Equity Markets at a Bargain, 13 Upgrades to Our Star Ratings!

Doom, gloom, pessimism – that’s what table 1 tells us. All markets that we cover suffered a dip, 10 out of the 15 markets los t more than 20% in October alone. This is a sharp contrast to 2007, when we s aw 13 out of the same 15 markets having full-year positive returns. What do falling markets tell us?

Table 1: Market Performances as at 31 October 2008

Source: Bloomberg, All returns in local currency terms.

Without taking into account emotions in investing, and really taking note of numbers and logic, falling markets tell us:

Table 2: Upgrades to 5 star markets

Source: iFAST Compilations and Bloomberg

Are we being overly optimistic here?

Time to Bottom Fish

It has been a hard time for most investors for the first 10 months of 2008. It is quiet possible that you would let your emotions or pessimism get the better of you and give up on markets. The only way to avoid getting swayed too much by all th is pessimism is by looking at the facts. Let’s look at them right now.

After the huge and painful fall in markets, most of their price earnings (PE ) ratios look more attractive than anytime in the past five years (from end October 2003 to 2008) . But then not all equity markets which have fallen warrant an upgrade in Star Ratings – it could be that other factors including political factors and long-term economic term growth factors have deteriorated along with the huge dip. And hence, we are not simply upgrading a market because it has a low PE ratio; there are other factors that we consider as well.

One factor that we should consider would be the Price-to-Book ratio or PB ratio. PB ratio represents the ratio of the price of the market with the underlying book value of companies in the market. A PB ratio of less than one essentially means that the market is selling for less than the book value (assets minus intangible assets and liabilities as at the previous quarter) of the company. That essentially represents good value for the investor. It also gives the investor a good idea of assets that the company has if it were to liquidate their assets immediately. It is difficult to compare this ratio across the different country markets because different companies across these markets may have different accounting procedures on how they define the assets and liabilities. Thus, this ratio is more meaningful if you make a historical comparison instead.

Another pertinent factor to consider is that, when there is economic weakness, there is a natural tendency for consumers and businesses to spend much less . Company revenues would be the first hit and even if we assume that operating costs remain the same, earnings tend to show declines.

Fast forwarding the scenario to when the economy recovers - during a business cycle, when economies start to recover, consumers tend to spend more and companies could see a strong potential for some earnings recovery . Thus, if we just look at the earnings for the next 12 months – we would be pessimistic o n equity markets. But this is not a good reflection of the view that we should have on company earnings for the medium term, wh ich we shall define as over the next three years. Thus, in a later part of the article, we would also look at the average earnings growth from 2009 to 2011.

For the star ratings, we base our analysis largely on four main factors and score the markets based on these factors . A market could get a score of as low as 1 (Not Attractive) or as high as 5 (Very attractive). Market valuations takes up 45% of the score, 3 year average earnings growth takes up 25% , the long-term economic potential takes up 15% and currency views takes up the remaining 15% . For this article, we shall zoom in on valuation and earnings. For example, for South Korea, the score was 4.9, 3.0, 3.0 and 3.0 for the respective factors and that made up a score of 3.9, which we are rounding up to 4 stars.

For valuations, we widened our scope to look at the excess earnings yield and PB ratios of the various markets.

Yes, market fell, how are valuations?

For valuations, table 1 already shows that most markets have fallen tremendously on a year-to-date basis. The markets have fallen on average by about 47%. A lot of them are now at levels similar to before the bull-run actually started in 2003. We have come out with articles such as US: Upgraded to a 4 star market and Take Heart: Why the Malaysian Bear Market is Common to illustrate the kind of pessimism we have already seen in the market. For the United States , low consumer confidence, higher unemployment rates, and a marked slowdown in the manufacturing and service sectors all point to pessimism in the economy. Table 1 already shows that with markets already fallen by such a huge margin – a lot of this pessimism has been priced in.

From column 1 on table 3, we see the estimated PE ratios of the various markets covered. All the markets  show a lower estimated PE ratio in comparison to the average PE seen in the past 5 years (from end October 2003 to October 2008). For example, one of our favourite regional markets (Asia ex-Japan) has a star rating of 5 stars and its estimated PE as at 31 October is 8.3X, compared to its historical average PE of 14.7X.

