Be afraid, be very afraid

At the pit stop

Warren Buffett, the third richest man on earth and considered as one of the most successful investors of all time, has repeatedly counselled regarding the stock market: " Be fearful when others are greedy; be greedy when others
are fearful".

In the last few weeks when the Philippine stock market index has been piercing new highs at an alarming regularity, it may pay to take stock (no pun intended), pause for some breath, and assess where the market is going. And reflect on the above words of the sage of Omaha.

Most of the professional fund managers sing the same chorus that yes, the market is expensive on both absolute and relative terms. Absolute, in the sense that if you were to buy entire companies listed on the bourse, you wouldn't be paying for them at the quoted prices. Relative, in the sense that compared to our neighbors, to well developed markets and to other developing countries far and wide, our market is simply more expensive.

On the same breath, the same fund managers justify the valuation and the rally, saying that it is sustainable.

Listen to a recent declaration by a CEO of one of the largest financial firms operating in the country: "we believe that this rally is sustainable" for three reasons:

1. Liquidity. There is too much money sloshing in the financial system. Yes, it is too much money chasing too few options in the stock market. But when the music stops--a thunderous thud. That liquidity can easily be siphoned off. It takes only an acceptable resolution of the Cyprus crisis, or even a realization that it is no big deal, for foreign funds to float away. Upcoming top-up offerings (issuance of additional shares) to comply with PSE's minimum float requirements such as that of the LT Group of Lucio Tan (PSE:LTG) of soon-to-be renamed Alcorn Gold Resources (PSE: APM)  of another Lucio (Co) could dry up the local fountain of money.

2. Robust earnings growth. "Earning were up 15% in 2012".  That is not big compared to the increase in stock prices. Telecoms earnings are flat. Income at major mining firms are lower. What if there are few takers to those gleaming new condominium projects that are mushrooming like mushrooms?

3. Strong political mandate. Maybe, but big infrastructure projects have not really taken off. Most are bogged down by politicking and posturing. As commentator Wlliam Pesek of Bloomberg cautioned on the recent Fitch ratings country upgrade, what if the next administration would have a different idea on reform?

Just how expensive is expensive?

The easiest valuation tool to understand even to the layman and the small investor especially, is the so called price to earnings or p/e ratio. This is calculated by dividing the current quoted price by the earnings per share of a given company. The latter is in turn obtained from dividing the net income by the number of shares outstanding or shares issued. Apply that to all the companies listed that are part of the Philippine stock index (the PSEI) and divide by 30, the number of firms comprising the index, and you have the average market p/e.

You get a value of something like 21.7--overvalued by historical standards. By comparison, the U.S. indices are deemed reasonable at p/e 14 and somewhat expensive at 18 or 19. At present, the Dow Index has an average p/e of 15.8; the S & P, of 18.5--and analysts are already warning of a bubble in the making. During the dotcom bubble, average p/e values have reached the high 20s, with individual technology stocks that have earnings sport multiples of 35, 40 even 60.  Our neighbors in Asia are cheaper in this regard.

By looking at the average the details may be hidden. So I plucked the p/e values of notable names which I really would like to invest in  from an investment newsletter and here's what I got: Banco de Oro (PSE: BDO), 21.8; Puregold (PSE: PGOLD), 37.5; Jollibee Foods (PSE: JFC), 39.8; SM Prime Holdings (PSE: SMPH), 33.4; Ayala Land (PSE:ALI), 46.8; Manila Water (PSE: MWC), 20.7. These are for 2012.

No further evidence, your honor.

For the case of BDO, that number corresponds to a price of about P 85/share, which is already down from above 100 a share. I used to own MWC which I like due to its prudent management and steady, albeit not so rapid growth. But when the p/e hit 18, I decided to let go.

P/E valuation is not an end by itself. In fact, I use it as a starting point in further delving into a target company for potential investment. One should also look at other aspects such as book value, dividend yields, the industry where the company operates, and integrity of management, among others.

So, what now?

For a start, be afraid, be very afraid. But not terrified or fossilized into inaction. You do not earn when you are not invested in much the same way that you cannot win in chess by resigning.

Being in a state of anxiety to the point of paranoia can have a cleansing effect on your thinking and decision process. You start deciding on the basis of data and not by emotion. You don't get carried away by herd mentality.

Remember that we are talking of average values. There are hidden gems which carry cheaper valuations than average. Finding them would still reward the diligent.