Reasons To Be Optimistic About the Foreseeable Future

IN THE NEWS from Asia Times

The Philippines' sound economic fundamentals, financial conservatism, and the Aquino government's efforts to shake up the bureaucracy seem to have finally caught the attention of the global investing community.

Recent upgrades from credit ratings agencies (and further upgrades expected in the near future) and positive outcomes of studies by respected multinational financial institutions have stoked investor interest and confidence  in an economy that has been a consistent underperformer in the region. One study now places the Philippines as one of the most important investment destinations in the world, trailing only China and Indonesia.

The points made in the article seem to validate some observations that were made in the ADB seminar about Emerging East Asia in December of last year about the resilience of the Philippine economy amid threats of another global financial crisis. All in all, these findings suggest that economic advances in the previous year will continue well into this year and that further investments in the Philippine stock market now might be a good idea. In 2011, the PSEi had been up 3.7% for the year even as other markets around the world floundered in the midst of economic uncertainties in the US and Europe.

The Price-Earnings Ratio Revisited

DEAR INVESTOR JUAN
PERSONAL FINANCE 101

10-year P/E ratios as predictors of 20-year annualized returns, as compiled by Prof. Robert Shiller

Dear Investor Juan,

Happy New Year! Kamusta na kayo sa HK?

Sir, it might appear like a silly question but I'm just confused: why is it good if the P/E Ratio is >10? Isn't it that if the earnings per share is higher, the company has good prospects since its generating more revenues (per share)? However, with a higher EPS, the denominator would also be big which will decrease the ratio.

Hoping for your response sir.

Thanks!

Nikko


Dear Nikko,

I'm doing fine here, thank you for asking. Just busy with my research and other things, but of course I always have time for Investor Juan. :)

I have already introduced the price-earnings or P/E ratio in previous posts like this one about stock picking, but I'll use your question as an opportunity to discuss it in greater detail.

First, let me briefly discuss what it is. As the name suggests, the P/E ratio is what you get when you divide a firm's stock price by its earnings per share or EPS (and we get EPS by dividing annual net income by the total number of outstanding shares--the number of shares currently owned by investors). So it's a measure of how much investors value a stock relative to the firm's earnings, and it is used in making personal investment decisions and and valuing stocks or businesses. Since the stock price should reflect a firm's future profitability, strictly the forecast earnings for next year should be used in computing for the P/E ratio. However, for practical purposes people just use current earnings to compute for something called the trailing P/E ratio since that information is what's more readily available.

On its own, the P/E ratio of a stock does not mean anything--it only means something when we compare it to a benchmark, like the P/E ratio of competitors or of the stock market index in the same period, or past P/E ratios of the same company in a time series. So if all we know is that a firm's P/E ratio is 11x (read: eleven times), we can't really say if that is "good" or "bad". What I'm saying is that no finance professor or practitioner worth his or her salt will tell you that "P/E ratio > 10 = GOOD"; even as a rule of thumb, it lacks basis and is therefore useless. So you have to check or question where you got that "rule" from (and write your thoughts in the comments section, if it's all right with you).

But if you know that the P/E of a stock is 11x and that the P/E of the stock index is, say, 13x, then now you have enough information to make some sort of evaluation: at least now you can say that it seems that investors are pricing the stock less than the market as a whole, or that the stock maybe cheap so it may be a good idea for you to buy some shares. But again, it is usually not as simple as that since you would have to consider other things like the state of the industry the company operates in and the firm's other financial and operating characteristics. And even if you are pretty sure that the P/E ratio of a stock is "low," that's not necessarily a good thing.

When would a "high" P/E ratio be "good"?

Investors place a premium on stocks that show promise of high growth in the foreseeable future; in more developed markets like the US, it is not uncommon for "tech stocks" like Google and Apple to fetch P/E's in the neighborhood of 25x and still be considered cheap even if the benchmark index is just at 15x. In general, high-P/E stocks may be considered good (to buy, that is) if:

• Past earnings have shown considerable growth in the past five years or so
• The firm pays little or no dividends and invests heavily in research and development instead (although a few firms like Apple would rather keep a sizable portion of its earnings as cash)
• The firm is in an industry with potential for expansion or reinvention (e.g., the tech industry, in general)

When would a "high" P/E ratio be considered "bad"?

