Monday, October 29, 2007

How will U.S. stocks perform versus foreign equity markets?

Reader's Question: Do you think the U.S. stock market will provide at least 10% to 20% returns over the next one to two years? Also, how about foreign equity markets?

I am bullish on equities over the long term and think it very possible that the U.S. stock market will see returns around the level you indicate. Negative factors--softness in residential real estate, sub-prime debt problems, possibility of recession, record high oil prices, weakening dollar--have potential to derail the current bull market and will continue to worry investors. Nevertheless, despite the short-term negatives, equity markets tend to exhibit a secular rise on the back of economic growth--and this long-term trend, with solid footing in our world's market economy and capitalism, is unlikely to subside anytime soon.

Think Global

Rather than focussing solely on U.S. equities, I would encourage you to think and invest globally, if you aren't already doing so. The pie chart below shows how the U.S. accounts for about 27% of the world's economy as measured by nominal GDP. This means that almost three-quarters of the world's economic output (i.e., the overwhelming majority of the pie) is generated outside of the U.S. Certainly, the U.S. remains the world's largest economy by a wide margin; however, rapid economic growth rates elsewhere provide a reason to look beyond U.S. borders.

Economic Growth Matters

The world's three largest economies--U.S., Japan and Germany--all have real GDP growth rates in the neighborhood of 2% to 3% annually. That's very sluggish when compared to high growth rates in many other countries among the world's largest 15 economies. Most notably, China continues to show robust 10% to 11% growth, India around 9% or 10%, Russia around 7%, and South Korea and Mexico about 4% to 5% growth. Since GDP growth in the underlying economy drives corporate revenue and earnings growth, which in turn determines stock price performance, it behooves us to focus in on high-growth countries.

As investors, we want growth, but we also want to make sure that we are not paying too much for the growth we get. A good way to gauge the cheapness or richness of entire stock markets is to look at the P/E ratios of representative ETFs. Barclays iShares manages country-specific ETFs that can serve as proxies for most of the largest economies. For example, one of their most popular ETFs is the FTSE/Xinhua China 25 Index (NYSE: FXI), which invests in H-shares of 25 large companies listed in Hong Kong and doing business in China. This China ETF has a market capitalizaion-weighted P/E ratio of 31, as of the end of September.

It is helpful to plot P/E ratio against GDP growth to develop an intuitive feel for how cheap or expensive the various stock markets are. In the graph below, I have drawn lines sloping upward from the origin for the four countries with the most attractive (i.e., lowest) ratios of P/E (for proxy ETFs) to GDP growth rate (for the corresponding countries). This composite ratio is a type of "PEG ratio" that measures P/E relative to growth, allowing for a quick comparison of low-P/E, low-growth and high-P/E, high-growth investment alternatives.

Observe how the ETFs of India (NYSE: INP) and China (NYSE: FXI) offer the most attractive PEG ratios, indicating that even though their respective stock markets are currently trading at relatively high P/Es of 23 (estimated) and 31, respectively, the double-digit (or near-double-digit) growth of their underlying economies appears to support their high-P/E valuations. The ETFs of Mexico (NYSE: EWW) and South Korea (NYSE: EWY) also show attractive PEG ratios.

Prospects for Growth and Profit

Although it is extremely difficult to predict which stock markets will rise the most over the next year or two, or whether the recent strength of global equity markets (particularly China and India) will continue in the near-term, I offer two suggestions:

1. Invest Globally: As a baseline when investing in equities, weight countries in approximate proportion to their contribution to world GDP. ETFs provide a means for taking on exposure to foreign equities while keeping costs and management fees low. Buying ADRs (U.S.-listed shares of foreign companies) is another way to go for those who enjoy (as I do) investing in individual companies. While U.S. equities may comprise the largest single-country contribution, all of the non-U.S. countries together should, in my opinion, add up to more than half of your overall portfolio.

2. Over-weight High-Growth Countries: Given their high GDP growth, China, India, Russia, South Korea and Mexico are good places to search for equity investments. Investors willing to take a long-term view and ride out the higher volatility of these markets stand to benefit from the tailwind that higher GDP growth provides.

Reporting this week of Mukesh Ambani and Carlos Slim's rapid ascent to the #1 and #2 positions in world wealth ranking (both appear to have edged out Bill Gates) is a sign of India and Mexico's strong economic growth and soaring stock market fortunes (as well as evidence of how concentrated wealth is among the super-rich in these countries of relatively low per-capita GDP). Also, Warren Buffett's investment in POSCO (NYSE: PKX) and other South Korean stocks is indicative of the potential upside this Asian market offers.

