Stock market crashes: Crisis or opportunity?

Dubai: The truth is rarely pure and never simple, to paraphrase Oscar Wilde; and wild it seems when markets that can do 100 per cent in 12 months can lose 50 per cent over the next five months.

Not an unfamiliar state in the Gulf markets at present with the Dubai and Saudi markets attracting the local headlines. How can this happen? Is it important?

The truth of the matter is far from pure and certainly not simple. Interpretation rather than facts might help in understanding it.

Grab a cappuccino and a steak whilst we examine the nature of a market.

Note the froth at the top of your cappuccino that might equate to the number of actual shares being traded.

If we take, say, Emaar stock on any one day it is the froth that is traded, the rest of the drink remains untraded.

In a rising market the trades are generally buy trades, in a falling market, the trades are mostly sell trades. When the headlines cry "market sell-off", what is usually happening is that the sales are vastly outstripping the buys sending the price down. Note, the stock is still there, it's only the froth dictating the price of the entire drink!

Of course you wouldn't buy a cappuccino without froth, and you wouldn't buy stock at the wrong price (on purpose).

So enter the steak. "Buy the steak and not the frizzle" says John Goodlad of Hartley's stockbrokers in Perth. The point is that the steak is the key ingredient of whether you enjoy the meal. A bad steak excellently cooked is still a bad steak.

Macro environment

A good company in a falling market is still a good company. "If the macro environment in which the company operates is still positive, and if the company's earnings are still growing, this is still a good company whether the price is rising or falling," says Goodlad.

In the same way that bad company can ruin a good meal, negative sentiment can ruin the "fair value" of your stock.

For further insights I asked specialists in four other markets on what they see as "fair value".

Whilst "fair value" for a stock is a stand-alone and complex subject, most market watchers fall back on the Price earnings ratio as one of the "guides" to fair value. This ratio is a valuable benchmark because it reminds investors that there are TWO reasons to buy shares: capital appreciation and income from dividend yield.

The PE ratio indicates how long you might expect to receive your initial investment back from "earnings", i.e. the dividend. According to Goodlad, "when the earnings outlook is strong I would be happy to buy stocks at a higher rate than the market norm".

If it were possible, then for Dubai companies to demonstrate a continued earnings drive, higher than normal PE ratios would be tolerable, and certainly higher than other markets where the earnings outlook is grim.

For Goodlad, an expert on the S&P Australian ASX 200, "fair value" for Australian stocks is somewhere "around 15". So, how does Goodlad deal with the sell-off scenario in an environment where fundamentals are still reasonably strong but where market sentiment is dragging prices down?

"The answer is in the charts", says Goodlad. No this is not a reference to horoscopes but the suggestion that the charts will tell you whether prices are being driven too high or too low.

In the falling scenario, investors need to be wary of the fabled "dead cat bounce". The morbid humour of the exchange floor has it that if you throw a dead cat at the floor it will bounce, but its still dead, so it will fall again. Over-sold markets tend to produce many such bounces.

The skill is in the highly subjective art of assessing which is the last bounce. Then, "as long as you are buying good companies with good earnings growth potential", then crashes are clearly opportunities for savvy investors.

For Prakash Idnani of Indian stockbrokers, Padmakshi, "The Indian Sensex PE is currently around 22 which is unusually high versus the average for the last 5 years. The last time the Sensex PE reached 24.47 was in the year 2000 during the great tech bubble which eventually burst and led to a crash. However, the earnings growth rate is the saving grace this time since the Indian economy is on a sustainable growth path, I do not believe that we are in bubble territory though a correction in the Sensex index cannot be ruled out."

So a similar theme on earnings being espoused. With India so close to the Middle East, how did Idnani interpret the Dubai sell-off?

"The main concern appears to be the fact that oil prices will peak shortly and earnings growth will slow down. The Dubai Financial Market Index P/E was unusually high and when earnings expectations fell there was a sell out by the smart money. Of course, the liquidity factor due to the fact that at least 100 companies want to go public which is double that of the 2005 number did have a role to play as far as the retail investors go but that is not where the smart money lies. The retail investors merely followed the herd by instinct."

A slightly different view is taken by Peggy Farley, chief executive officer of Ascent Management.

Farley is well versed on the S&P where the P/E is 17. Farley, who made her name with Morgan Stanley in the capital markets, says: "Fair value, for any market, in my view, is a two-pronged assessment. Firstly, the growth potential of the economy, and secondly the growth potential of the company and how impervious it is to the economy in which it is domiciled.

Therefore, a trailing P/E ratio is not meaningful to me and never has been. It is often the case that a high trailing P/E is justified by a growth scenario for the company, often enhanced by an expanding economy.

Fundamental problems

On the other hand, a low P/E may well be the result of a company that is sluggish and has little chance of seeing its shares rise. With respect to the markets in the United States, I am not bullish because the economy has fundamental problems that are exacerbated or will be by the Fed continuing to raise rates.

Those problems are also impacted by the current high oil prices as well as the high level of other commodity prices.

There continues to be leverage in our market that is so substantial that it cannot be increased to foster an upward movement. Finally, while we see foreign investment, it is not increasing at a rate rapid enough to drive our markets higher."

Stan Lock, of London brokers Brewin Dolphin, shares the Goodlad/Idnani analysis. "Company earnings and earnings growth, asset values, dividends, are the primary drivers of share value," says Lock. At the moment London is being driven at "around 14 times earnings which on a global scale looks quite cheap for very good companies, so we remain bullish on UK companies for now," says Lock.

Smell the coffee, taste the steak, the only sure way of knowing the fair value of a stock asset is to get out there and genuinely kick the tyres, otherwise sentiment will dictate the quality of the ride.

- The writer is the Managing Director of Mondial (Dubai) LLC.