap to success.
Decide Your Financial Objectives.
If you are a 60 year old looking for cash flow to fund your impending retirement, your priority would be to generate an income stream rather than large asset value growth.
If you are a 25 year old who wants to begin to invest, capital growth would be the priority, rather than income stream.
Your financial objectives will determine whether you trade liquid shares or not.
Decide Your Risk Level.
Decide on your risk level and the types of investments you can afford to make will be set. Remember, the higher the return you want to achieve, the higher the risk.
Low Risk Level
I am not very comfortable with risk and will invest in fixed interest/capital guaranteed securities (government bonds, bank term deposits).
Medium Risk Level
I can take on a moderate amount of risk (blue chip Industrial and Banking and Finance sector shares).
High Risk Level
I am comfortable with risk. I am seeking a high return and prepared to evaluate companies early in their growth phase (recently listed resource companies).
How Do You Fund Your Investments?
For most of us, we do not have immediate access to a large pool of ready savings. Using the equity you have in a property to fund your share portfolio is a common approach.
EPF savings is also an effective vehicle for providing funds for investing and the majority of Malaysians have access to these funds.
Most major banks and insurance groups offer margin loan facilities. This is where you start a portfolio with savings and then use this portfolio as security to borrow further funds to buy more shares.
In most instances, the problem is not acquiring funds to start a portfolio, it is having the knowledge to invest with confidence.

Employ Risk Management Strategies

With any investment, be it stock trading, real estate or business, it is important that you understand what the risks are and how to minimise your exposure to these risks. This process is known as 'Risk Management'.

The Three Elements Of Risk Management

1. Spread Your Risk: Don’t Put All Your Eggs In One Basket
Spreading you risk is as simple as not putting all your eggs in the one basket. This is called diversifying your portfolio.
Spread your capital so there is never more than 20% in a single stock.
Don’t however take this to extremes and over-diversify by investing in too many stocks at once. You cannot expect to outperform the market if your portfolio closely matches the market. A rule of thumb is to limit your portfolio to between 5 and 10stocks.
2. Plan Your Exit: What Is An Acceptable Risk?
Amateur traders buy a stock and their focus is to hope it increases in price. If it goes down, they continue to hold in the hope the price will recover. When a professional buys a stock they recognise that success is a probability, not a certainty. At the time of entering the trade they establish an Early Exit price. If the stock falls past this point the good investor will immediately exit and never run the risk of making a large loss.
Maintaining your capital is fundamental to successful trading. If you invest in a stock and make a large loss, then it is impossible to consistently profit from the stock market. Having incurred a large loss, you must now make a large profit just to break even. The key to successful trading is keeping your losses small.
3. Stop The Loss: Don’t Drive Without A Seatbelt
The second must sell signal is a Stop Loss. Just tracks the highest price reached by the share since purchase. If the share falls by more than 10% from this price, it is time to sell. We suggest 10% - you can change this depending on your trading style. Too small a percentage and it will get you out too early. Make the percentage too large and you give back too much of your profits before exiting. Start with a 10% fall and see what you feel comfortable with.