(Disclosure: The author does not currently have positions in any of the ETFs or stocks mentioned in this article but is overweight in non-U.S. equities from high-growth countries.)

Tuesday, October 23, 2007

Can sentiment predict market direction?

Question: Is investor sentiment a useful indicator of market direction? If possible, I would like to trade on sentiment to make money.

Blogger Sentiment

Popular measures of investor sentment are reported in Barron's each week. For brief background reading, try the Investopedia article entitled "Investors Intelligence Sentiment Index." The article cites an academic study published in 2000 by Ken Fisher and Meir Statman that concluded: "We found the relationship between the sentiment of newsletter writers as measured by the Investors Intelligence survey and future S&P 500 returns to be negative but not statistically significant." As is the case with most (if not all?) fundamental and technical indicators, the prospect of using a simple sentiment index to trade and consistently realize excess profits does not look very encouraging.

However, instead of giving up so easily, let's have a look at a newer sentiment index that is being tracked by Ticker Sense, a financial blog of Birinyi Associates, run by former Salomon executive Laszlo Birinyi. Beginning in July of 2006, Ticker Sense has been reporting at the start of each trading week market sentiment figures resulting from a poll sent out to participating bloggers the prior Thursday. Bloggers state whether they are bullish, bearish or neutral on the S&P 500 for the upcoming 30 days. The chart below shows this sentiment data for the past 12 months.

We can develop a qualitative feel for how useful this type of sentiment data might be in a trading context by plotting the S&P 500 index alongside the weekly difference between the bull and bear sentiment percentages. The chart below shows that for the past couple of months blogger sentiment has correlated favorably with the directional movement of the S&P 500 index--the market moves down with negative bull-bear sentiment in early August, up with positive bull-bear sentiment from about mid-August through the market's recent highs in early October, and down on slightly negative sentiment last week. Hey, this is beginning to look promising. . . .

"Batting Average" Test

One barometer for gauging how helpful blogger sentiment can be in predicting market direction is to perform a "batting average" calculation. A baseball player's batting average is a number between zero and 1.000 (or zero and 1000, if we ignore the decimal point), indicating the ratio of hits to at-bats during a season. For example, during 2004 when Seattle Mariners all-star player Ichiro set a new all-time major league baseball record with 262 hits, his batting average in his 704 season at-bats was 262/704 = 0.372.

In an analogous fashion, we can define a sentiment "batting average" as being the time-average of the relevant (bull, bear or neutral) sentiment percentages corresponding to the actual up, down and flat market outcomes observed during all of the trials in a specified testing period:

Sentiment "Batting Average" = Sum(Xi)/N,


Xi = bullish (bearish, neutral) sentiment percentage at time i-1 if market return ends up in bullish (bearish, neutral) range at time i,

and i runs from 1 to N, inclusive, where N is the number of trials in the testing period.

(Note: Since the Ticker Sense sentiment poll is updated at a weekly frequency, for our analysis we pair each week's sentiment data with only the following week's market movement. In effect, sentiment predictions are "refreshed" each week, even though bloggers participating in the poll are asked for their opinion about the next 30 days.)

Here's a numerical example: If a particular week's sentiment poll gives bull-bear-neutral sentiment percentages of 50-30-20 and the market ends up falling into the bearish range the week after the poll is taken, this particular trial contributes an X-value of 0.300 to the average. Obviously, the highest batting average is attained when the actual market movement always matches the strongest prevailing sentiment (or highest percentage) among the three possible sentiment "states" (bull, bear and neutral).

Two extreme cases help to clarify the meaning of our sentiment "batting average": If all bloggers participating in the poll had complete clairvoyance, the sentiment percentages would always be 100-0-0 (bullish), 0-100-0 (bearish) or 0-0-100 (neutral), and each trial would always contribute an X-value of 1.000, resulting in a perfect time-average of 1.000. At the other extreme, if the bloggers were always completely split without any predominating opinion, the sentiment percentages would be 33-33-33 (rounded), and each trial would always contribute an X-value of 0.333, regardless of whether the market rises, falls or remains flat. Importantly, this batting average of 0.333 is also the expected outcome when collective opinion, whether skewed or split, is no better than a random guess at determining market direction.

