Buy Low, Sell High? Think Again

Foreword from ShareInvestor

This article “Buy Low, Sell High? Think Again” by Cai HaoXiang was first published in The Business Times on 01 Feb 2016 and is reproduced in this blog in its entirety.

Simple ratios like price-to-earnings or price-to-book can give false signals to investors

Conventional market wisdom tells investors to “buy low, sell high”. It sounds like a no-lose proposition. Who doesn’t want to do that?

You can always say you use fundamental analysis to decide a stock’s intrinsic value so you know when is low and when is high. But reality is never that simple.

Let’s start on the buying front. What does it mean to buy low?

Beginner investors often rely on the price- to-earnings (PE) multiple or the price-to-book (PB) ratio.

The PE multiple refers to the number of times a company is trading at based on its historical earnings, or next year’s estimated earnings.

The PB ratio refers to what the market is currently valuing the company relative to its book value, or what is left for investors after we deduct liabilities, like debt, from assets, like properties and factories owned.

Beginner investors then use the ratio they get to judge whether a stock is cheap relative to a mentally “high” number plucked out of thin air, or relative to history, again based on data from a number of years, the number plucked out of thin air.

These numbers can mean little.

PE multiples, for example, are not very useful to evaluate property developers with.

Property developers with projects overseas, for example, recognise their revenues, construction costs and profits only when their projects are completed and handed over to the buyer.

As a result, earnings come at a go, and then don’t come at all.

The PE multiple here is meaningless because you may get a very large spike that pushes the stock to trade at a few times earnings for the year, or very high multiples in the years when most projects are under construction.

Just from the number, you can’t determine what is cheap and what isn’t.

Growth companies, meanwhile, can trade at very high PE multiples of 50 times or more, but can still be cheap.

This is because what they are investing in can result in far bigger profits years down the road than the market was anticipating.

When evaluating a growth company, what is more important is your own estimate of how fast it will grow, or what a steady state of its earnings will be.

You have to reverse-engineer today’s PE multiple into a set of growth assumptions the market is making, and decide whether you are more bullish or less.

Mature Companies

Multiples and ratios give false signals that lure an investor to “buy low” when that is not the case.

Mature companies can trade at PE multiples in the teens, but may still be expensive.

An example is tech giant Apple, which fell below 10 times earnings overnight last Wednesday.

The actual multiple is even lower because Apple holds a couple of hundred of billions of dollars in cash and bonds.

Yet there is a big debate over whether the company is overvalued.

Quarterly revenue and profits had soared to new heights in Apple’s latest results. But Wall Street fretted that iPhone sales, which propelled phenomenal profits at the company, will fall significantly.

Why are investors worried? If earnings fall, the historical PE multiple is no defence.

If you think Apple’s earnings will halve in the next year and then stabilise there, then a PE multiple of 5 might be fair today, because it will be 10 again next year.

Back to property developers. You might think that the value of the properties they hold, as recorded on their balance sheets, can give you a way to decide if they are cheap.

You thus use the PB ratio. I’ll buy when it trades at 0.5 times book, you say.

Yet the PB ratio is distorted by the stage of the market cycle one is in.

In an economic upswing, the annual value of properties held by any company can get reappraised upwards as consultants forecast rental growth and expect vacancy rates to stay low.

In a downturn, the opposite happens. Consultants revalue assets downwards, because the market value of properties will plummet once rents fall and tenants go out of business.

Similar to how a low PE multiple can be a trap, a low PB ratio can lure investors in at the wrong time.

Ratios don’t matter if you don’t understand what will happen to the economy.

Let’s look at a real estate investment trust (Reit). These are vehicles that have to pay out most of the rental income they get from the properties they hold, giving them a high dividend yield as a result.

Investors like to use the PB ratio, in addition to the dividend yield, to evaluate these companies.

Yet they can again be misled.

At end-2007, CapitaCommercial Trust, a Reit which owns prime office properties in Singapore’s central business district, was trading at a PB ratio of 0.86.

That might have looked cheap, but the Reit had recorded a S$1.3 billion fair value gain on its investment properties in 2007.

When the global financial crisis hit, the Reit recorded a net fair value loss of S$1 billion in 2009.

Shareholders who bought at end-2007 on a “low” price-to-book ratio – at an adjusted price of S$1.77 a unit – will still find themselves underwater today on price alone. The Reit is now trading at around S$1.30 a unit.

Essentially, a PB ratio of 0.86 at end-2007 was not cheap, because it did not reflect growing headwinds to the economy.

Ironically, the Reit was again trading at a similar PB ratio of 0.83 at the end of 2009, after the massive write-off.

Yet this time round, the Reit was not expensive. Shareholders who bought then – the adjusted price after a rights issue was S$1.17 a unit – will still be better off today.

What happened here?

Both ratios were cheap relative to the number 1, which investors like to anchor themselves to when buying Reits.

Yet the first ratio represented an investor base who was worried about the economy, but not worried enough in hindsight. The “low” price-to-book ratio was too high, based off a highly inflated level of net assets.

The second ratio similarly represented worried investors, but this time round, the ratio was based on an overly-pessimistic valuation of the Reit’s net asset value.

The Reit’s office properties would go on to produce a growing stream of income over the years, resulting in higher dividends, higher valuations, and higher stock prices.

The point of this example is to show how the PB ratio can be practically useless. The underlying values it is based on can fluctuate dramatically with economic events.

Sometimes, the mistakes we make in the market are sins of action as much as sins of inaction. We buy high when we should have avoided the temptation to do so, and should have sold instead. We sell low, thinking things will get worse, when in fact they don’t, and we should have bought or held on to our shares instead. FILE PHOTO

The Perils Of Trading

If buying low is difficult, selling high is even harder. In a rising market, everybody makes money. People who sell later, however, make much more money than people who sell early.

