Sunday, 19 January 2014

Safe bets on stock market?

Risk-averse investors tend to put all their money into safe instruments – mainly bank deposits and government bonds. The stock market, on account of its characteristics, exposes investors to much bigger variability of returns, tempting with gains much higher than on bank deposits, but also scaring away with prospects of losses that can wipe out large chunks of invested capital.

Risk profile of investments in equities is not homogenous. The two factors affecting the risk undertaken by an investor are, in my opinion: type of security an investor trades in and timing of transactions.

As for the former, the risk, commonly measured by volatility of returns, is lower for: bigger (blue-chips), counter-cyclical (sectors such as telecommunication or utilities) and sound (i.e. not grappling with financial difficulties) companies. The low-risk stocks usually are said to be a good-quality equity investments and offer expected return a few percentage points above risk-free rate and relatively low standard deviation of returns.

In the case of the latter, the issue is far more interesting. In terms of risk, timing of trade might matter more than other characteristics of an asset. You may pick out an excellent security, with absolutely firm fundamentals, no skeleton in the cupboard, etc. and lose money on the investment, if you pay over the odds. This is what happened to investors who were buying shares of sound IT or telecom companies at the peak of dot-com bubble in late 1999 / early 2000 and lost over 90% of invested capital. The companies whose stocks were trading at sky-high levels are still alive and generate profits, but fourteen years ago were… mispriced.

Now let’s consider two concepts essential in comprehending what I am getting at – the value and the price.

There are plenty of definitions of value put forward by economics academics, in my consideration I will narrow down to only one – the intrinsic value, or fundamental value, which is to some extent objectively justified by characteristic features of an asset. In the case of a share of a company, it is primarily determined by the company’s capacity to generate income to its owner, or in simplest words, to make profits. In valuation theory, a company is worth as much as discounted stream of positive cash flows it can generate to its equityholders.

The price, in turn, is the amount of money one party (a buyer) pays to another party (a seller) when they trade in an asset. The price is driven by several factors, including two of utmost importance – demand and supply. For a stock-listed security, a price is technically set by forces of demand and supply and most of the time (except for extreme cases when trading is on hold to prevent extreme movements) reflects the balance between supply and demand, which in turn is unstable over time. If supply exceeds demand, the equilibrium goes down, if the opposite holds, the equilibrium goes up.

It has to be underlined price does not have to equal value. In the long run, if a market is efficient, the equation above should hold true. In the shorter run deviations are very likely to occur and, if discernible and evident, can be exploited to earn.

Let’s look at two examples from the Polish stock market.

First days of September 2013. The Polish government unfolds its plan to curtail operations of private-run pension funds operating under the public pension system. Market participants react with panic sell-off. Let’s examine the motives / rationale behind the sell-off. This could have been an act of revenge of foreign financial institutions, whose risk-free business in Poland had just been undercut. 

The mini-crash could have also been sparked by fears that pension funds would dispose of some of the stocks they hold and that they would not generate additional demand for stocks in the future. The former argument could have served as incentive for speculators who could sell (short) stocks in order to buy them back at cheaper prices from pension funds. The latter theory was actually favourable for the stock market, as without artificial demand from pension funds, risk of overvaluation and market bubbles on Warsaw Stock Exchange diminishes.

A cool-headed analyst should ask a question, whether existence and scale of operations of private-run pension funds in Poland has any impact on fundamental value of stock-listed companies. For some financial services companies who deal with pension fund management, the answer could be affirmative, but for overwhelming majority of companies, dismantling of pension system has no impact on value. The conclusion is then simple – even if forces of supply and demand bring prices of some securities down, the situation creates investment opportunity – you can get the same value for lower price! A wise investor should grab such opportunity.

14 January 2014. Before trading commenced, Vattenfall announces it intends to dispose of its stake in Enea quickly. Trading opens 8% below previous day’s close, then the price of Enea slides further down, total 1-day loss reaches 14%. The accelerated book-building ends on the same day. The next day stocks of Enea rebound, yet still trade at discount to 13 January 2014 close. 

The rationale behind the sudden drop was the fear of increased supply of stocks from Vattenfall, or expectation if the stake is to change hands quickly, the vendor would have to accept a discount and market quotations would follow the price at which Vattenfall transacted with its counterparties. You could argue the price at which the vendor and several buyers agreed is an indicator of the company’s intrinsic value. I would counter-argue price in a fire sale is a poor valuation measure. Again, does the increased supply of stocks from Vattenfall affect income generation capacity of Enea? My answer is ‘no’. Does Vattenfall’s presence in Enea’s shareholder structure affect its income generation capacity? Given all facts and circumstances shaping the company’s operations, my answer is ‘no’ Again, probably the price deviated negatively from value. A shrewd investor should have grabbed this opportunity.

The strategy illustrated above is not foolproof though. There are 3 major traps an imprudent investor can fall into.

Firstly, you should be considerably confident the when price of a security plummets, it drops below its intrinsic value. Such sudden shock can occur as well when an asset is overpriced and its price is being abruptly adjusted towards the fundamental value. You have to carefully analyse the information that triggered the sell-off – maybe on second thoughts you realise it affects not only price but also value. Upward potential is then limited.

Secondly, the rebound might not be a matter of days. It might take weeks or months for a security to climb back to pre-plummet levels. In September 2013 losses of stockholders were quickly offset by subsequent gains, but it I would treat it as an exception that proves the rule. If you cannot accept the fact your money might be frozen for a few months before it fetches a decent profit, better give up on this strategy. Remember the market might stay irrational longer than you can stay liquid.

Thirdly, even if you are pretty sure you have just spotted an underpriced security and you will not need some portion of your money for a while, do not execute the strategy in one shot. Do not buy securities for all the cash you have at hand. Divide your holdings and be prepared to buy even more at even lower prices if the decline continues. Such approach reduces both potential gains if the price bounces back quickly, but can maximise them if the price keeps falling, as your average buy price also gets lower. Anyway, remember you are playing with turbulent market, so caution, cool head and restraint are advised.


Michael Dembinski said...

On 1 Jan, I launched a competition for my children. Here's 100 virtual złotys to buy shares. At the end of 2014, we see how each portfolio stands, and I award them with real money over and above the initial 100zł. Eddie picked Newag (4 shares) and Quercus (2 shares). Moni picked Kinopol (1 share), Lodz cable operator Toya (5 shares), and travel firm Rainbow (4 shares).

My portfolio for 100zł: Indykpol (1 share), Pekaes (2 shares), Primamoda (6 shares) and Rawlplug (3 shares).

I'm guided by the Sage of Omaha's maxim: 'Invest in a business that can be run by an idiot. Because sooner or later, it will'.

We'll see how they fare - an interesting little lesson in capitalism.

Alexander said...

Bank deposits safe ? Not in the euro zone. With the Cyprus crises Germany decided there had to be a “bail in”, the bank robbery of the bank accounts of the common people.
And this morning I read in the news the EU is going to create growth by changing definitions of GDP per September 1st. R&D will no longer be an expenditure, but an investment. And the purchase of arms by a country will be considered an investment too.
This will make the stock markets a safe bet.
Even this big left, pro EU Dutch newspaper is getting scared.

Best regards, Alexander