If you can measure it, you can manage it
Without numbers, terms such as “chances are” and “probably” would have no real meaning. Without chances and probability, the only way to approach risk would be through fate and destiny. Without numbers, risk would be based on nothing more than a hunch. We live in a world filled with numbers and calculations, whether its the clock telling us what time it is every day, or telephone numbers that can connect us to people all over the world in a matter of seconds, or even how many teaspoons of sugar you take in your coffee or tea. It’s difficult to imagine a world without numbers and yet it’s a relatively new concept that’s only been to our disposal for the last 1 000 years or so.
When we take a look at our own stock market, we also have historical data at our disposal to determine the level of risk we can take in this particular type of investment. This data helps us to measure the probability of a further rise or drop in the market or a specific share price.With the help of numbers and calculations, we were able to develop another very handy tool, called the benchmark, and this always reminds me of the well-known saying, “If you can measure it, you can manage it.” Warren Buffet, one of the most famous and successful investors globally, said that he has often been labelled as a value investor, which is something that he does not agree with. He sees himself as a focused investor who bases investment decisions on probability. In other words, with the historical data at his disposal, how likely is a company’s share price to rise or fall?
A very popular measuring tool is the historical price earnings ratio (P/E). The P/E is used to measure the ratio between the share price and earnings (profit) of the company and it is calculated by dividing the company’s share price by the last reported earnings (usually released annually and bi-annually). The P/E usually moves in the same direction as the share price.
Let’s suggest that share A is currently trading at R10 and its most recently reported earnings per share (EPS) is R2. This would provide us with P/E of 5 (R10 ÷ R2) or 5 times. If the share price rises to R12, the P/E will rise to 6. If the company increases its earnings by 25%, the EPS will rise to R2.50. If the share price continues to trade at R12 per share, the P/E will drop to 4.8. This gives us a fairly good indication of just how cheap or expensive a share is.
Although this ratio may seem simple enough and despite the fact that it is based on historical data, its also probably one of the most widely used ratios in determining the value of a company/stock exchange/index. In 1977 in the Journal of Finance, Sanjoy Basu took things one step further by showing in an analysis of 750 New York Stock Exchange shares between 1956 and 1971, that low P/E shares delivered higher absolute and risk-adjusted returns compared to high P/E shares in his research report titled “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A test of the Efficient Markets Hypothesis.”
Since then, multiple reports have been released which have helped to establish smart beta strategies. The fact remains that there is a good reason why the P/E still plays a massive role in our investment world.
All that said, how does it affect our South African market? Very recently, we had to hear that the FTSE/JSE Top 40 Index was still trading at high levels, especially with the inclusion of Naspers, which has already been trading at high historical P/E levels. By turning back time to 12 months ago, we can argue that a P/E of 20 (January 2018) is still on the higher side compared to the Index’s 13-year average of 16.85. But where are we now?
We are currently trading below the average P/E of the last 13 years and if we take into consideration the 12-month expected P/E consensus forecasts (Thomson Reuters) of 14.3, it becomes clear that we are starting to trade on the lower P/E side and that the value bells are slowly but surely starting to ring.
I’m not saying that investors should go wild and buy everything in sight, though. Just be careful of being so emotionally affected by the poor growth we have experienced over the last few years, that you start to sell out of panic. Now probably is a much better time to buy.
The opinions expressed in this blog are the opinions of the writer and not necessarily those of PSG. These opinions do not constitute advice. This is intended as general information and does not form part of any financial, tax, legal or investment related advice. Although the utmost care has been taken in the research and preparation of this blog, no responsibility can be taken for actions taken based on the information contained in this blog. Since individual needs and risk profiles differ, it is always advisable to consult a qualified financial adviser before taking action.