The great legendary investor Warren Buffett used to say, “Be fearful when others are greedy and be greedy when others are fearful.”
But in a market like this where stocks are losing badly every day, it is not easy to be greedy.
Past studies have shown that the pain of losing is twice as strong as the pleasure of gaining. Market players tend to overreact and do irrational things whenever they are threatened. The massive collapse in the market last week caused by fears of a global pandemic of the deadly novel coronavirus has raised concerns of a prolonged economic slowdown.
When market uncertainty rises as fueled by the growing negative sentiments, risk premiums also increase, leading to lower share price valuations.
Based on past market crises where the PSE (Philippine Stock Exchange) index fell by at least 20 percent, excess volatility in share prices tends to raise risk premiums to unwarranted levels. For example, in the 2013 market correction, where the PSE index lost 23 percent in seven months, the opportunity cost was estimated at 8.4 percent.
The opportunity cost as we know from the capital asset pricing model is the sum of a “risk-free” rate, which in this case was the 3.2 percent, 10-year bond yield plus market premium.
But because the market lost so much that year, the median price-to-earnings (P/E) ratio of the PSE index also went down to 16.7 times.
The low P/E, which translates to an earnings yield of 6 percent in reverse plus standard growth of 6 percent, would imply a minimum market return of 12 percent.
If we compare the market’s minimum return with its opportunity cost, we will get an extra risk of 3.2 percent, which we will call the fear factor.
Incidentally, this was the highest factor reached before the PSE index bottomed out in 2013.
This behavior will follow the same pattern for every major correction where the PSE index will recover after stretching the limits of the market’s expected returns.
In the 2015 market correction, the PSE index recovered after losing 25 percent in nine months when the fear factor reached a high of 2.8 percent, while in 2016, the fear factor was 1.5 percent when the market rallied strongly from a 20-percent loss in five months.
The fall in the market last week represents only a 15-percent loss from its high in November last year, but its fear factor has already reached a high of 4 percent.
The P/E ratio of the market has also fallen to only 13 times, which translates to an earnings yield of 7.7 percent against the prevailing 10-year bond yield of 4.6 percent, making investing in stocks very attractive.
If the law of averages is any guide, the current fear factor of 4 percent should reverse toward its mean in due time, which could limit further market decline.
But given historical average market correction of 20 percent and the underlying negative sentiment, noisy trading can possibly send the PSE index falling by another 5 percent toward 6,800 level.
In any case, current market conditions offer a compelling buying opportunity for the long term. The value of growth opportunities at current share prices is only 13 percent, down significantly from 43 percent last year.
The low growth value in stocks implies extreme market pessimism, which may signal possible mispricing, particularly those with a history of reliable earnings growth record.
Among the notable large-cap stocks with potential discounts include Ayala Corp, which has a negative growth value of 30 percent. This is followed by Megaworld, -29 percent; Metrobank, -8 percent; San Miguel Corp., -13.4 percent, Puregold, +4 percent; and Meralco, +3.7 percent.
While it may not be easy to invest when the market is in crisis, there are always opportunities to make huge returns during a recovery if you have the discipline and focus on value. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 82nd batch of RFP program this March 2020. To register, email info@rfp.ph or text at 0917-9689774