Hang Seng Index currently has a price-earnings ratio of 12.5 times. That’s way cheaper than S&P’s ratio of 18 times and Nasdaq’s 20 times.
Should investors simply go for the cheaper stocks?
Benjamin Graham, the father of value investing, said investors should only buy stocks when their prices are significantly below their real value. In time the stock price will gradually reflect its real value. Therefore, the rule of thumb is to invest only in stocks with a big price discount.
But in today’s financial markets, it’s very hard to find bargains that are overlooked.
There are far more participants in equity markets than before, stocks are all well-researched or even over-researched.
Institutional investors now represent a much bigger share of the stock market, and market liquidity is often ample, further reducing the possibility of spotting mispriced counters.
That means stock prices generally reflect their real value. Cheap stocks are typically cheap for a good reason, and expensive ones, too, are usually selling at a premium for a good reason.
Cheap valuation might be a warning sign.
One should not just look at financial ratios but adopt the approach of billionaire investor Warren Buffett, who has refined the value investing approach by adding new dimensions of valuing a company, such as the overall industry, the company’s products, management capability, etc.
That means stocks with low P/E ratio do not qualify as cheap, while those with high P/E multiples may not necessarily be that expensive. Things have to be judged against their growth prospects.
Weigh the company’s prospects and examine the reasoning behind the market consensus. If the logic does not make sense, go against the crowd.
In early 2017, for example, the market thought China’s economy was in big trouble. But had investors bet on the opposite view, they would have been rewarded handsomely: the Hang Seng Index had seen a 30 percent rally since then.
At one point, semiconductor firms were out of favor. But since the dawn of the big data era, their prospects have brightened and their share prices have soared.
The full article appeared in the Hong Kong Economic Journal on Marhc 14
Translation by Julie Zhu
[Chinese version 中文版]
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