By Tekoa Da Silva
† Photo credit
Since 2017, I’ve spent time studying financial statements of companies in two markets I believe are attractive: energy and emerging markets (with an emphasis on China).
The recent outbreak of novel coronavirus in China has accentuated the plunge in Shanghai-listed securities. The national response to the virus will likely impact all companies operating in the region. However, in this writer’s view, the ultimate outcome is unpredictable.
Extraordinary events aside, many energy and Chinese stocks, based on their financial statements, are attractive for the purpose of rent collection. By “rent collection,” I mean enjoying an ongoing stream of earnings from the business, flowing through the company, and into one’s pocket in the form of dividends.
Using some traditional metrics — such as discount to book value, price-to-earnings ratios, leverage (debt and liabilities), management/employee ownership — one can narrow down a basket that meets the type of criteria that famed value-investor Ben Graham and his students would often target: price-to-book ratios of less than .6, price-to-earnings ratio less than 7, and enjoyable dividend yields of 5%-6% or greater.
Alternatively, there are historical extremes of the opposite type, in terms of pricing of U.S. stock market indexes and individual companies. There are an abundance of U.S. companies selling at prices greater than 12 times book value and 20-30 (or more) times price-to-earnings ratio. In addition, there are many multi-billion-dollar market cap (USD) companies that have never reported a single cent in positive net annual income on their income statements.
There is clearly an extreme difference in asset pricing, when comparing U.S. equity markets with global energy and Chinese securities.
Given the difficulty of gauging the amount of money in circulation at any given time and determining whether an asset is actually cheap in US dollar terms, I’ve come to enjoy using ratios, such as the gold-to-silver ratio, gold-to-oil or gold-to-DJIA (Dow Jones Industrial Average).
In this case, I thought to use ratios to help determine if the sectors I am looking at are historically cheap, relative to other things.
CRUDE OIL VERSUS DOW JONES INDUSTRIAL AVERAGE
Here is a ratio chart of West Texas Intermediate Crude (WTIC — a benchmark global energy product) versus the Dow Jones Industrial Average (DJIA):
Source: StockCharts.com
Going back 25 years, the WTIC-to-DJIA ratio is currently in a pricing band which was only visited four times: 1998-1999, 2001-2002, 2016 and late 2018.
In each of those periods, the extreme low ratio (suggesting WTIC to be cheap) violently reversed higher, and not long after. In addition, the nominal WTIC price also reversed.
Here is a chart of WTIC, with those same ratio-bottoming years circled in red:
Source: StockCharts.com
As you can see, not only did the ratio snap higher in favor of WTIC during all four circumstances, but so also did the USD pricing of WTIC.
Recovering off the 1999 ratio bottom, WTIC registered a total move of approximately 200%. In the recovery off the 2001-2002 bottom, WTIC moved up over 100%. In 2016, WTIC shot up over 100% and, in late 2018, moved up over 50%.
There is no guarantee WTIC will move higher from its current price, or from its current WTIC/DJIA ratio. Additionally, there is no guarantee that energy securities, a broad global industry, will move higher in sympathy with a hypothetical recovery of WTIC.
However, the existence of extreme asset class-to-index ratios combined with baskets of attractively priced individual securities within that asset class could be a warning flag (in this writer’s opinion) of a ripe condition for price recovery.
SHANGHAI STOCK EXCHANGE VERSUS DOW JONES INDUSTRIAL AVERAGE
In looking at the Shanghai Stock Exchange Composite (SSEC) Index relative to the DJIA, it too is registering price ratio extremes that are within a 25-year bottoming range:
Source: StockCharts.com
Following each of the four prior ratio bottoms — 1996, 1999, 2005 and 2014, the SSEC demonstrated a violent reversal to the upside in favor of Chinese stocks relative to the DJIA.
In addition to a reversal in the SSEC-to-DJIA ratio, the pricing of the Shanghai exchange index reversed higher following each of those four ratio bottoms as well, as shown below:
Source: StockCharts.com
Recovering off the 1995 ratio bottom, the SSEC registered a total move of greater than 170%. In the recovery off the 1999 bottom, SSEC moved up approximately 100%. In 2005, SSEC began a move which totaled over 500%, and in late 2014, began a move roughly totaling 160%.
There is no guarantee the SSEC index will move higher from its current price, or from its current SSEC-to-DJIA ratio. Additionally, there is no guarantee that all Chinese securities will move higher in sympathy, with a hypothetical move higher of the SSEC index.
MAINLAND CHINA FOCUS
It should be noted that the Hong Kong exchange contains a healthy number of dual listings from the Shanghai Exchange, as well as companies with mainland Chinese focused businesses whose sole Asian listing is on the Hong Kong Stock Exchange.
However, the Hong Kong stock market also contains a large number of companies exposed to Hong Kong real estate and other industries whose pricing behavior has moved in sympathy with Western (U.S.) financial markets. It has primarily been mainland focused businesses whose share prices have lagged.
I’ve spent the last few years looking over financial statements in search of stock market bargains. The trail of good numbers (and cheap companies) has led me east, toward emerging markets (China in particular), and to energy companies.
Today, one can use traditional stock valuation metrics to build a portfolio of cheap energy and mainland Chinese focused stocks, in which large companies with years (or decades) of stable earnings can be bought for an attractive price and dividend yield (akin to “rent collection”).
If history repeats itself, the multi-year ratio extremes between the WTIC-to-DJIA and SSEC-to-DJIA may reverse violently to the upside in favor of global energy and mainland Chinese securities.
This article originally appeared on LinkedIn.
Investors seeking speculative opportunities in foreign markets may benefit from the assistance of an experienced, licensed professional.
About the author
Tekoa Da Silva is a registered representative with Sprott Global Resource Investments, Ltd., a broker dealer in the United States registered with the SEC, FINRA, and a member of the SIPC, and an investment advisory representative with Sprott Asset Management USA, Inc., an SEC registered investment advisor.
Contact the author by phone at (800) 477-7853 or email at tdasilva@sprottglobal.com.
