Puzzling Valuations: Price-to-Book

When I last left off, we looked at PE ratios and the forward 12-month return on the Singapore market.

The general conclusion there is lower PE ratios tend to correspond with higher returns, and higher PE ratios tend to correspond with modest (but still positive) returns. While not entirely discounting the buy-low-sell-high (BLSH) principle, it’s not exactly a full endorsement, since apparently you can still buy high, and make a decent ~10% return.

So I figure we can try a different valuation metric - price to book ratio (PB).

The PB ratios compares price to the book value of the company. Book value measures tangible assets, i.e. all measurable, quantifiable assets. So PB says how much you’re paying for all the measurable assets in a company. (As opposed to PE that tells you how much you’re paying for the earnings of a company).

So over the same period (end-2008 to end-April 2012) I’ve plotted 12mth fwd returns, against the index-adjusted PB ratio of the STI.

The relationship seems similar – low PBs correspond with higher returns, which higher PBs correspond to lower returns. Historical data says PB of ~ 1.8X is a sign that 12months later, returns are likely to be negative. On the flipside, historical data says PB of ~1.2X is a sign that 12months later, you’ll see pretty good returns. Sorting the PB ratios in ascending order gives a clearer picture the relationship.

Sorted PB ratios make a clearer case for the BLSH approach. Up to 1.4X and even 1.5X PB ratios, historical data says you can still see positive returns if you take a 12-month position in the market. Somewhere around 1.6X your returns are far less certain. And no good has ever followed getting in ~1.8X.

By now, you can tell this is pretty simplistic analysis. Most professionals armed with Bloomberg terminals can pull this data instantly and slice, dice and triple splice it like a samurai.

My own efforts are more suited to wielding a butter knife…less chance of me cutting myself, which I do fairly frequently.

There is one more way I want to spread the data - by varying the holding period. But that’s some number crunching I’ll save for next week.

Puzzling Valuations:Price-Earnings

Having started this blog on the spur of the moment, I decide to populate it with all manner of magical thinking, such as valuations.

Leonardo Da Vinci, famously quoted, says ‘simplicity is the ultimate sophistication’.

In the investing industry, one way this can be interpreted is thus: behind the complex engineering and backroom operations that goes on, a few simple rules stand the grinding test of time. Sure these rules get forgotten, usually to the detriment of the overall system, from consumer to producer to business owner.

Thankfully, if the system is sufficiently robust, it will recover from various shocks, and continue along its merry march. One robust rule of the industry is that of valuations, which is easy to preach, but harder to practice.

The trouble with valuations is that it often gets you in trouble with the herd, which in the industry is often made up of very intelligent people with multiple three-letter titles behind their names, all of whom will claim, with the intellectual tyranny of absolute certainty, that: You. Are. Wrong. If you spend any period of time in the finance industry, you quickly develop a keen appreciation for the simple empathy of the modest intellectual, and a strong constitution for sharp criticism. 

At a practical level, valuation indicators try to measure the relationship between price (sentiment driven) and value (business driven). One commonly used indicator is the PE ratio, which compares price with earnings.

But PE alone isn’t very helpful. 

 From end-2008 to April 2011, plotting STI 12-mth fwd returns (that is returns 12 months after the stated date) against the index-adjusted PE (a PE derived from the individual weightings of each index component) suggests that getting in at 23X on 30 Dec 2009 would have netted you around 10% return. Hardly what “buy-low, sell high” preachers would sing about. 

Even after the adjustment for earnings on 31 Dec 2009 (where the big drop occurs), you could still get a decent 12-mth return of around 10% or less, at least until around July-Aug 2010, where 1-yr returns turned negative. 

If I sort the PE ratios from lowest to highest, how does it look? 
What this chart says is that historically, from 2008 to April 2011, you would have gotten much better 12-mth returns if you got in at PE ratios below 9X. But then again, even if you got in at nosebleed 23X PE, you’d still have a positive 12-mth return.

So what gives? Does this mean PE doesn’t work for the Singapore market? If anyone wants to throw in their two cents, I’d be more than happy to bounce ideas around. I certainly don’t have any special insight into these observations, but I’ll explore this topic in more detail next week.

Case Study: The Unit Trust Dividend Portfolio

Spurred by a question from a reader, this article gives an example of how unit trusts can be used to generate a steady stream of dividends.

