Downside Limited But Trade Wars Present Conundrum

This is a very good write up by The Hooi Ling. She is now the manager of Inclusif Value Fund and a friend that I respect very much.

Technical and Fundamental analysis Go Together Like Horse and Carriage

My friends call me a “technical analyst”. It is half the truth. Fundamentals tell you what the upside or downside is. You don’t buy a stock at 3x price to book, 100x PE and 50x EV / EBITDA when the chart is a “BUY”. Especially when the business is undergoing disruption. I will look at the technical for a SHORT and ignore the BUY signals.

Technical analysis determine when to buy or sell. It usually cannot determine the % upside / downside nor can it tell you the list of stocks to buy or sell. This list of stocks come from fundamental analysis.

Downside is Limited But US and Trade Wars Present Conundrum

From the table below, we can gather that 1.2 to 1.5x price to tangible book value, and 1.0 to 1.4x price to book is likely the bottom of MSCI Asia Pacific. 1.2 / 1.0 PTBV / PTB occurred in a “great recession” of 2008 / 09. For most “normal” recessions like 2000 and 1996, the valuations are at 1.4 to 1.5 / 1.2 to 1.4. Valuations are now at 1.6/1.4. Given that we are experiencing SLOW GROWTH and not a recession,  I believe the downside is at most 5 to 10% away. There is very limited downside going forward.

The conundrum is with the valuation of S&P500 which is a lot more downside. Never has the Asian markets risen when the US falls. The US valuation has a downside potential of 15 – 30% to go. Hence I come to two potential scenarios:

1.     The US’ equity valuations mean reverts and falls another 15%. Meanwhile Emerging Markets and Asia Pacific falls another 10%. Second half of 2019 will be a fabulous year for equities because after such a big fall, the rally will be at least 30% for Asia Pacific.

2.     The US’ equity valuations DO NOT mean revert and rises. Emerging Markets / Asia Pacific rallies. 2019 will still be a good year for equities, but the upside will be 20% for Asia Pac instead of 30% in scenario 1.

In both scenarios, Asia Pacific, due to stronger GDP growth and cheaper valuations, will outperform.

There are risks to the scenario though:

1.     The trade war may tilt strongly in the US’ favor. Manufacturing heads back to the US. Because Asia is still primarily a factory for the developed country, it suffers the brunt of the trade war.

2.     Developed countries, with GDP 67% comprising consumption, will receive a bigger boost and outperform Asia in both GDP growth and equities.

As we have mentioned before, in investing we have to differentiate betweenpermanent loss and temporary loss of capital. Permanent loss is forking out $2 for something that’s worth, say, $1. When the market comes to its senses, the asset price will fall back to its fair value of $1. The excess $1 paid is lost more or less on a permanent basis until, in the case of stocks, the company is able to add to its book value or its worth through profits over time.

Meanwhile a temporary loss is paying $0.50 for something that’s worth $1, but seeing the price drop further to $0.40 because of some term negative market sentiment. The price will recover faster from $0.40 to $0.50, compared to the earlier stock which has to climb from $1 back to its future potential value of $2. Hence, this is described as temporary.

The loss suffered by our portfolio is a temporary one.

We compiled here the portfolio characteristics as at end Oct and the month before, end Sep 2018.

As you can see, our portfolio is substantially cheaper than a month ago. There’s a market wide discount going on now!

Benjamin Graham, the father of value investing, had this advice for investors: Increase your allocation to equities when the market is cheap, and reduce it when it is expensive. You’ll find the link to what Mr Graham said about market volatility later in this letter.

So how soon will the market recover? We went back some 30 years to get some idea.

In the table below, we compiled the previous six major market peaks and the length of time the market took before it hit the trough. We also showed the market valuation at the peak and at the trough.

(There was no market valuation data before 1995.)

For the market peaks in 1996 (before the Asia Financial Crisis), 2000 (the Dotcom bubble), 2007 (just before the Global Financial Crisis), the price to tangible book value (PTBV) ratios for the MSCI AC Asia Pacific Index were 2.5x and above. From that height, for all three cases the market plunged by some 50 per cent. The bottom for first two crashes were at PTBV of 1.5x and price-to-book (PB) value of 1.4x.

The Global Financial Crisis was especially severe, for at that time, pretty much the entire global financial market seized up. Investors and financial market participants had no idea which companies or institutions would still be around in a few months’ time because of what companies were carrying on their balance sheet. Because of this fear of the unknown, buyers could only be enticed into the market at a big enough discount. Consequently, the Asian markets sank to a PTBV of 1.16x and PB of 1.01x.

For all the other crashes in the last 30 years, PTBV of about 1.4-1.5x and PB of 1.2-1.4x proved to be the floor.

