Thursday 28th February, 2008


Fragile concept of value

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By IAN NArine

How much is it worth? That’s a question relevant to any asset you own. The worth of that asset will provide you with either a sense of joy or sorrow, satisfaction or disappointment. There are two key assets in your portfolio where valuation (sense of worth) is key. They are property and stocks. The latter is topical because of the debate surrounding the RBTT transaction and the former is topical because of the extremely high valuations currently attached to local real estate.

In assessing the value of an investment an important factor is its liquidity. If you believe an investment to be worth $100 but there are no buyers on the market willing to pay such a price then all you really have at that particular point in time is a theory. The real value of the asset at that particular point is the price at which someone is willing to purchase that asset.

The more persons willing to purchase an asset at a particular price the more realistic is the price being quoted. This is exactly what liquidity is all about and its existence is an effective pricing mechanism. There are many classes of investment assets competing for your money. The ones that are more liquid are generally the ones that are more attractive.

A liquid stock may be much more attractive to hold than say land, jewelry, or art since it should be easier to sell if needed. Similarly, a liquid stock may also be more attractive than a fixed deposit or other term products since these often carry a penalty for early withdrawal.

In addition, understanding the role of liquidity in classifying an asset as an investment is crucial if you are to make the right choices with your money.

Take for example, the run up in property prices in the US (something which we are currently experiencing here in T&T). Many in the US viewed their house as an investment so when the value of the property went up they began to feel wealthier and began to consume more. Some even went to borrow against the increased value and used the funds to fuel further consumption.

The reality is that these people were misguided in their actions and may even have been mislead by those who are supposed to know better. Your house does not qualify as an investment. It is an asset, yes, but not an investment. Your house is your home, the place where you live.

An investment’s value is determined by the price at which it can be sold. If you sell your house then you have no place to live. If the value of your home increases then it is likely that the value of other properties are increasing as well so unless you plan to take a step down in your standard of living, selling your home usually means utilising most if not all of the proceeds to acquire another place to live.

If you consumed more based on the value of your home but you are not in a position to sell at the high valuations then when the market adjusts, as it must, you can very likely find yourself in financial difficulty. This is exactly what has happened in the US leading to the subprime issue in particular and a high level of default on mortgages in general.

The bottom line is that the house you live in is never an investment, never was and never will be. Any suggestion to the contrary should be viewed with caution.

Boom and bust

The lesson here is that you really need to understand the asset that you own before you can attach an investment value to that asset and further, you need to understand where that value lies in the cycle associated with that asset. An observer of a market would realise that prices move from boom to bust and then back to boom again.

Even though there is always a fundamental or intrinsic value, human nature being what it is tends to extrapolate from a particular point so that good news leads to a feeling that more good news will follow causing prices to rise above the fundamental value and bad news leads to the same process causing prices to fall below their fundamental value.

This is the reason why you will buy a stock and be unwilling to sell it when the price goes higher or sell a stock after it has already fallen by a significant amount. Investors should juxtapose this insight against the movement of the RBTT share price over the past couple years to see if the theory matches their actions.

How many investors actually sold RBTT at around $45 a few years back? Not many, since there was the expectation that the price would go higher. This view was not based on expected earnings but rather simply because the price had moved rapidly upwards in the past and we expected it to continue this trend into the future.

Similarly, how many investors sold at prices lower than $40 to 45 based on the expectation that the price was falling and would therefore continue to fall.

It is important that you appreciate whether the purchase of a stock at a particular price was based on an understanding of its intrinsic value or based on an emotive response to price movements. These two contrasting ideals highlight the difference between risk and uncertainty.

According to one school of economic theory, risk occurs where the probabilities can be assigned with confidence. In this context we know that valuations are subjective and different methods give rise to different valuations. The best we can hope for is to establish a range of values. Risk in this instance means that the price of a stock should reflect the range of reasonable valuations available so that while the stock price may be variable the variation is based on the underlying valuation range; the possible prices can be assigned with confidence.

If stock prices are instead based on an emotional reaction to past price movements then there are no precise probabilities to rely on in assessing the future.

In such instances the stock price is subject to sudden and rapid changes causing investors great discomfort in the process.

If you understand the concept as it relates to a particular stock, then it becomes easy to translate this insight to the wider economy. As an economy continues to grow and prosper (take T&T or the US over the past few years as examples) people begin to expect that the economic growth will continue; the future will be similar to the present.

Companies in various sectors in the economy that are most profitable will be rewarded very well for taking on higher levels of risk. Success from this type of behaviour will see similar actions being taken by others in the same sector or by companies in different sectors. If a bank takes on additional leverage and is rewarded by increased profits, other banks may follow suit or risk incurring the wrath of shareholders.

Companies in other sectors may increase their level of borrowings as well or take on other types of risks. The growing economy means that these actions will produce profits easing any fears that the increased borrowings may go unpaid.

In addition, economic growth is usually associated with low levels of interest rates further encouraging companies to take on leverage. Low interest rates means that the risk free rate (Treasury bills) is also at low levels. The longer this environment spans the more risk that a financial institution will have to undertake in order to maintain or enhance its rate of profit growth.

The combination of home owners mistaking their homes for an investment and the need for ever increasing levels of risky assets in order to fuel bottom line growth offers a potent mix that has lead to the type of write downs that we have seen from financial institutions around the world.

Stocks of companies in the financial services sector have declined as much as 50 per cent over the past few months. Investors now need to do some homework to determine how much of those declines are due to a change in fundamental value and how much is attributable to a negative market sentiment. The answer will determine what you buy and when.

Ian Narine is a stockbroker registered by the

Securities Exchange Commission.

Today’s article marks four consecutive years of writing in the Business Guardian.

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