Wednesday, January 18, 2012

Is the 'Silent Stock Killer" Hunting our stock portfolios? A look at the fundamentals of the TOP 40 Index

In my previous post I suggested that the JSE Top 40 Index may be heading for a crash. I looked at a very long run technical chart that suggested that the SA stock market is basically on the verge of  massive crash. 

Have I been proven wrong? Short term coverage seems to say so.  In a technical research chart, released yesterday, by one of the big brokerage houses in SA, it was indicated that the JSE Top 40 index had broken a historic technical resistance level. 

Such a confirmed breakout suggests a very positive upward move for the market, which does not look good for my previous technical analysis.  Yet, in all fairness, yesterday's move still has to stand the test of time.  So we'll just have to wait and see.  

However, I am still concerned about the index. In today's post I want to present the findings of some research I did on the Top 40's fundamentals. What I did was to analyze the historic Price to Earning multiples of 39 of the 42 Top 40 shares. I also looked at earnings per share (EPS) histories of 22 of the 42 shares (selection favored shares with 10 years or more EPS  and PE histories). 

I used these numbers to develop annual PE multiples and an average annual EPS histories*. 

A bit of context ...  

But first a bit of context: briefly explained the PE multiple/ratio indicates how much investors are willing to pay for the earnings of a company. For example a stock with R1-00 EPS and a PE multiple of 10 will have a market price of R 10-00 on the stock market. A stock with a PE or 15 will cost R 15-00, and a stock with a multiple of 5 will cost R 5-00.   

Why is this important? Certainly for many reasons, but in this post I want to look at ways how a share's price can fall in the context of PE and EPS. 

Basically, there are two ways for a share to drop in market price 1) through a shrinking EPS and 2) through a shrinking PE.

Lets say the share in our example above still has a PE multiple of 10 but the EPS shrank to 50 cents; now our share will be valued at R 5-00 (10 x R 0.5).  Or, lets say the share's EPS is R 1 but the multiple shrank to 5, in such a case the share is also valued at R 5-00. Both a drop in EPS or a shrinking multiple imply a drop in the market price of shares. 

But, what happens when the both the EPS and the PE shrinks? Lets say our share has an EPS of R 0.5 and a PE of 5, in such a case the share will be valued at only R 2.50 (R 0.5 x 5). The reverse is also true; shares may go up in value when the PE multiple expands or when earnings expands. 

To profit in stocks

So, to profit in stocks it is necessary to watch the PE multiples and EPS of stocks carefully. Note that markets trade a different multiples at different periods of time.  

Jim Cramer of CNBC's Mad Money explains that the multiple is expected to shrink when interest rates are raised and is expected to expand when interest rates are lowered. 

Why? Simply because savers (e.g in the money markets) and bond holders earn greater profits in high interest rate scenarios. When interest rates are raised, the risks associated with stocks look less appetizing to investors. Consequently investors downgrade the valuation on stocks resulting in lower PE's (all things being equal).     

Beware of the 'silent stock killer'

A shrinking multiple can kill the market prices of stocks, even when earnings (EPS) remain stable. Cramer calls the shrinking PE multiple the "silent stock killer".  If both earnings and the PE multiples shrink stock investors may be in for a double whammy!

So, now that the stage is set it is time to consider the following chart of the TOP 40's averaged PE Multiples since 1992. I used the data obtained from Standard Bank OST for my calculations.  I averaged the annual PE's of 39 stocks for each year since 1992 and plotted the data on the chart below: 

Click to Expand
The numbers I ran seem to suggest that since 2003 the Top 40 has expanded from  a PE of 9.1 to a PE of 15.6 prior to the 2008 market crash. During the crash the PE multiple shrank to  9.8. Thereafter, the multiple expanded again from 9.8 to 16.5 in 2009 -2010. However, the last numbers available to me shows that the multiple has since 2010 to date again started to shrink. The average multiple at 2011 was at 15.1 close to the mean average of 14.4.    

So it is likely that the Top 40's PE multiple may be declining.

But, what about the average EPS? To answer, I did a similar exercise averaging the annual EPS of 22 of the 42 companies of the Top 40. 

[Note that we have to interpret these numbers with caution since it is a smaller sample and the 2011 earnings data for many of the companies are not available yet. I had a sample of 12 companies for 2011's to work with. So the EPS average, in this case, might not be as reliable. However, the sample does point to the possibility that the earnings of the Top 40 companies may be under pressure for 2011].  

Refer to the chart below:

Click to Expand
Notice that for 2010 the average EPS was R 9.44 and for 2011 it was 9.33; suggesting a potential drop in EPS. 

The Repo Rate at 5.5 % is very, very low 

Next, we have to consider interest rates. To do this looked at the RSA Repo Rate.

According to the "Repo Rate is the rate at which commercial banks can borrow money from the Reserve Bank".

In a crude explanation of the Repo Rate's function, we can say that the lower the Repo rate, the more people and companies can afford to borrow, and the greater the supply of money will be in South Africa.

So, at low interest rates, more money is available to chase goods, services, and investments (such as stocks).  

Testing Cramer's idea mentioned above; I have plotted the average annual PE's of the TOP 40 (in red) along with the averaged annual RSA Repo rate (in blue) on the chart below.  

Click to Expand
The following things struck me looking at the chart. 1) The Reserve Bank has dropped the interest rates to a historic 10 year low in response to the 2008 recession.  

[It seems to me like they cannot drop rates by much more. At some point they have to start raising rates or face run-away inflation produced by all the excess money supply that has been created].  

2) Even at the historically low interest rates the Top 40's PE Multiples had still started to indicate possible decline. 

How is this possible I wonder? If the market is facing a PE decline in the low interest rate scenario, what will happen if the Reserve Bank starts to raise the Repo rate (which they have to do at some point).  

In conclusion ... 

This posting concludes a number of posts I did on the economy and 2012.  When considering stock investments I like to think in terms of upward pressure and downward pressure.  The question we have to ask ourselves is which on the of the two pressures are more likely to win.  My bet is that downward pressure will win in the medium to long term.

It is clear to me that we may be facing a possible scenario of shrinking of PE multiples, which may erode the market price values of shares, even if earnings remain stable (which appears not to be the case). My research also seems to suggest that corporate earnings may be coming under pressure again. If both earnings and PE's comes under pressure, buying and holding shares may not be a good idea. 

Many may disagree with me, but I think that the JSE is being kept alive on stimulus through low interest rates and global money printing, not through actual value. In value the index may have actually declined.

Will the market's prices follow suit, I guess only time will tell ... 

Posted by Gerhard van Onselen. Follow me on Twitter, Linked In or Google Plus

I am not a professional financial adviser. Information presented is intended to be solely conversational and educational, please don't make investment decisions based on just this  source, do your own research, and consult a registered financial adviser.

While I tried my best to present accurate information and numbers in this posting, I cannot guarantee the accuracy of any information presented.  

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