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How to find winners in a losing market

/ 07:14 AM June 03, 2015

Q:  My broker told me that the market may fall further in the coming weeks and this may be the best time to start buying stocks at bargain prices. While I am aware of some stocks that have gone down recently, I am not sure if they are really cheap. Can you advise me? —Evy Genesis by e-mail

A: Buying stocks during a massive market sell down is like catching a falling knife. You will never know if the stock that you are buying will bounce back or continue to lose value. Sometimes, it can be frustrating to see your stock rallying shortly after being beaten up only to fall deeper at the close.

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Higher risks

Trying to buy into a falling market can be dangerous but this should not discourage you from investing. It is just that the risks are higher when there is a strong downward momentum that pushes share prices lower, but if you catch them at the right prices, you will be richly rewarded in the long term.

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The challenge is not to get the stock at the cheapest price, but to get it at the best value. Never mind if the stock has fallen a little bit more after you bought it, but for as long you acquired it at less than its fair value, you can always be assured that the stock will recover soon. When you buy an undervalued stock, your risks are relatively lower compared to the potential rewards that you will gain when the stock goes up.

So how do you find stocks at undervalued prices? The easiest way to do this is by relative valuation. You simply compare the Price-to-Earnings (P/E) ratio of a stock with the market average or industry peers. You can screen all PSE stocks and filter those that are trading at least 50 percent discount to market P/E and from there you can choose which ones you would like to buy based on track record and earnings potential.

For example, Megaworld (MEG) has a Price-to-Earnings (P/E) ratio of 7.2x. If you compare this to market P/E average of 21x, the stock is undervalued by 66 percent. If you compare this to other property stocks, such as Ayala Land (ALI) which has P/E of 37x and Robinsons Land (RLC) at 22x, MEG would still come out as grossly undervalued. Based on this comparison, assuming at 12x P/E, you should expect MEG to catch up toward P7.80 in the long-term when the market goes up.

Relative valuation is the most common method most investors use in finding good buys in the market. The other method of valuation is by estimating the present value of a stock by discounting its future cash flows. How do you value a company that generates cash flow annually? Do you pay for the cash flows that it generates only for this year? How about the cash flows that it will generate in the next 10 years? By discounting, you can put a value to the future cash flows of the stock.

Future cash flows

To illustrate, let’s say DMCI Holdings (DMC) is expected to grow its cash flows by 15 percent every year for the next 10 years, the key driver of which is its annual net income. To discount future cash flows to the present, you will need to use an interest rate that will represent your opportunity cost.

Assume that your current placement in the bank earns 5 percent a year.

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If you expect to receive P100,000 at end of the year from your placement upon maturity, your principal must be P95,238 at the beginning of the year. If you check, simply multiply P95,238 by 5 percent to get the interest and add this to the principal to get P100,000.

Assume again that instead of this year, you will receive the P100,000 by end of second year. To determine the beginning principal, you simply divide the P100,000 with 1.05 factor twice for two years and you will get present value of P90,702. Again, to check, you simply multiply 5 percent to P90,702 and add this interest to the principal to get total of P95,238. On the second year, this amount will earn 5 percent interest again so that it will total to P100,000 by the time it matures.

Applying the same process, imagine that instead of placement maturity, DMC will receive the cash flows for the next 10 years. To discount this, assume that opportunity cost is 5 percent.

Present values

Use this to convert all future cash flows to present values. Once done, simply add up all the figures and we derive an enterprise value of P263 billion for DMC.

To convert this on per share basis, divide this amount by the company’s 13.2 billion outstanding shares and you will get intrinsic value of P19.80 per share. At current price, this offers great margin of safety at 32 percent.

If you want to be more conservative, you can deduct the company’s long-term debt of around P33 billion and you will get an adjusted intrinsic value of P17.30 per share. At this value, current price still offers a good discount at 23 percent.

While this process of discounting is a little bit more difficult to do because it involves some effort on your part to do some research and financial projection, it is more objective and educational because you not only get to value the stock based on its own fundamental merits but also learn more about the company’s business model and prospects.

Current downtrend in the market offers a lot of opportunities for value investing. Market tends to overreact to negative sentiments with fear, resulting in undervalued stocks that do not match with long-term fundamentals. Now is the best time to study and invest.

Henry Ong is a Registered Financial Planner of RFP Philippines. To learn more about computing for intrinsic value and value investing strategies, attend the globally recognized Accredited Financial Analyst (AFA) program on June 20 to July 25. For more details, inquire at info@rfp.ph or text <name><email><AFA> at 0917-3464126.

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