HOW MUCH ‘CHEAPER’ CAN THE STOCK MARKET GET?
Iam amazed by the fact that although my daughters are growing older and, as a result, want less and less to do with Mom and Dad, they still teach me a life lesson or two every day. At ages 15 and 16 respectively, they already have a firm understanding of the concept of a discount. A few months ago, with winter barely beginning, I was told that there was a “once-in-a-lifetime” 10% discount on all winter wear at their favourite clothing store. I couldn’t help smiling when I happened to walk past this very store earlier this week, only to see that there is now a 25% discount on all winter items.
The fact is that those who took the chance and waited now got those items for much cheaper. The other side of the blade is just as sharp, however, because if you had waited for the 10% discount to pass in the hopes of a bigger discount, you would have missed out completely had the bigger sale never materialised.
Equity investors worldwide are now faced with the same choice with regard to f illing up their investment baskets. Since August, the stock exchange has lost nearly 8% of its value, leaving the market at the same levels as in January this year. Is this the buying opportunity that investors with lots of cash have been waiting for? Or should they take a chance on a possible larger discount? Before I try to answer this, I’m going to explain roughly how to determine whether the market is really trading at a discount.
A ver y popular benchmark t hat can be used to determine how cheap or expensive a share is, is the historical price-earnings ratio (P/E). The P/E is the relation between the share price and the company’s earnings per share (profits). It is calculated by dividing the share price by the company’s last reported earnings per share (usually at year-end or half yearend). The P/E usually moves in the same direction as the share price.
Let’s say that Share A is trading at R10 and the most recent earnings per share (EPS) figure is R2. The P/E would be 5 (R10 ÷ R2), or 5 times. If Share A’s price were to rise to R12, the P/E would rise to 6. If the company increased its earnings by 25%, the EPS would rise to R2.50. If the share price still traded at R12, the P/E would then drop to 4.8. This gives us a fairly good indication of just how cheap a share really is.
Looking at the accompanying graph, you will notice that the average P/E of the FTSE/ JSE All Share Index since 1995 was 14.8 times.
That means that at the current 17.7 times levels, we are definitely trading on the more expensive side and have not yet necessarily reached those “once-ina-lifetime” trading opportunity levels, especially if we take into account how many times during the past four years (after the great correction of 2008) we fell below the 13 times levels.
At this stage it may be difficult to believe that it will happen in the near future, but with the economic climate having changed as much as it did over the past year (higher interest rates, weaker rand, etc.), this market may very well be purchased at that proverbial 25% discount (compared to end of 2014), should it move back towards the 13 times P/E.
So should we stay away from shares for the time being? This answer will differ from individual to individual, and will depend on their respective investment horizons.
It can be said, however, that for those currently invested in shares, these surely are uncertain times. That being said, however, these movements are as natural as every end-of-season sale. The key is to keep your emotions away from your money and invest your hard-earned capital in well-managed, high-quality companies.
SINCE AUGUST, THE STOCK EXCHANGE HAS LOST NEARLY 8% OF ITS VALUE, LEAVING THE MARKET AT THE SAME LEVELS AS IN JANUARY THIS YEAR.