Comparing the earlier three market downturns with the two recent ones in 2011 and 2015, you can see that the previous three (highlighted in the table above) turned south at a much higher valuation of 2.5x and above. From that elevated level, the length of the downturn was longer – average of 27 months, or just over two years.

The recovery, from trough to peak, for them was also longer at an average of 38 months. (Again we see evidence of the market going down by elevator, i.e. faster, but going up by escalator, i.e. slower) For someone who was fully invested in the market at the peak in those three occasions, and didn’t top up as the market declined, he or she would have to wait an average of 65 months, or more than 5 years, to have their portfolio climb back up to where it was before the crash. Incidentally, the market took more than 16 years to reclaim the peak reached in 1989 after it was knocked down from that perch in the beginning of 1990.

The market downturns in 2011 and 2015 however happened at a lower valuation, at PB of 1.5x and 1.6x respectively, or PTBV of 1.8x and 1.9x respectively.

From that lower height, the decline was less severe, about 19 per cent over a period of about 12 months. The recovery was also swifter, at an average of 11 months. Peak-to-peak, the two episodes were over in about 22 months, or less than two years, each.

The current downturn that we are going through belongs to the second category of correction, where the starting valuation wasn’t exceptionally excessive. It’s been 9 months since January this year when the market reached its peak. The market has corrected by 17 per cent. The current market PTBV is 1.6x, and PB is 1.4x.

Comparing the above numbers with those from the previous two downturns suggests that we should be quite near the bottom.

Another way to look at it, to sink to the low of 2011, the current market has about 11 per cent more to fall. To fall to the depressed levels of 2009, the market has about 26 per cent to go. Situation today is unlike that of 2009, and so my view is the probability of the second scenario happening is quite low.

Below is the chart for the MSCI AC Asia Pacific Index relative to its PTBV and PB.

Of course book value will vary over time. When companies make profit they add to their book value. When they make losses, their book value decreases. So if the expectation is that book value of Asian companies will decline substantially over the next one, two years, then the index may have more to fall.

Just to give you an idea how companies in the MSCI AC Asia Pacific Index have done in terms of their book value per share:

 

From 1995 till 2004, the index’s book value didn’t grow much because Asia went through one crisis after another – from the Asian Financial Crisis, to the Dotcom bubble burst to the SARS epidemic. That’s why the 1989 peak took more than 16 years to recover! Since then, every decline in book value has proved relatively short-lived.

We add the price index to the book value per share in the chart above. Using 1995 as the starting point, the MSCI Asia Pacific Index has more or less been tracking the component companies’ book value up till around 2008. Since the Global Financial Crisis, the index has been lagging behind the rate companies were adding to their book value. There was an attempt to catch up in 2016 and 2017. But the index declines in the last 9 months have widened the gap again.

Book value is an estimate of fair value of companies. And value has been described as the gravitational pull of the financial markets, in that prices can’t deviate too far away from value. Over time, the gap will close.  

Fund Update

We had new subscriptions of $1.4 million in October for Dealing Date 1^stNovember 2018. We are starting November with about $109 million asset under management, 3.9% of which in cash.

Just a gentle reminder that for investors who have subscribed to Class A shares, you have up till end of this year to top up your investments into the same class of shares. Given the current low valuations, it is not a bad time to do so.

Presentation and article

Motley Fool Singapore invited me as a guest speaker to their FoolFest event last month. My topic is Securities in an Insecure World Revisited. I’ve uploaded the slides of the presentation onto our website under Resources page. You can find it via this LINK as well.

Key takeaways:

·       “Investors cannot have a dependable view on the market’s future action in the next year or so, but that a large and disturbing decline is likely to take place again sometime in the future, and that we should be prepared in thought and action for it, it is a necessary assumption for investors to make, and for sensible speculators too if there are any such.”

·       “Investors as well as speculators must be prepared in their thinking and in their policy for wide price movements in either direction. They should not be taken in by soothing statements that a real investor doesn’t have to worry about the fluctuations of the stock market.”

·       Implication: Volatility – up and down – is to be expected in equities market. Just as you need to buy, you need to sell as well. Don’t kid yourself that if you own a good company, you never ever have to sell!

·       “Investor’s portfolio allocation decisions should be clearly based on value considerations, i.e. own more common stocks when the market seems low in relation to value and less common stocks when the market seems high in relation to value.”

·       “The main need here is for the investor to select some rule which seems to be suitable for his (her) point of view, one which will keep them out of mischief, and one, I insist, which will always maintain some interest in common stocks regardless of how high the market level goes.”

Last week, I contributed this article to the Business Times. It’s a fun piece about stocks’ names. Companies containing this word in their names are the only ones as a group that outperformed the Straits Times Index over the last 30 years. Guess which word is it? 😉