Let’s shift to factors other than PE.

PB is another valuation method and we have found that PB ratios of the markets are also trading below their averages for the past 5 years. For Europe, the PB is 1.26X as at 31 October 2008, much lower than the average PB of 2.81X. Also, for markets like Thailand and Korea with PB ratios less than 1, a discount to the underlying assets (net of intangible assets and liabilities) show that stock prices have discounted a large part of the pessimism regarding the subprime-related crisis.

Another factor that we assessed w as the excess earnings yield of the market. Earnings yield represents the reciprocal of the PE ratio. Earnings yield is the amount of earnings you purchase for every dollar worth of a stock market (for example, if a market has an estimated PE of 9 X, the earnings yield is 11%). Excess earnings yield would be how much yield the market is offering right now in comparison to the country’s 5-year government bond . A high excess earnings yield would mean the equity market is much more attractive than bonds . From the table below, we can see that with the exception of the Emerging Market region, Indonesia and India, all the excess earnings yields are now at 4% or more!

The last column shows that with the index levels that we are at right now , most markets we cover receive high scores for valuations of 4 and above. In fact, markets such as Singapore, Hong Kong and Europe have a valuation score of 5. Enough talking about valuations, we all know that they are low and markets are at a discount compared to the past five years. But the valuation measure – PE ratio is very dependent on one thing, which is the ‘E’ or earnings that would likely get affected when a recession occurs .

Table 3 : PE & PB Ratios as at 31 October 2008

Source: iFAST Compilations and Bloomberg. Column 4 shows the 5-year average PB ratio is from end October 2003 to end October 2008 * Singapore’s 5-year PB ratio is based on the old STI, before its revamp to the new FTSE STI in 2008; ** Taiwan's PB numbers are based from November 2007 to end October 2008 only

Earnings Growth

We think that pessimism in earnings has not been fully incorporated in some of the earnings forecasts. To stay relatively conservative, based on the sectors that we think would be affected by the US recession, we chose to reduce the existing estimates given by the consensus Bloomberg forecasts. That is why you can observe that there are a number of countries spotting negative growth in the next two financial years (2008 and 2009) but a number of the markets are expected to see their earnings recover in 2010-2011. As the earnings score is based on the average earnings growth from 2009 to 2011, we do see some high scores here for markets such as the emerging market region, Hong Kong, China, India and Indonesia.

Table 4: Earnings Growth (Updated as at 6 November 2008)

Source: iFAST Compilations and Bloomberg.

Top Choices for Investors – The 5 star markets

After including the scores for the other two factors including the long term economic potential and currency factor, we have upgraded 13 markets out of the 15 markets we cover. Are we being overly optimistic here and are the upgrades too sudden ? One may think so if you just simply look at the number of upgrades but if you do track the markets from September to October, you would realize that a number of these markets have fallen to levels that both PE and PB ratios scream ‘Buy!’ There are two regions and three Asian countries that have a 5 stars rating. They are the emerging markets , Asia ex-Japan,  Singapore, Hong Kong and China. In the following few weeks, we would have articles that cover in detail why these markets have become 5-star markets.

Table 5

Source: iFAST Compilations and Bloomberg.

In the meantime, we really hope that investors are aware that while we are experiencing adversity in markets right now with a lot of pessimism floating around – the same adversity could also mean an opportunity to buy into markets at a bargain!

This could be quite a cliché, but ‘during times of crisis’ or ‘危机’, even though there’s risk (危险) there is also opportunity (机会). Table 1 shows you the risk and how much markets have fallen. On the flip side, tables 3 and 4 shows you the opportunity that these equity markets provide using cold hard figures. And the upgrades are not just about the PE levels, other considerations including earnings growth, long term economic potential and our views on currencies are also incorporated in the analysis.

Instead of ending the article telling investors to see the long-term potential of markets or use dollar cost averaging which is what we have advocated most of the time and even now, I shall end by reminding investors that markets are already at a bargain and the figures that we have shown say it all!

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