Singapore market still deemed healthy

Published May 14, 2011


Show me the money

Singapore market still deemed healthy

It seems that high profit margins do not translate into high PE ratios

By TEH HOOI LING

SENIOR CORRESPONDENT

CO-FOUNDER and chief investment strategist of Grantham Mayo Van Otterloo, Jeremy Grantham, was in Singapore last week for the 30th anniversary conference of the Government of Singapore Investment Corporation.

MR GRANTHAM

'It's administered profit margin, administered by the Fed's deliberate behaviour, particularly pushing up financial profits' on the PE ratio relative to profit

I had the opportunity to have a chat with him after the conference. During our chat, Mr Grantham said the S&P 500 is worth only about 925 points. It's now about 1,350. 'It could go to 1,500. In fact, I thought it probably would by Oct 1,' he said. 'But too many things have gone wrong in Libya, in Japan and so on, plus the end of QE2 (the Federal Reserve's bond buying programme). Everything's going wrong. So I thought better throw in the towel and be a little more conservative.'

Then I asked, but in terms of price-earnings (PE) ratio, we have not gone beyond the normal historical range, right?

He asked: 'So PE is price times what? You can't take a spike in profit margin and look at the PE without taking into account that that's a spike, a peak. Because profit margins are more mean reverting, they have a stronger tendency to go back to normal than PEs do.

'So what you have to say is, fair price is a normal PE of normal profit margin. And today's market, there's more damage from profit margin going back than the risk from PE. So you have a moderately higher than it should be PE, and a much higher profit margin. Both of them working in the same direction means a badly overpriced stock market,' he said.

'You could have had a higher PE on lower profit margin and it would actually be cheaper. And that's the way to do it. That is truly the way to do it.

'People who talk about PE without normalising profit should be taken out and shot. They are just trouble makers. Profit margin now, relative to history, is very high. Think how strange that is in America,' he said.

'There is a lot of unemployment, and there is a lot of spare capacity. And yet you have pretty much peak profit margin. What's that? Tell you what it is? It's administered profit margin, administered by the Fed's deliberate behaviour, particularly pushing up financial profits, and the Treasury and the stimulus programme. All working to inflate profit margin on a temporary basis.'

So can we see this in the charts if we plot S&P 500's profit margins versus PE, and the subsequent performance of the index?

Well yes. From the S&P 500 charts, you can see that profit margins in 1999 at 15.6 per cent was at its highest point in the last 13 years. PE, at 30 times, was at its peak too. That, as it turned out, was one of the biggest stock market bubbles in recent memory.

In late 2001 and early 2002, profit margins sank to just under 9 per cent. PE at that time was relatively high, at 25-26 times. In the following 12 months or so, as the margins recovered, the PE got compressed. The margins recovered even further, and the market ran away after that.

That is until 2007, when again margins were peakish, having risen to above 14 per cent. PE at that time was moderate, at 16-17 times. This was soon followed by the global financial crisis.

Profit margins hit a low again at just over 8 per cent in September 2009. Since then, the S&P 500 has gained 29 per cent.

Today, the net profit margin for S&P is about 13 per cent - rather near the peak. PE, however, is not exorbitant, at about 15 times.

Return on equity and return on assets, which are also mean reverting, are at 24 per cent and 8.7 per cent respectively. That's again near the peak of 27 per cent and 10 per cent in the last 13 years. But to be fair, the market's profit margins and return on equity and assets are just slightly above the median of the last 13 years.

Only in price-to-book (PTB) is the S&P 500 now slightly below its 13 year median of 2.8 times. It is now trading at 2.3 times book. So on the whole, I think we are still not in an excessively overvalued territory.

The tendency of the market to value stocks higher when companies are enjoying fat profit margins is also observed in the Singapore market.

I averaged out the profit margins of the three banks here over the years, and plotted that against their average PE, and their stocks prices. The chart shows high stock prices coincided with periods of high margins.

The average net profit margin has risen from 35.5 per cent from 2009 to 37.4 per cent in 2010. But it's still some way to the peak of 49.9 per cent registered in 2006. For all the measures - from profit margin to ROE and ROA to PTB and also PE - our banks are now in the median of their various ranges in the last decade.

How about industrial and commercial companies? For this, I averaged out the numbers of City Development, Fraser & Neave, Jardine Cycle & Carriage, Jardine Matheson, Keppel Corp, Neptune Orient Lines, Singapore Airlines, SembCorp Marine and Singapore Press Holdings.

For this group of companies, there appeared to be a counter-cyclical pricing. When the profit margins are high, the PEs are low, and vice versa. Currently, net profit margins for this group at 15 per cent is near the peak. PE, however, averaged 12 times. That's below the median.

Meanwhile, ROE and PTB are already at peak levels. But as mentioned, the market is not valuing them at peak pricing.

So all in all, the Singapore market appears to be still relatively healthy.

The writer is a CFA charterholder