In itself, a high P/E ratio would mean that a stock is relatively expensive for whatever reason, so unless this high price could be justified, it may be best to not buy such stocks for the moment. But sometimes a P/E ratio is high only because earnings are dismally low and investors speculate that the stock will bounce back eventually--and this combination of a failing business and excessive speculation is something investors would want to avoid. In my experience, it happens frequently with "penny stocks" (those that trade for only a few cents a share) as speculators bid the price up often undeservedly and almost always blindly and with mining stocks for which speculation has been rampant and where the possibility of successful operations is often insignificant.

When would a "low" P/E ratio be "good"?

Yes, you're right, if we think about it a low P/E stock with substantial and stable earnings should be a good thing for investors since it would mean that the stock is cheap enough to buy. Good, low-P/E stocks are usually characterized by the following:

• The business has reached the maturity stage of its life cycle and has exhausted all avenues for growth, but remains highly profitable 
• The firm is one of the top players in the market in terms of market share (this and the characteristic above make the firm a "cash cow" in the Boston Consulting Group sense)
• The stock pays regular, stable, and predictable cash dividends

When would a "low" P/E ratio be "bad"?

Sometimes even if the last reported earnings are still quite good, the stock price falls significantly and brings the P/E ratio down with it. This happens when investors come across information that the firm is about to fail; unfortunately for those who are left holding the soon-to-be worthless stock, reported earnings don't reflect material changes in information in real time. So even if you see a P/E that's temptingly low, first make sure that the firm still has a viable business or at least enough assets to justify a purchase.

That's it. I hope I was able to answer your questions satisfactorily, Nikko. Good luck to all your future endeavors. :)

The Not-So-Obvious Link Between Personal Finance and Obesity

FINANCIAL TUMBLR-ISMS

via Reddit

Break Even Analysis: The Easiest Way to Know if Your Business Model Makes Financial Sense

PERSONAL FINANCE 101

Kat and I recently started working on (what could turn out to be a big) project, and I volunteered to be responsible for the financial stuff. Between this project and my regular dissertation work (for which a conference paper is due at the end of the month), I realize that I will have even less time for Investor Juan and my other "less noble" pursuits (think what you will). So this month at least, I'll try to hit as many birds as I can with the few stones that I have. I worked on our project's break even analysis earlier this morning, so it made sense to to make that the topic of this post.

What is break even analysis?

Break even analysis, if done right, should be able to tell you if your business concept has a good chance of making money. As the name suggests, it shows how much sales you need to generate to break even: if you are confident that your business can easily and consistently beat break even sales, then you're on your way to riches; if, on the other hand, you think only a miracle could make you beat your break even point, then it makes no sense to proceed with the business.

However, since break even analysis only determines the profitability of your planned business and does not consider the investment (in real estate, machinery, or vehicles, for example) that your business would require, your financial analysis should not end there. To determine if your business can actually create additional wealth or value for your investment, then you would have to use your break even analysis results with capital budgeting procedures like net present value analysis and others that I'll discuss in future posts. Still, break even analysis is the most practical starting point of every financial analysis for a business venture.

Variable and fixed costs

Break even analysis is based on how the costs of operating a business behave differently. One set of costs or expenses--variable costs--rise and fall with revenues or sales. Some common examples of variable costs are the cost of raw materials for manufacturing and the cost of merchandise for retail or merchandising firms. Expenses that stay the same regardless of sales (only to a certain degree, which I'll get back to later) are referred to as fixed costs: examples include rent, (usually) wages, and overhead expenses.

A simple example to see how it works

Say, you're thinking of investing in a sandwich cart business. Your only product is ham and cheese sandwich, which consists of bread, ham, cheese, and mayonnaise; you estimate that these materials cost around 20 pesos per sandwich. You've found a suitable location for your business, for which the lessor asks 5,000 pesos per month. Finally, you figure that you would have two get two personnel--one to man the cash register and one to prepare the sandwiches--and you would have to pay each 7,000 pesos per month. If you plan to sell each sandwich for 30 pesos, how many sandwiches would you have to sell to break even? How much would you have to sell to break even?

