Equities are the rock stars of the investment world. They are glamorous, volatile and get all of the attention. They can be very good or very bad; they are loved, hated and feared. Some television channels are devoted almost entirely to the stock markets and their machinations.
With all of the hype it is easy for investors to lose perspective. In the media every opportunity seems to be better than the last and portfolios often drift towards equities at the expense of other asset classes. The biggest struggle is to have the discipline to keep emotion out of your investment decisions. It is easy to become too enthusiastic or too apprehensive about investing in equities.
Stock market valuations are subject to more comment and more scrutiny than any other asset class.
Individual stocks and the indexes themselves are the primary topic of conversation on high powered financial channels such as CNBC, MSNBC and BNN. Books like ‘The Intelligent Investor” by Benjamin Graham, “Bull’s Eye Investing” by John Mauldin and “One Up on Wall Street” by Peter Lynch outline their approaches to investing in stocks and the stock market and are worth reading.
Equities represent ownership (or at least partial ownership) of a company.
Investors share in the growth in value of a company through the growth in value of their shares(s) of the company. If a company declines in value, the value of the investors’ share of the company also declines.
The equity asset class includes many different sectors, including energy, mining, financial services, manufacturing, utilities, health care, technology and so on. Each of these sectors will react differently to economic influences and shrewd investors will ensure they have appropriate exposure to the various sectors.
The manufacturing sector, for example, will often react in a positive manner to lower oil prices, while the energy sector will not. Ensure that you have appropriate diversification or ask your advisor for assistance in this area.
The two ways in which equities can provide a return to investors are the dividends they pay and the change (hopefully growth) in the value of their shares. Depending upon the prevailing circumstances, far more emphasis is often placed on one rather than the other, but both provide an important contribution to the total return achieved by the investor.
One of the biggest challenges faced by investors is determining the fair value of the equity market and the outlook for its value in the future. When compared to the asset classes of cash, fixed income and preferred shares, there are more factors affecting equity values and they are more difficult to measure. Two of these factors are earnings and investor expectations.
Because the equity market is simply a collection of individual companies, the principles that apply to the market also apply to individual companies.
When examining equity valuations, the terms equities and stocks will be used interchangeably.
Fundamental Analysis – Earnings
Earnings drive a company’s (or the market’s) value. They are necessary to enable a company to pay dividends and earnings are necessary for a company to expand and grow. The greater the earnings, the more value a company will be. It is the most basic principle of investing in equities.
Factors that can affect a company’s earnings are the level of sales they achieve, the profit margin on their sales, the interest the company must pay on money it has borrowed and so on. In periods of economic strength sales and margins are expected to grow, while in recessions, sales and margins are expected to decline.
It is not only the current level of earnings that determines the value of equities; it is the level of earnings they are expected to achieve in the future. If investors anticipate that a company’s earnings will rise, they will often pay a premium over fair value in the expectation that rising earnings will result in an increased fair value.
Fair value of a company (or the equity market) is often measured by its price earnings ratio.
Price Earnings Ratio
Over time the average value of publicly traded companies has been about 16 times its annual earnings with the value falling between 10 and 20 times its annual earnings the majority of the time.
This ratio between the earnings per share of a company and its share price is known as its price-earnings ratio or PE ratio.
Outside those parameters the markets could be considered cheap or expensive but as the previous chart shows, the price of stocks or the value of the overall markets can stay cheap or expensive for much longer than we expect. As you can see, markets can go from overvalued to more overvalued, but eventually values revert to the mean. In other words, the market eventually reverts to a value that is close to the long term average multiple of its earnings.
The chart below illustrates the average value of companies traded on the US stock market compared to their earnings per share.
Another way of looking at this chart would be to say it illustrates the share value of a company that earns $1 per share. It is also important to remember that the market doesn’t necessarily have to drop to bring valuations back into line. An increase in earnings could accomplish the same thing.
While PE ratios are a good measure of value, they are a poor statistic to use when trying to time the purchase or sale of an investment. As the chart indicates, they can go from slightly overvalued to being significantly overvalued before coming back to fair valuation levels.
What, then, makes a company that earns $1 per share worth $10 at one point in time (year 1980 on the chart above) and worth $40 at another point in time (year 2000 on the chart)? If the earnings are at the same level, should the price not be at the same level?
It is obvious that other factors influence price and one of these is investor expectations.
The problem with PE ratios is that they are a snapshot in time that measures current price against current earnings. Investments, however, are made with an eye to the future. When someone expects earnings to rise, they will often pay a premium over the historical price earnings ratio.
Let’s look at a hypothetical example.
An investor looks at a company that has $1 in earnings per share. Using the historical average PE ratio, the fair value would be about $16 per share but it is trading at $24 or a PE ratio of 24. However, this investor believes that earnings will reach $2 per share next yearand with a PE ratio of 16, the fair price would be $32. At $24 these shares seem to be a bargain. In this case, the investor’s expectations play a big part in the price of the stock.
Technical Analysis - Charts
While fundamental analysis examines such factors as earnings, book values, interest coverage and so on, technical analysis involves examining charts of the price movements on the markets and stocks.
The theory is that price movements reflect investor expectations and technical analysts attempt to draw conclusions from the way in which the price of the market moves.
