Monday, 18 June 2012

Puzzling Valuations:Price-Earnings

Having started this blog on the spur of the moment, I decide to populate it with all manner of magical thinking, such as valuations.

Leonardo Da Vinci, famously quoted, says ‘simplicity is the ultimate sophistication’.

In the investing industry, one way this can be interpreted is thus: behind the complex engineering and backroom operations that goes on, a few simple rules stand the grinding test of time. Sure these rules get forgotten, usually to the detriment of the overall system, from consumer to producer to business owner.

Thankfully, if the system is sufficiently robust, it will recover from various shocks, and continue along its merry march. One robust rule of the industry is that of valuations, which is easy to preach, but harder to practice.

The trouble with valuations is that it often gets you in trouble with the herd, which in the industry is often made up of very intelligent people with multiple three-letter titles behind their names, all of whom will claim, with the intellectual tyranny of absolute certainty, that: You. Are. Wrong. If you spend any period of time in the finance industry, you quickly develop a keen appreciation for the simple empathy of the modest intellectual, and a strong constitution for sharp criticism. 

At a practical level, valuation indicators try to measure the relationship between price (sentiment driven) and value (business driven). One commonly used indicator is the PE ratio, which compares price with earnings.

But PE alone isn’t very helpful. 
 From end-2008 to April 2011, plotting STI 12-mth fwd returns (that is returns 12 months after the stated date) against the index-adjusted PE (a PE derived from the individual weightings of each index component) suggests that getting in at 23X on 30 Dec 2009 would have netted you around 10% return. Hardly what “buy-low, sell high” preachers would sing about. 

Even after the adjustment for earnings on 31 Dec 2009 (where the big drop occurs), you could still get a decent 12-mth return of around 10% or less, at least until around July-Aug 2010, where 1-yr returns turned negative. 

If I sort the PE ratios from lowest to highest, how does it look? 
What this chart says is that historically, from 2008 to April 2011, you would have gotten much better 12-mth returns if you got in at PE ratios below 9X. But then again, even if you got in at nosebleed 23X PE, you’d still have a positive 12-mth return.

So what gives? Does this mean PE doesn’t work for the Singapore market? If anyone wants to throw in their two cents, I’d be more than happy to bounce ideas around. I certainly don’t have any special insight into these observations, but I’ll explore this topic in more detail next week.

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