Break even analysis is based on the simplest business formula there is: PROFIT = SALES - EXPENSES. To perform break even analysis, we just have to break these terms down into their respective components:

PROFIT = SALES - EXPENSES

PROFIT = SPU*Q - (VC + FC)

where SPU = selling price per unit, Q = quantity sold, VC =  variable costs, and FC = fixed costs. Going further

PROFIT = SPU*Q - (VC + FC)

PROFIT = SPU*Q - VCU*Q - FC

PROFIT = (SPU - VCU)*Q - FC

Where VCU = variable cost per unit. Remember, since VC rises and falls with Q, then VCU = VC/Q should be constant regardless of sales.

By definition, break even is the level of sales at which profit is zero. So at break even,

PROFIT = 0 = (SPU - VCU)*Q - FC

(SPU - VCU)*Q = FC

Q = FC/(SPU - VCU) = BEQ

Where BEQ = break even quantity. The break even point in pesos is just BEQ*SPU. SPU - VCU is referred to as the contribution margin per unit or CMU. It's the amount that each unit sold contributes to the recovery of fixed costs.

Now, back to your sandwich business. The first thing we have to do is identify which are variable and which are fixed costs. Based on how we defined these earlier, I hope that it's (even a bit) clear that the cost of bread, ham, cheese, and mayo represents variable costs and that rent and wages comprise fixed costs. [Speaking of which, one wise economist once mentioned that in the long run (or in continuously increasing sales quantities), all costs are variable: this means that some costs are only fixed at a certain level of sales called the relevant range. For example, as your business grows and you sell more sandwiches, you may eventually realize that two personnel are not enough to manage the demand at that branch and that you would have to hire another one. Soon, you may even decide to expand and open another branch and pay for another location. In both these instances, sales will have grown enough to drive "fixed" costs such as wages and rent past their relative ranges and become somewhat variable. But I digress...]

VCU = 20

FC = 5,000 + 2*7,000 = 19,000

SPU = 30

So now we have everything we need to proceed with our analysis.

BEQ = 19,000/(30 - 20) = 1,900 sandwiches per month
Break even point in pesos = 1,900*30 = 57,000 pesos per month

Based on the analysis, you would need to sell at least 1,900 ham and cheese sandwiches or generate sales of 57,000 pesos to break even. That's around 64 sandwiches or 1,920 pesos of sales per day. The next question that you need to answer is: do you have what it takes to break even?

If at first pass your think your break even point is too high, there are still a few things you can do to get better results. Try increasing the selling price, but not too much that it will result in significantly less demand (an estimate for the price elasticity of demand for your core product or service would be helpful, but that's another story altogether). Or try looking for cheaper supplies or a less expensive place to bring down your fixed costs. Tweaking your model is okay as long as you remain realistic.

Well, that's it. Now to go back to my other pursuits. ;)

New Year 2012 Mailbag: Global and US Dollar Funds

DEAR INVESTOR JUAN

I spent the last week of 2011 with some friends in Negros Occidental and Guimaras, so I did not have much time to check my email and reply to some comments on the website. My flight back to Hong Kong is still a few hours off, so I'll use this time to answer some of your questions.


Dear Investor Juan,

Your posts are very informative. I have tried investing with BDO Equity, BPI Odyssey High Conviction, and BPI Odyssey Philippine Equity funds and these were able to give me 10 to 13% in 2 months. I already redeemed my investments and bought dollars at 43.50 to 43.65. I am planning to try BPI Odyssey Asia Pacific High Dividend Equity Fund and BPI Global Equity Fund since the NAVPUs are now below par. Seeking your advice. Thanks in advance.

Sandy


Dear Sandy,

Congratulations for being able to earn very high returns on your funds in the short term; I hope you would be able to earn as much or even higher returns on your future investments.

One important benefit in investing in the global funds that you mentioned is geographical diversification, which minimizes risk that is specific to any one country. Of course, this benefit come at a cost: since gains by high performing stocks in one country may be substantially pulled down by underperforming stocks in another country, don't be surprised if you earn lower average returns than a Philippine equity fund. Whether this cost is worth paying is all up to you.


