Background
Everyone knows that when an article talks about stock trading, the first thing that comes to mind are those who deal with options or contract for differences. There is no debate for that and thus I will not be discussing on the group.
Instead in this article, I would like to highlight the risk to rewards for new investors looking to enter into the market.
A disclaimer before you proceed any further. Let me highlight to you that I am not trying to say which type of trading is the best. It is up to an individual to decide which style they prefer based on their personal risk to rewards. As long as you are comfortable with what you are doing, I don’t see why not.
Without further ado, in this page, I will share my thoughts on who are actually investors and traders.
My view
Price-to-Book ratio
My classifications are using the Price-to-Book (“P/B”) ratio. This is less volatile than Price-to-Earnings (“P/E”) ratio, as Companies can do well in one year and have disastrous results the next due to income manipulation. It does not necessary need to be fraud, but can be as simple as fulfilling orders earlier than expected or delaying some shipments to the following year.
Another issue I have with P/E ratios is that P/E can be inflated easily through borrowings. A Company can easily borrow large amounts from banks (usually disclosed as borrowings in the financial statements), to fund their expansion plans. In general, Net Asset Value (“NAV”) per share will not have significant changes as for every liability you take up, you have an equivalent amount of asset (in this case cash). However, it has a very small impact on the bottom line as the interest expense incurred from these borrowings (presented as finance costs), are usually insignificant relative to the other metrics.
Nonetheless the issues comes where these profits have to be taken to repay these loans. So even if the Company is generating positive operating cash flows and profits, these cannot be passed on to the shareholders as they have to be used to pay down their liabilities. This gives me a reason to use P/B ratio as the first guide.
Using the P/B ratio as a benchmark, I have thus grouped as follows:
- Investors – Enter positions with shares at a P/B ratio lower than 3.
- Traders – Enter positions with shares at a P/B ratio higher than 3.
In my opinion, a P/B ratio below 3 is deem reasonable. This is due to the value of stock will always be forward looking. On the assumption that the Company will be doing well in the next few years, naturally you will get a higher intrinsic value after discounting the future cash flows. This intrinsic value will be higher than their current book value.
My believe that when you buy the shares of a Company, you are buying its assets, and also taking on their liabilities. The result is its shareholders equity.
To put this into perspective, assume today you have bought a share trading at a P/B ratio of 20. The Company decides to file for closure the next day. You will only get its book value of 1 as the assets will have to be sold off to pay their liabilities before the excess is returned to the shareholders. The additional multiplier of 19 is unrecoverable.
As such, anything more than my benchmark of 3 is considered trading. The share price is less backed by any fundamentals of the Company and is speculative in nature.
Buying into an equity with a P/B of 1 means you are essentially paying for what the Company is holding at the respective reporting date. This to me sounds more like a fair price.
Strategy
Don’t get me wrong, you can still earn money from investing in these high P/E or P/B stocks given that it is the industry normal. It just requires more time to monitor as they are more susceptible to fluctuations.
Personally I do look into these high P/B ratio equities. I do so with the mindset for the short term which is less than 2 years, and must be ready to take them off the table if the environment turns against them.
My advice for these positions however is that you will need to constantly keep yourself up to date with the environment of the Company at least once every two weeks. This is to take note of any key developments in the industry that you have to revise your strategy for.
That does not mean that you do not have to keep up to date with those trading below a P/B of 3, or that I will hold other value stocks to perpetuity or only sell once it hits a P/B ratio of 3. You still have to update yourself with the performance of the Company against the backdrop of the environment. It is just that this can be done on a less frequent basis for industries with less speculation. This is more suitable for me given my other commitments.
The share price can appreciate by more than 30% and yet still has a P/B ratio of less than 3. However, if the fundamentals have not changed from my initial assessment, I will consider to take profit if there are other opportunities available.
Case study – Nokia
Most people would have remembered Nokia Corporation (“Nokia)(NYSE: NOK) before the rise of smartphones. Nokia was previously doing well in the mobile industry and was the key market leader enjoying the largest market share.
With the introduction of the iPhone by Apple Incorporate (“Apple”)(NASDAQ: AAPL), Nokia was suddenly left behind. They did not manage to keep up with the advancement of smartphones and within a few years, was knocked out of the mobile phone industry, and its devices and service division was bought by Microsoft Corporation. This ended their race.
Website: Nokia: The rise and fall of a mobile giant
As of the time of this writing in June 2020, Nokia’s P/B ratio is less than 2. On the other hand, Apple is trading at a P/B ratio of around 18. This shows the large speculation gap when a Company is doing well versus one that is not.
The argument is that currently Nokia is no longer in the same industry as Apple today. However it does not change the fact that if you have bought Nokia at its all time high with the mindset to hold to perpetuity, you would be sitting on heavy capital losses today.
It is something you should take note of and allocate some time in your schedule to keep yourself up to date with the Company business.
Conclusion
I hope I have managed to highlight some key things to take note of for you to build your strategy. As always remember to do your due diligence before entering a new position. Fortune favors the bold. Good luck.