Buy when there is blood on the streets

Question: The stock market has been very volatile lately with the uncertainty in the global markets. I have always wanted to try investing in stocks but I don’t know if this is the right time as everybody seems to be losing money from stocks these days. What should I do?—JK, by e-mail

Answer: “Buy when there is blood on the streets” is a favorite motto of investors who are looking for opportunities to buy stocks at bargain prices when the general market is into panic selling. This is actually a good time for you to start investing in stocks because your odds of making money are higher with stocks generally selling cheaply. But how low should a stock price fall before you start buying? What kind of stocks should you buy during this time of uncertainty?

While it is easy to say to buy low and sell high, it is not possible to actually catch a falling stock at its lowest price and sell it at its highest later on. The strategy is to accumulate at a certain price range until you get the desired average acquisition price. With the general market sentiment now turning bearish, this is your best opportunity to start screening stocks and building up your portfolio for the long term.

Here are some stock-picking tips that I can recommend for you:

1.) Buy blue chip stocks. Blue chips with good track record of profitability and management are the safest stocks to invest because they recover fast when market picks up. They are the first stocks that fund managers look to buy when market sentiment improves. You can find the list of blue-chip stocks in the PSE Composite Index (PSEi). Majority of PSEi stocks are financially solid companies so you can minimize the risk that you may be investing in a crummy company. If you can afford to diversify with a sizeable fund, I suggest that you diversify by investing in several blue chips. You can pick the top five best-performing stocks in the PSE index as your initial portfolio. Holding on blue-chip stocks is ideal especially if you are a beginning investor and you don’t have the time to monitor the stock market daily.

2.) Look for stocks with strong cash flows. The earnings quality of any listed company is determined by its ability to generate cash flows. Always select the stock that can consistently demonstrate positive operating cash flows rather than net profits. Why? Through the use of creative accounting, any company can hide its true financial health by manipulating its income statement. When you analyze the cash flow statement of a company, you find that there are three sources of cash flow activities—operating, investing and financing. To check the quality of earnings, look only at the operating cash flow activities because this is the source of internally generated cash flows derived from the business. The most attractive stock in this case will be the one that can show increasing growth rates of operating cash flows. The higher the expected cash, the higher will be its projected stock valuation.

3.) Target stocks with attractive valuations. There is a lot of valuation multiples that are used in the market but the most common measurement of it all is the price-earnings (P/E) ratio. The P/E ratio is computed by dividing the current stock price with expected earnings per share. The P/E ratio suggests how much investors are willing to pay for the stock as a multiple of earnings. The higher the stock price, the lower the earnings yield. The strategy is to look for specific target P/E ratio that you want to buy. As a general rule of thumb, the fair P/E ratio for an average blue-chip stock is derived by subtracting the inflation rate from a base of 20. To apply this rule, you subtract the latest inflation rate of 4 percent for July 2011 from 20 and you will get target P/E of 16x. You can use this as a guide and buy blue-chip stocks that have attractive P/Es below 16x.

Does this mean that stocks with P/Es higher than 16x are not attractive?

Not necessarily. This is just one way of setting specific value target to select stocks. There are blue-chip stocks that may be trading higher than 16x but are comparatively lower than market and industry average. In this case, they can be considered undervalued especially if the stock can command a premium.

4.) Look for high dividend yield stocks. Another measure that you may use to pick stocks is to compare their dividend yields. Dividend yield is computed by dividing the annual cash dividend with the current stock price. The lower the stock price, the higher the dividend yields. Although your objective for investing in stocks is to profit from price appreciation, the dividend income that you get helps you lower your investment costs while holding on to the stocks. Take note that when comparing stocks by dividend yield, consider also the growth rate of earnings. Select the stocks with highest total return by combining both dividend yield and earnings growth rate. As a general rule, make sure that the total return is always higher than 10 percent. For example, the current dividend yield of SM Prime Holdings is 2.28 percent, but its earnings growth rate is estimated at 12 percent so the total return would be 14.2 percent, which is higher than 10 percent. This is one measure that you should check while you look at other criteria.

Once you invest in the stock market, always be patient with the occasional price swings. The greatest rewards will come when the market fully recovers. Do not confuse investing in blue chips with investing in speculative stocks. While it is true that you can possibly make more money by following hot tips from your broker to speculate on problematic companies, it is best that you leave this to the experienced investors. You will be safer by betting on fundamentally sound stocks.

(Henry Ong, RFP is a registered financial planner of RFP Philippines. You can e-mail him for comments and questions at [email protected]. To know more about becoming RFP, visit www.rfp.ph or inquire at [email protected].)