***

Dear Investor Juan,

What would be a good combination of investments for dollar and peso. For dollar, I can put in about USD 3000 and for peso, about P50,000.00.

I hold most of my savings in two BDO dollar accounts. Given the downward trend of the dollar, is it better to convert it now? What proportion do I retain in dollar?

Thanks.

Anonymous


Dear Anonymous,

Looking at BSP's historical forex data, I'm not so sure if there is a downward trend for the dollar; even if there is, I'm not very certain whether this trend will persist in the indefinite future.

That said, in my opinion there are no hard fast rules in allocating your capital to specific currencies, so your proposed dollar-peso mix should be as good as any. What I do recommend is for you to just invest in the currency that you earn since changing back and forth between currencies in the short term involve fees/spreads (i.e., the bank or money changer's markup) that could easily wipe out any gains from one currency's appreciation or depreciation.


***

Dear Investor Juan,

Just asking where to put my dollar investment with low risk of losing the principal amount?

Thanks!

Ed


Dear Ed,

Money market US dollar funds offer the least risk of losing principal since these are mostly (often, exclusively) in "safe" instruments like short-term deposits, and Philippine and non-Philippine government securities.

In my opinion, however, US dollar bond funds are also worth considering since they offer substantially better returns without significantly compromising safety.

You can check out this past post about US dollar UITFs for a detailed comparison of available funds from major banks.

GMA 7 is on MVP's Christmas Wish List

FROM THE RUMOR MILL

Are You Ready for the "Kaputid" Network?

I got this off one of my contacts in Facebook. Rumor has it that Manny V. Pangilinan, a.k.a. "MVP", has made an offer to the Duavit, Gozon, and Jimenez families for GMA 7, and that the offer figure is so "mind-boggling" that it's "impossible to counter." And if you think Ruffa Gutierrez is a reliable source, then it seems that this already is a done deal.

Haven't we seen a similar move from MVP months ago with the PLDT-Digitel merger? If the offer is true and if a deal does materialize, it would be interesting to see the following unfold in the next few days:

• How much premium MVP is willing to pay to own the undisputed number one network in the country
• If ABS-CBN would go the same way as Globe and try to block the deal (and how much political clout the Lopezes still have left)
• How the stock prices of affected players (e.g., PLDT, GMA, ABS-CBN) would be affected 

If the offer is indeed as high as rumored, then we should see significant short-term gains for GMA (up around 5% as of this writing) and possibly a short term drop for PLDT (down around 0.08% as of this writing). If the tremendous growth of TV5 since MVP took control in 2008 is any indication, then a GMA7-TV5 "alliance" should eventually bear significant fruits in the long run; whether this additional value is worth more than the premium paid for the acquisition is another question altogether.

As for ABS-CBN, just like with Globe in the PLDT-Digitel merger, some would argue that the move will also benefit the second player since industry consolidation would decrease competition for the entire industry and all its players. Frankly, I'm not a really big fan of the network and I think I pretty much loath everything the "kapamilya" network comes to represent. Ever since the Lopezes regained control of ABS-CBN in 1986 from Marcos's cronies, it had been in the best position to innovate and provide high quality entertainment for Filipinos, but what it did in the next 25 years was serve regurgitated crap that just made everyone dumber. Anyway, enough about that; I just hope that with this additional pressure will force ABS-CBN finally try to live up to its promise.

***

UPDATE 28 December 2011, 2:22 PM via PhilSTAR.com

GMA has just denied the rumor:

“There is no truth to the rumor ongoing around in social media sites and the Internet that Mr. Pangilinan has bought GMA Network. In fact, there is no negotiation going on between GMA and Mr. Pangilinan regarding the latter’s acquisition of GMA-7.”

And now we know what the rumored "mind-boggling" offer is: 500 billion pesos, or 25 times GMA's current market capitalization of around 20 billion . Wow. Yeah, that can't be right.

GMA 7 shares are down around 0.5% today.

How International Economics Affects Christmas

FINANCIAL TUMBLR-ISM

via Abtruse Goose