Always Trade With The Trend

Trends are the cornerstone of trading. If a share price is rising, we can make money by buying that share. If the share price is falling, we need to look for other opportunities. It does not make sense to buy a falling share. Our aim is always simple – find a share in an uptrend and take a large chunk from the middle of the trend.
Overall Market Strength
It is important to look at how the overall market is doing. This can be gauged by looking at the top 500 shares, otherwise known as All Ordinaries. If All Ordinaries go up, it is because stocks in the top 500 have risen and the market is in an uptrend.
There are over 1000 companies listed on the Bursa Malaysia that you can invest in. To examine each one individually would take a great deal of time. Instead, you trade with the trend and find the strong sectors in the market.
Strength of an Industry Sector
What is a Sector?
A sector is a group of companies involved in the same industry. For example, mining companies are grouped together in the Materials sector while banking companies are in the Finance sector. Entire sectors are generally affected by economic conditions so entire sectors tend to trend in the same directions. Trends do not have hard and fast rules, individual stocks within these sectors will perform at different levels.
Strength of Shares in a Sector
Although the general rule of novice investors is to buy on an uptrend, there are people who buy during a downtrend as a strategy. This is a process of buying more shares as the price falls, so the average cost of the share is reduced with every purchase. This kind of bargain hunting is a riskier strategy, as the stock price may never recover. The second downside is that the price may fall and then stabilize, meaning the investor may have to wait for a while before recovering losses or making a profit. In this scenario, capital that could be used for profitable trading would be lying idle.
Resistance to this type of trading is not new. One of the greatest traders of the last century, Jesse Livermore wrote, “Experience has proven to me that the real money made in speculating has been commitments in a stock showing a profit right from the start.”
By now you should understand that trading with the trend is critical to success. Also, our objective is never to buy at the bottom or sell at the top of a trend. We simply want to take a large chunk out of the middle. Let the trend be your friend.

Don’t Buy And Hold

The Malaysian stock market is one of the strongest and sometimes most dynamic markets in the world.
While the market has always recovered from falls, the same cannot be said for individual companies. Even during a booming market, some companies can suffer significant losses.
Trade only on an uptrend and sell the poor performers, this will make it impossible to experience a large loss. This is the secret to outperforming the market and achieving a consistently superior return.
Undertake some research on the Bursa Malaysia or in a local investment paper. List three shares that have showed decreased performance recently and three shares that have showed increased performance recently.

Trade Only Liquid Stocks

Look at the column called Lots Done in your market report. This is the amount of stocks that were traded on the day. If you multiply this by the price of the stock, you can see how much money actually changed hands on that day. If this amount is high, then the stock is very liquid, meaning it is easy to buy and more importantly, easy to sell. The last thing you want once you've bought a stock is to be stuck with it because you can't find a buyer.
For example, if a company has traded 100,000 stocks today and the closing price was RM2.42, we can estimate that RM242,000 worth of that stock changed hands today.
For example:
Innovics' last price was RM 0.30 and Lots Done were 1000. This means that an average of RM 3,000 worth of stock changed hands today. In other words, Innovics is only trading an average of RM3,000 of shares each day.
Now, you own RM10,000 worth of Innovonics and you want to sell. If you enter your sell order on the market, you will inject 3 days worth of turnover onto the market. There will not be enough buyers for you to immediately sell the stock at your chosen exit price.
To ensure you invest in liquid shares, only trade stocks that show a daily turnover of at least ten times what you are planning to invest. If you are investing RM10,000 in a stock, look for an average daily turnover minimum of RM 100,000.

Develop Your Own Trading Plan

Trading is about probabilities, not certainties. A Trading Plan establishes a series of steps that ensure a higher probability of success.
The Plan will set certain guidelines for:

What stocks to buy

When to buy

When to sell

The Structure of Your Trading Plan

A Strong Market:
Before deciding what to buy, first establish if the market is in a positive phase. If the KL Composite Market has been negative over recent weeks (or longer), it is not a good time to enter the market. If the majority of stocks are going down or sideways, the probability of you buying a share that is going to rise in the immediate future is slim.
A Strong Sector:
Having waited until the market is in a growth phase, determine if there are any sectors showing strong growth in the past few weeks. These are the sectors that have stocks performing well and are increasing in price.
Examine stocks in these strong sectors and determine those that are on an uptrend, meaning the price of the stock has been steadily going up for at least 3 months.
These stocks will qualify as having potential for ongoing growth as they are generating positive market sentiment. If they have adequate liquidity on top of that, you could add any of these to your portfolio knowing that you could exit quickly at any point in time.
Exit Strategy:
Having selected shares to include in your portfolio you must then have an Exit Strategy in the event that these shares show signs of reversing. Simply set an Early Exit price to ensure that the stocks you buy never generate losses.

This is a simple description of a Trading Plan. It holds the basics for selecting stocks that have a good probability of increasing in price and risk management to protect your capital. These three ingredients are the key to success in stock trading.