Sell too early, and you are tempted to jump back in to ride on the momentum. You buy back what you sold, at a far higher price. The alternative is to sit in cash and wait, sometimes for years, for the market to correct to levels you think are reasonable.

Yet if you don’t sell, eventually a bull market ends, often faster than you think. And you are left holding on as the market plummets around you. Inertia kicks in when it shouldn’t.

If you had bought at a low, you might think there is no point in selling because you are still “up” on the stock and it will recover.

If you had bought at a high, you might think that you will be left regretting your decision to realise your loss, if markets rebound again.

So you don’t sell high when you should.

“Buy low, sell high” is thus more complex than it appears.

The phrase is also a call to action.

By believing in it, you fall into a trading mentality, and with all the costs that come with it.

On the Singapore Exchange (SGX), trading costs for amounts under S$50,000 are 0.32 per cent for the online brokerage I use.

Essentially, this means that stocks have to rise more than 0.64 per cent before I break even on my trades.

Just for fun, I experimented with contra trading twice in the past month using a small amount of money.

For the uninitiated, this is a way of trading stocks without putting money upfront. As long as you sell what you bought within the third market day after the day of your trade, money to pay for your stocks won’t be required.

Essentially, your broker is financing your trading. Your profits and losses will then be credited to your bank account on the fourth market day.

Contra trading is the shrine of “buy low, sell high” where greedy and fearful investors worship at.

I tried to think like a day trader, jumping in when I saw momentum or news, and getting out as soon as I made some kind of profit.

The first time I tried, I bought an S-chip (Chinese company listed on SGX) just before noon. The next morning, it was up 4.9 per cent from my purchase price within the first 10 minutes of trading, and I quickly sold, netting a 4.2 per cent profit.

It was beginners’ luck. It closed below my purchase price the day I sold. Then the new year came, and the stock would begin a harrowing 30 per cent decline over the next four weeks.

The day trader here had very few chances to make money. Every day, the stock would decline by 0.6 per cent to 6 per cent.

He would have lost 0.64 per cent every time he traded, plus whatever the stock’s price was when he got out.

My thinking, originally, was that I would hold the stock if it fell, because I thought I saw some value there. After all, the price-to-book ratio was below 0.5 times when I bought it.

Of course, when you buy something, you think it is “low” and it can go higher.

As it turned out, the stock fell all the way to 0.3 times book.

The second time I tried contra trading, I picked a blue chip, thinking, again, that I could hold on to it if things went south.

This time, it took many hours of staring at a screen before I got out the next day when the stock was up 2.5 per cent from my purchase price.

Because the stock was a blue chip, and a very stable one at that, it did not move much.

Contra trading had few chances to work. Even though I got out at a 2.5 per cent profit, trading costs had lowered my gains to 1.8 per cent.

I checked the price again a few days after I got out. It was up 4.7 per cent from my purchase price. I missed out on more than double the gains I otherwise would have had if I had sat on the shares and done nothing.

Nobody in the right mind sells something when he thinks it will go up still.

But sometimes, our market mistakes are sins of action as much as sins of inaction.

We buy high when we should have avoided the temptation to do so, and should have sold instead.

We sell low, thinking things will get worse, when in fact they don’t, and we should have bought or held on to our shares instead.

Theory And Practice

The “buy low, sell high” dictum is easy in theory but difficult in practice.

Trading – the conservative form of which I did – is not likely going to make me rich, but it will definitely make my brokerage firm money.

If I really want to make money I can live on, I need a far bigger capital pool to deploy. But as a result, I will have to deal with risk in a far more harrowing way, and every day at that.

One wrong move on a volatile stock and I can wipe out the gains from an entire month’s worth of effort. Another wrong move on margin and I can go bankrupt, as safeguards like stop-losses do not work when significant down-moves occur.

Already, I am tempted to trade more. Already, I am holding on to another position that can easily wipe out whatever I made should stock markets tank again.

The more profitable trades you make, the more you are tempted to take bigger risks with your money.

And the more you lose, the more you are again tempted to take risks to make back what you’ve lost.

The only way I can guard against losing all the money I have is to ensure I only “contra” with money I know I can cough up should I need to hold on to a losing trade in the hope that it will rebound in the future.

And I should only “contra” with stocks I am prepared to hold in the long term due to their fundamentals, which leaves me with blue chips.

But if I am prepared to hold them for the long term, why am I even selling them in the first place to make a quick buck but lose out on the long-term gains and dividends?

And if they are blue chips that I can “safely” contra, they are not worth contra-ing, because they won’t be volatile.

The only logical conclusion is to buy and hold. Buying low, after all, goes beyond just the PE and PB ratios.

Business performance during downturns can be unpredictable, and stock prices will plummet any way.

The best companies, however, will be able to survive. And they are likely to survive because they have little debt to repay and are not bogged down by interest payments. Their costs will be well-managed. Their revenues might be down but they are still profitable. And their customers are financially strong enough to pay them back.

In theory, stock markets “mean-revert”, meaning prices move towards the mean or average over time. So good companies which are usually expensive can occasionally become cheap, during a downturn, offering a buy opportunity.

Unfortunately, the world’s best businesses, like food giant Nestle and consumer goods giant Unilever, are still trading at historical multiples that are not really below average.

For what it’s worth, Nestle has traded at an average PE ratio of 20 times over the last 15 years.

Investors are happy holding on to the stock as it keeps growing its earnings. In the last 25 years, Nestle has delivered an average of 11 per cent returns a year with dividends reinvested.

Buy low, sell high? Good luck with this one.