19 September 2019
Low valuations don't mean that stocks won't slide further. Photo: HKEJ
Low valuations don't mean that stocks won't slide further. Photo: HKEJ

Why investors should expect the unexpected

Amazon founder Jeff Bezos requires all top executives to read the book “The Black Swan”. The book says the causes and conditions behind everything in the world are very complicate.

If people try to take simplified answers for granted, it leads to narrative fallacy. False understanding can only result in wrong answer. Such misunderstanding may trigger the so-called Black Swan events.

The possibility for a Black Swan event is really low, but every time it happens, it causes huge impact. Why? Because it shakes the existing beliefs and knowledge people have in their minds.

For many years before the 2008 financial crisis, it was not only ordinary Americans who thought that home prices will keep on rising. The belief was also shared by some so-called experts on Wall Street. That led to everyone moving in the wrong direction.

When the bubble burst, the impact was big and people were caught on the wrong foot.

The 2008 crisis was avoidable. In the preceding years, people were worried about the dotcom bust and the 9-11 terrorist attacks, but ignored the snowballing property crisis. In the end, people lacked the imagination to think about “impossible” and unprecedented risks.

The average price-to-equity (P/E) multiple in the Hong Kong stock market is only 10, while the P/E of Hang Seng China Enterprises Index is only 8. It is cheap. But can it be cheaper? Yes, of course.

The mainland is under deflation pressure. Company profitability is declining and inflation and export data are sluggish. Does the renminbi face devaluation pressure? And if the currency is devalued, will the profitability of mainland companies listed in Hong Kong be impacted?

The tepid stock markets in both mainland and Hong Kong cannot simply be explained as stemming from “slowdown of the Chinese economy”.

Common sense can help make better investment decisions. For example, in 2008, when people with problematic credit profiles could get mortgages for new home purchases, we should have known that a crisis would not be far away.

For value investors, the common sense is “margin of safety”. If there’s no profit growth, even a low valuation wouldn’t mean much safety margin for an equity investor.

This article appeared in the Hong Kong Economic Journal on Nov. 20.

Translation by Myssie You

[Chinese version中文版]

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Columnist at the Hong Kong Economic Journal