One day someone tossed an idea at me.

“Can you give me an example of how unit trusts can be used to create a stream of dividends?”

Well, he didn’t actually put it in those terms, but I’m reinterpreting it as such to suit my needs, which includes not giving advice to someone whose financial background is unknown to me.

But examples, hey, it’s an intriguing question. So in the spirit of exploration, here’s what the historical data tells us about a unit trust portfolio designed with dividends in mind.

Requirements and Caveats

Requirement: A portfolio of unit trusts that pay out regular dividends while maintaining one’s capital.

Caveat #1: No one, not even the fund manager can guarantee you won’t lose money and/or receive dividends. (Caveat to caveat #1: Having said that, there are two funds based on my experience, which have been historically ridiculously good at preserving capital while paying out dividends.)

Caveat #2: Any and all observations made are based on historical data, which makes no statement about what the future might bring.

Selecting Ingredients

I can think of two funds that I would feel comfortable putting into a portfolio designed to pay out dividends.

First State Dividend Advantage and Eastspring Investments MIP A or MIP M (A = Annual dividend, M = Monthly dividend). Why these two?

Wins vs Loss: Rolling 12mth periods, from end-2005 to end-May 2012
Measure	Eastspring Investments MIP A	First State Dividend Advantage
# loss	547	559
# win	1279	1267
total #	1826	1826
% loss	29.96%	30.61%
% win	70.04%	69.39%
max win	41.87%	64.83%
max loss	-28.23%	-48.32%
mean win	13.18%	23.73%
mean loss	-10.41%	-19.98%

To give some idea of how these two funds perform, I look at rolling 12-month period. This is a moving measure of all 12-mth periods within a state time range (end-2005 to end-May 2012). Over that time, both funds tend to have positive periods (#wins) more often than negative periods (# losses). 

Average performance tends to balance out for Eastspring, and tends to be positive for First State DivAdv. In other words, over 12-month holding periods, you’re more likely to see positive returns than negative returns. Take note of the worst drawdown too, so you can mentally steel yourself for when the bad times come.

In short, after looking at the returns and risks, these two funds seem to have a consistent approach that beats the market in the long term.

Putting it Together

For simplicity I’ll go for a 50-50 equity-bond split. This diversification is important, not only because it gives access to two assets, but also because dividend payouts (which are not guaranteed) have been historically made quarterly and yearly.

First let’s plot the portfolio including dividends.

Performance looks quite good over the timeframe stated. I’ve used the MSCI World Index (all-equity index) to serve as a comparison. No it’s not a fair comparison, because the two-fund portfolio is a mix of equity and bonds. But the point is the advantage of having a two asset portfolio over a single asset portfolio.

So what happens when we strip out the dividends from the equation?

Chart looks pretty ok, the portfolio with dividends paid out still managed to beat a pure-equity index. But how bad are the bad times?

If we assume dividends are paid out, then it becomes a question of whether the initial capital is preserved. Based on the past 6 years or so, the portfolio would have gone as far underwater as -41% in a single year.

Wins vs Loss: Rolling 12mth periods, from end-2005 to end-May 2012
	2F noRe
# loss	842
# win	1135
total #	1978
% loss	42.57%
% win	57.38%
max win	45.73%
max loss	-41.62%
mean win	14.34%
mean loss	-13.27%
Star/End CAGR	0.66%

Over the 6+ years we looked at, the portfolio does manage to hold its return steady, at 0.66% over the end-2005 to end-May 2012 data.

All About The Cash Flow

That just leaves us with the actual dividend payments. For simplicity, I’m using the declaration date and the payout per unit. Assuming the portfolio of Eastspring Investments MIP A and First State Dividend Advantage has 10,000 units each, this is roughly the payouts amounts declared.

Dividend payouts for the MIP have remained fixed at an annual 0.05c/unit, while DivA pays out quarterly.

The big caveat to all of this is, of course, dividends are made on the discretion of the fund manager, and are not guaranteed in any way. Much like one’s career, which these days is far more volatile than one would like.

So yes, a portfolio of unit trust has historically been shown to provide a steady stream of dividends. Will it do so going forward? I certainly don’t know, in theory at least, it’s possible.