Thursday 23rd June 2005

 

The importance of diversification

Lessons from recent market correction

 
 
 
 
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The performance of the local stock market over the past few months has been described by many commentators as a “measured correction.”

Of course this correction may have seemed anything but measured depending on the stocks you held in your portfolio.

Take for example RBTT which in terms of an overall trend moved from a 52-week high of $45.50 to a 52-week low of $36.37 in a matter of weeks. This represented a loss of value of 25.1 per cent despite posting pre tax profits of over $1 billon.

In fact that decline in RBTT’s share price amounted in a decrease in the company’s market capitalisation from $15.591 billion to $12.463, a staggering $3.1 billion.

Guardian Holdings was another one of the major declines losing 12.2 per cent of its value after posting its 52-week high of $46.00 on May 13. NCB Jamaica, CCMB, JMMB, CCN, Sagicor and Neal and Massy also caused concern among investors as these companies share prices declined.

However, the story was not only one of gloom as persons invested in NEL, Ansa Finance, Prestige Holdings and Angostura were no doubt smiling as Prestige Holdings share price increased by 15 per cent and the other three generated gains in excess of 20 per cent over a eight to ten-week period.

It is the gains in this area of the market that offset the more publicised declines overall resulting in a very measured stock market decline.

Market lessons

There are two lessons to be noted here. One is that it is possible to make money in any market once you are in the right stocks at the right time.

Last year stocks such as CCMB and Neal and Massy were the stars of the show. In the early part of this year GHL and RBTT produced good rallies. These shares went into a bit of a decline and others stepped forward to post strong gains.

However, being in the right stock at the right time in many instances amounts to trying to time the market and in one such as ours which is not very liquid this is often easier said than done.

In fact, market timing in our local environment can often times become an exercise in speculation if you are not careful.

The second lesson is, in fact, the more pertinent one and has to do with the value of diversification.

There is a view among some that the most successful investors, the Warren Buffet’s of this world, have become successful not through diversification but by taking concentrated positions in selected stocks which over time appreciated in value many times over creating significant wealth for these investors.

This type of approach has some merit depending on your financial circumstances and the level of risk that you can undertake.

However this approach would not have gone down too well with someone who had put all their eggs in the Enron, Worldcom or even BWIA basket.

The point is that for the average investor diversifying your portfolio is not some textbook guideline but a real and important tool on the road to the most basic investment objective—that of preservation of capital.

Before you start to seek out growth you have to establish a sound enough base to minimise the risk that your capital will be eroded.

That is why people who are looking to start investing for the first time and have relatively small sums of money at their disposal would probably be better served starting out with a mutual fund.

Of course it all depends on your particular circumstances such as your age, savings potential and your tolerance to risk but generally speaking it is always better to start from a position where your funds can be professionally managed as part of a diversified portfolio.

Once you are comfortable in this regard and you have a better understanding of what is involved you can then progress to taking up more concentrated positions by investing directly in selected stocks that you think may perform well over your investment horizon. It is at this point in time that you should venture directly into the stock market.

Not for the feint-hearted

It is often said that the stock market is for the rich, and the above discussion may have reinforced that view for some. If that is the case, then you have missed the point.

The risks of investing in stocks with a short time horizon are quite high. You should have appreciated this from the opening discussion which described some share price declines over the recent past.

A wealthier person may have a greater tolerance for such risks, someone of more modest means may be more risk-averse.

The point here is that for the average investor there may be additional risk management steps to be taken before getting into the stock market. It does not mean that you should not be there at all.

The events of the past few months should really bring home the value of diversification.

Almost all the stocks in the banking sector have underperformed the market during this time but the manufacturing and trading sectors have done reasonably well.

Losses in say RBTT or GHL would have been offset by gains in NEL or Angostura.

Similarly even if you have a preference for a particular sector then diversification within that sector is also helpful.

The gains in Ansa Finance compared to the general underperformance of other financial services stocks highlights this point.

The local stock market is quite small and there are quite a few cross relationships between companies.

If you are not careful to recognise these cross relationships you can end up holding a reasonable portfolio of stocks without achieving too much diversification.

There are cross shareholdings between GHL and RBTT such that the performance of one company’s share price may impact on the performance of the other. A similar situation exists with BS&T and Neal and Massy.

In addition there are three companies from the Ansa McAl Group listed on the exchange and TCL also has a subsidiary in the form of Readymix.

In addition the performance of NFM will have some impact on the performance of NEL.

Another factor that will impact on the performance of your equity investments is the process used to select stocks for your portfolio.

It is clear that a lot of local investors trade on momentum rather than a company’s future earnings potential.

To confirm this one only needs to look at the recent trading pattern of RBTT which traded at its then 52-week low of $39.00 from January 28 to March 23. Once the share price started to move it climbed 16.6 per cent to a 52-week high in under two months only to post another 52-week low one month later.

These movements suggest an element of momentum trading as opposed to a view on the company’s future prospects. The 80 cent increase in the share price last week Wednesday suggests that the roller coaster may be on its way up again.

Another good example of momentum trading is CCN.

On April 6, CCN’s share price stood at $12.25 and there were no sellers in sight.

The mismatch between demand and supply was so great that by May 18 the share had climbed 75 per cent to $21.50. However, just as suddenly the share turned around and started to decline, closing last week at $17.96.

There was no new information coming to the market over this period yet investors were not prepared to sell CCN at this same price a few weeks ago but now seem willing to do so.

The point here is that while trading on the momentum of the stock or the market as a whole does sometimes have its merits, it is better, at least from a risk management perspective to have some appreciation of the future prospects of the company you are invested in as well as its fundamental value in relation to its current share price.

At present investors trading on momentum seem willing to part with shares in GHL even though the company is trading at a price to earnings (P/E) multiple of 10.67 times forecasted earnings.

The focus seems to be on trying to trade at or below the rights issue price rather than on the fundamental value of these shares.

As I indicated earlier momentum also seems to be at play with RBTT’s share price.

As at March 31, RBTT’s investment in GHL was valued at approximately $2.32 per share. Based on the March 31 accounts 71 per cent of this amount is still unrealised in the balance sheet, yet this fact seems to be largely ignored by investors following a trend and prepared to sell the share a P/E of 13.90 times historic earnings.

Developing an understanding of fundamental value either on your own accord or through discussions with your financial adviser will allow you to take advantage of opportunities when a share becomes oversold or to stay away when it seems overbought.

Hopefully the experience of the past couple of months would have brought this point home.Ian Narine can be contacted at [email protected] or at

http://www.wiseequities.com

The contents of this article are not to be used or considered as an offer to sell or a solicitation of an offer to buy.

The information contained above has been obtained from, and any opinions therein are based upon, sources believed to be reliable. WISE makes no representation as to its accuracy or completeness and it should not be relied upon as such.

All opinions and estimates therein reflect the judgement of the author and are subject to change without notice.

WISE is a subsidiary of RBTT.

 

 

 

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