The Crazy Opportunity: Series II
More cheery news about the economy came to the fore today as the new 2012 budget proposal hit the news. The Government has decided to budget N888 billion for fuel subsidy for the year but the budget deficit just went up slightly from 2.77% to 2.97% and still stays below the 3.0% mark. Read more.
Yesterday, I presented the economic basis for my optimism about Nigeria and the economy. Today I am going to delve deeper into the financial asset class that I expect will make a lot of money for the discerning investor. One of the most quoted Warren Buffet statements is: Be greedy when others are fearful and be fearful when others are greedy. Markets the world over are known to be terribly fickle and always have a way of overreacting when things go out of sync. Opportunities are then created but because of fear, and sometimes greed, that becomes magnified, investors stop making rational decisions and either oversell or overbuy, depending on the general mood.
Contrarian investment strategies generally provide positive skew when the downside risk is acknowledged and disciplined measures are taken. Thus they tend to generate many small losses and very huge gains that pay for the losses many times over, sometimes in multiples of tens and hundreds. No investment is risk free, it is the ability to generate alpha that distinguishes the superior investor.
The opportunity I was able to uncover lies in the Nigerian Stock Exchange. Yes, the equities market that I was so much against just a few weeks ago. Nothing has changed fundamentally between then and now and I don't expect the stock market to perform any magic in the coming months but a closer look at it will reveal a hidden opportunity. Investing in this section of the market will generate returns close to 100% or more when the market eventually comes alive and start producing the boring 10 - 20% returns. I cannot guarantee that it will happen but I believe that the chances are high.
The NSE Index has lost 23.25% over the past one year and has lost 2.01% year to date and still counting. The NSE-30, which is the Index created from the 30 most capitalized stocks on the exchange and accounting for 90% of the market capitalization, has lost 20.10% over the past one year and 0.37% year to date. A chart depicting the performance of these indexes can be seen below. The green line is the NSE-30, which can be seen outperforming the NSE Index, which is the white line.
This is where it gets interesting. We will take the NSE Index and strip out the NSE-30 Index. What we get is what I will call the Ex-NSE30 Index, which makes only 10% of the total market capitalization. If the NSE-30 Index has outperformed the NSE Index, it means the Ex-NSE30 has performed horribly. From the data quoted above, we can therefore extrapolate that the hypothetical Ex-NSE30 Index has lost a whopping 51.60% over the past one year and has lost 16.77% in just six weeks since the year started. So why did this happen? Two things.
High interest rates increase cost of borrowing, which hurts the bottom line. This affects smaller companies more because the bigger companies can issue A-rated commercial papers while the smaller ones have to depend on bank loans with prohibitive rates. The market has seen this and just decided to take a walk. Instead of walking, it has overreacted and sprinted.
Foreign investors are still buying stocks on the exchange. This is not a conjecture but the fact. These investors prefer to buy more liquid and highly capitalized stocks. Imagine, $1 can buy over 300 hundred units of many of the stocks on the exchange and these guys are bringing in millions of the dollars. Their purchase of the large cap stocks has created more stability for the NSE-30 than the Ex-NSE30. The issue I highlighted yesterday comes to fore once again. Foreign investors believe in us more than we believe in ourselves.
This is where the crazy opportunity lies. The Ex-NSE30 Index is where to invest your money if you want to smile when things begin to fall into place. Yeah, I know. The question on your mind is "How do you expect me to invest in an asset that you have proven is losing so much and will likely continue to lose? Are you crazy?" That is why I called it the crazy opportunity.
Let's look at a few more numbers. The earnings yield of the NSE as a whole is currently 13.93%. With that yield it means investing in the market will provide returns above inflation since inflation rate is over 350 basis points below this value at 10.30%. But the market yield is still far below the one year treasury bill rate of 16.00%, which is one of the reasons I don't see the equity market going anywhere anytime soon. The NSE-30 Index earnings yield is 7.92%, which is sub-inflation.
Get my drift now?
If the NSE-30 Index accounting for 90% of the market capitalization has an earnings yield of 7.92% and the whole market has a yield of 13.93%, it therefore means that the Ex-NSE30 earnings yield is 68.02%! Yes, the earnings yield of the low cap stocks accounting for only 10% of the entire market has a price to earnings multiple of 1.47x. That is a crazy number. But what do you expect when many companies are generating profits, growing on a yearly basis but the prices have gone down by over 50% just because people are scared?
This is the time to start buying up these stocks.
Here is an outline of my strategy.
Select stocks that have steadily grown their earnings over the past three years
Pick stocks that have good and strong cash flows that can fund their operational needs instead of depending heavily on bank loans with prohibitive rates
Select stocks have low dependence on short term loans
The lower the dividend payments the better. This is not the time to dole out dividends. Money is expensive nowadays.
Time my purchase by using technical indicators.
Wait for two years.
I will end with Warren Buffet quote again: "Be greedy when others are fearful and be fearful when others are greedy".