Published July 25, 2007

Do valuations really matter?

By R SIVANITHY

HERE's an interesting question for stock market investors to ponder. When momentum and liquidity are rising rapidly and everyone is looking to buy, do valuations really matter?

Offhand, most people would say yes, since logically, the main reason to buy stocks is that they're perceived to be cheap. Certainly, this has been the primary reason offered by analysts over the past couple of years, namely that relative to other assets like commodities, bonds, currencies or real estate, equities presented the best value. The thing is, how cheap is cheap, and how cheap can stocks remain?

If we were to rely on measures like price-to-earnings (PE) or price-book (PB) or price-cash flow (PCF) and apply them to local blue chips, things are relatively clear.

Bloomberg's financial service gives the Straits Times Index as trading at a current PE of 15, an estimated PE of 18 and a PB of 2.1 - so-so numbers that compare well with other markets as well as historically and so suggest the index isn't overly expensive nor overly cheap. You could quite easily make a convincing argument for greater upside using these figures and chances are, you'd find plenty of takers.

Focus on individual counters, and the picture becomes murkier. One of the top index performers in recent times, for instance, has been China shipyard Cosco Corp, whose shares have tripled over the past 12 months, thanks to the sheer number of contracts it has won, the announcements of which have been duly accompanied by plenty of fresh 'buy' calls.

Yet, perhaps less publicised is that its historical PE is 60, its estimated PE is 43, and its PB is a staggering 18.8. Bloomberg also gives its cash flow per share at 17 cents, which means that at $5.70, its shares sell for a PCF of 34. In comparison, the ST Index as a whole has cash flow per share of $2.30, about 13 times Cosco's.

Then, there's another recent favourite, the Singapore Exchange (SGX), which Bloomberg gives as selling at 38 times current PE, 34 times estimated PE, a PB of 19 and a PCF of 49. These numbers, or valuation metrics, are way above the ST Index's and are firmly in 'overvalued' territory.

Of course, one might argue that in either Cosco or SGX's case, it's future potential that investors are paying for, the former because of its significant China exposure and large contracts, and the latter partly because of its links to the Tokyo exchange.

But do supposedly superior prospects necessarily mean that grossly inflated valuations can be safely ignored?

Still, Cosco and SGX are profitable and their prospects have at least some visibility (even if they are arguably over-inflated). Take a look at the UOB-Sesdaq Index, which has gained an astounding 113 per cent this year but incredibly has no PE because many of its constituents have no earnings.

Some might draw parallels with the dotcom boom of 1999-2000 but in reality, it is more reminiscent of the huge speculative bubble that built up in the Malaysian Second Board in the mid-1990s, when the Second Board index rocketed almost 200 per cent in the 16 months between November 1995 to March 1997.

Most Second Board stocks were nothing more than listed shells with no earnings but with small free floats which made them attractive candidates to be cornered and manipulated. There was, of course, the usual circulation of takeover and merger speculation connected to the gains, but in truth, nobody believed any of it.

During its heyday, the Second Board was described as the world's best performing market; the crash when it came, was spectacular - in the ensuing 16 months after March 1997, the index lost 90 per cent and today still trades at a 10-year low.

Many Sesdaq stocks are currently in demand ostensibly because they may benefit from mergers or reverse takeovers. The truth, however, is that like their Malaysian counterparts a decade ago, punters have run out of ideas and are latching onto the momentum probably being generated by syndicates, house traders and pure speculation. One has to wonder - will valuations reassert themselves and if so, when?