The stock market is unlikely to pick up in the short run. Economists refer to a decline in prices of 20% or so as a bear market. Our market has fallen by about 10% this year in terms of the All Share Price Index. But if we consider the decline from the peak levels of 2009 and 2010 it has fallen by about 25%. Will it fall more? Depends on how the economy will perform next year. We have been experiencing economic growth of 8% which is expected to come down to 7.5% this year according to the IMF, a better indicator than the official sources. It depends on the global economic performance. Will the USA and Europe enter into a recession? If so we cannot avoid their impact on our own growth rate although the growth rates are not synchronized. So if we don’t face an economic recession next year owing to global factors then our economy should growth between 6-7% next year too. We really need to know the nominal growth rate rather than the real growth rate to relate it to company earnings. The nominal growth rate includes inflation. Assuming 7% inflation we may have growth of 15% say. So our company earnings may grow by 15% or more if the companies are financially sound. So what should be the Price Earnings ratio. It is now 15.6.
In my opinion it would be better to go for P.E ratios which are below 10 and perhaps 7-8. Of course our banks have an easy time except those which have lent recklessly to the stock market or against excessive pawning of gold by customers, paying inflated values for gold. The Commercial Bank has shown consistent growth patterns over the years and has done well for shareholders. But many other companies have not paid out enough to shareholders. Long term investors should look to those companies which have good dividend pay-out ratios and have regularly distributed dividends like Lanka Lubricants, Ceylon tobacco or Nestle. Their present prices may be too high in the context of the fall in the market. Their shares have shown resistance to the decline in prices. But they do constitute good investments if the price is right.
So should investors stay away from the market until prices fall further? No, because given our current inflation, prices are not likely to fall to rock bottom levels. But if there is a recession due to the fall-out from global factors then companies which have over-borrowed are likely to meet difficulties in financing. Their access to funding may be a problem because banks can’t take risks that in ordinary times would be prudent. As a result, companies that otherwise may have survived might not make it through if conditions deteriorate.
The intelligent investor is likely to want to focus on companies that boast several characteristics:
• Good long-term prospects such as in agriculture and food processing or manufacturing
• Little or no debt, especially short-term debt that will need to be refinanced
• High Reserves
• High returns on equity that allow it to generate large gains on book value each year
• Products that are necessary (drugs, food, consumer staples, etc.)
• A strong management team with the experience to steer the company through any decline in business
The writer is an economist and is the General Manager of a Colombo based stock brokering firm. You can reach him via firstname.lastname@example.org