You will hear terms such as technical support or technical resistance which represents the values at which the equity market will have some support from falling further or resistance to rising higher.
Sometimes a picture is worth a thousand words. A quick glance at a chart can easily tell you if a stock has been going up, down or sideways over any given time frame. That movement has been examined in a thousand different ways by a thousand different technical analysts each trying to draw conclusions about the future from what they see.
There have been hundreds of books written about technical analysis, each having claimed to uncover the secret indicators that can make you rich. A dose of skepticism is appropriate here but that does not mean that chart analysis is not worthwhile. Used in conjunction with fundamental analysis, these charts can be helpful in painting a clearer picture of the situation.
I will look at one technical indicator, the moving average price, and leave it to you to decide if you want to pursue the topic further.
Moving average price
The 200 day moving average price is the average price at which the market (or an individual stock) traded over the previous 200 business days.
Because it averages out all the highs and lows over the previous 200 days, it is much less volatile than the day-to-day price. As such it can provide a clearer picture of what long term value investors place on the stock or the index.
If the 200 day moving average reflects the fair price over a long term it becomes a useful comparison to the current market price. If the price is 20% above its 200 day moving average price, it may have got ahead of itself and if it is 20% below its 200 day moving average it may be undervalued.
If prices ‘revert to the mean’, the chances are that an overvalued market will eventually drop and an undervalued market will eventually rise. Using this method to monitor price movements can be applied to individual stocks as well as the overall market.
The TMX Group has an excellent website (www.tmx.com) where you can create your own customized charts. The following example is a ten year chart of BCE along with its 200 day moving average price.
Investors wanting to jump into the market might want to wait if the market is over-valued while those who are on the verge of panic and want to sell might want to wait if the market is under-valued.
These are not precise timing mechanisms but they can give investors a feel for the value of the market or an individual equity relative to its historic price.
Dividends – A Major Consideration
Many investors focus on the change in share price of an equity investment without considering dividends. When you invest in a company that pays no dividends, you are relying solely on growth in share value to generate a return on your investment. On the other hand, when you invest in a company that pays dividends, those dividends can generate a significant portion of the return and you are not a reliant on growth in share value.
A word of caution should be raised about dividend paying investments.
In times of low interest rates and uncertain stock markets, investors will often seek out yields in other areas. Stocks that pay high dividends can become the focus of their attention and as a result, they may be tempted to overpay for these stocks.
For example, an investor may be tempted to pay more than 16x earnings for a company that pays a high dividend. Use caution when paying a high price-earnings multiple for a dividend paying stock.
In an effort to attract investors, companies can sometimes pay a higher dividend than they can really afford, leaving little money available to operate and grow the company.
The dividend payout ratio is the amount paid out in dividends relative to the earnings of the company. A dividend payout ratio in excess of 100% is obviously a very bad sign.
Dividend payout ratios are a more useful tool when used for selecting individual stocks than for choosing a mutual fund or exchange traded fund.
Equity traps to avoid
Hundreds of books have been written about uncovering value in the stock market. Some of the most famous of these have been written by Benjamin Graham, including “The Intelligent Investor” which was first published in 1949.
Rather than repeating what has already been written by others and pointing out all of the ways in which equities can be valued, it might be more useful to highlight a couple of traps to avoid.
When an individual works for a company or when a company has a significant presence in a community there can often be a tendency to develop a bias towards that company.
Investors shouldn’t confuse familiarity with safety. If the company seems sound and it fits within the investor’s profile then a reasonable allocation may be appropriate.
Past performance trap
Using past performance to guide future expectations is common among mutual fund investors.
Economic conditions change, governments change, technology advances, wars erupt and the supplies of food and energy are disrupted. In the environment of those constantly changing circumstances it is irrational to expect the future to look like the past. Yet that expectation constantly repeats itself.
Rather than looking to what the future may hold and ways in which to take advantage of the changes, many investors are more interested in the past performance of a mutual fund investment. While that can provide some insight into the manager’s effectiveness compared to that of his peers, it provides absolutely no insight into what future performance may be.
Using past performance as the basis for making your investment decisions is like driving down a freeway looking only in your review mirror. It may work out, but it wouldn’t be because it was a good idea.
Whether you are using fundamental or technical analysis to make your investment decisions, the experience can be frustrating because the markets don’t cooperate as often as we would like them to.
Equities, including individual stocks or a basket like mutual funds, can go from being overvalued to even more overvalued. You might also buy them when they seem undervalued in the hope of a quick gain, only to find the price drops even further.
These kinds of price movements seem irrational and they are, but it is important to keep in mind that the markets can stay irrational for much longer than we expect.
A company’s fortunes do not change minute by minute, hour by hour, day after day. Big changes occur over time, yet the price can fluctuate wildly on a daily basis. Obviously, these constant price changes are not always the result of structural changes within the company.
It is the expectation of what a stock will do in the future that influences whether the investor buys or sells today. If expectations drop, buyers will be scarce and those who want to sell may have to lower their price.
Conversely, improving expectations will find a multitude of buyers, and sellers may increase their asking price.
Expecting to predict short term price movements is akin to having the ability to read the minds and emotions of millions of investors instantaneously.
In the long run, the price of a stock or an index will reflect their underlying fundamentals, but in the short term expectations and emotion can cause big swings in price.
NEXT: Asset Class - REITs
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