In order to apply our batting-average methodology to the blogger sentiment data, we also need to define what we mean by bullish, bearish and neutral outcomes, and ideally these three "states" should be equally likely, so that no particular outcome is favored over the others. To take into account the possibility of "trending" regimes, rather than referencing static return ranges I use a 26-week moving window ending just prior to each weekly trial:

  • "Bullish": Above 67th percentile return of immediately prior 26 weeks

  • "Neutral": Between 33rd and 67th percentile return of immediately prior 26 weeks

  • "Bearish": Below 33rd percentile return of immediately prior 26 weeks

  • Though there is some variation from week to week, for the S&P 500 over the past year the 26-week moving averages of the 33rd and 67th percentile weekly returns have hovered around -0.3% and 1.2%, respectively, giving sentiment ranges approximately as follows:

  • "Bullish": Weekly return above 1.2%

  • "Neutral": Weekly return between -0.3% and 1.2%

  • "Bearish": Weekly return below -0.3%

  • The graph below shows the week-by-week contributions to the overall average. For example, for the week ending October 5, bullish sentiment (from the poll sent out Thursday of the prior week) was 50% and the market traded up, thereby contributing an X-value of 0.500. Note, however, that the overall average from the past one year is the smaller figure of 0.319, which is slightly worse than the 0.333 expected in the case of random guessing. In other words, the batting-average calculation suggests that blogger sentiment will probably not be very useful in predicting market direction.

    Simulated Trading Test

    Another way to visualize the sentiment data is to look at scatterplots of the bull-bear sentiment difference (at time i-1) versus S&P 500 returns for the following week (at time i). I divide the past year into two 26-week periods to enable us to run two simulated trading tests on the sentiment data.

    For the first 26-week period, from October 2006 through April 2007, there is a somewhat negative correlation between sentiment and returns, suggesting that sentiment could be slightly contra-indicative of market direction.

    However, over the next 26-week period, from April 2007 through October 2007, the correlation is essentially zero, indicating no apparent relationship between sentiment and subsequent returns.

    We can trade on the sentiment data by using the weekly bull-bear sentiment differences to weight one-week trades on the S&P 500 index (or futures), going long when the difference is positive (net bullish) and going short when it is negative (net bearish). Trade size equals the absolute value of the bull-bear sentiment difference, so that we take larger trading positions when sentiment is more extremely bullish or bearish. The graph below shows the simulated outcome of such trading over our two 26-week periods. The initial 26-week trading period produces a loss, while the later 26-week trading period begins in negative territory but goes slightly positive from early August to early October when sentiment, as mentioned above, matches market direction.

    Is There Hope?

    Overall, with the batting-average test failing to show all-star-like performance above the 0.333 expected value of random guessing, and the trading test producing what appears to be little more than a random walk, it is difficult to place any confidence in blogger sentiment as a useful predictor of market direction.

    But, perhaps we should not overlook how traders, investors and bloggers (myself included) all learn as we go, thereby opening up the possibility that the blogger sentiment index could be an example of a self-improving dynamic system engaged in an adaptive learning process. The most recent two months certainly show promise, and sentiment data from last Thursday's poll (bull-bear-neutral: 50-33-17), with bloggers turning bullish following last week's 4% sell-off, again matches the S&P 500's interim performance so far this week (up from Friday's 1501 close)--though, of course, it is too early to tell how the remainder of the week will turn out.

    What, then, should we believe: the negative overall read from the past year, or the more promising performance of sentiment over the past few months? Rather than allowing our hopes to rise too high, I suggest keeping in mind a market truism: if there really is any predictive power in a well-publicized indicator, opportunistic traders will soon exploit this information, thereby squelching any excess returns that might have been available. Maybe, then, the trick is to be quick--exploit the winning "streak" before it vanishes! Good luck trading!

    Thursday, October 18, 2007

    How can I use the PEG ratio to value stocks?

    Reader's Question: I have a started to pay attention to PEG ratios. Can you please explain how to calculate the PEG ratio for a stock? Can you show how Apple's (Nasdaq: AAPL) PEG is 1.6, as you indicated in an earlier post? How can PEG be used to value stocks? What is a good source for finding estimated five-year growth rates?

    Calculation of PEG

    The PEG ratio is a straightforward way to combine two fundamental aspects of stock analysis for the purpose of gauging how cheap or rich a stock is trading:

  • Earnings: Traditional value-oriented analysis looks at price ratios, the most common of which is the price-to-earnings, P/E, or "PE ratio." At a given level of earnings (E), a lower price (P) results in a lower PE ratio, providing investors with a "cheaper" investment.

  • Growth: Extension of PE ratio analysis to include growth can be accomplished by simply dividing the PE ratio by the earnings growth rate (G), which gives (P/E)/(100 x G), or the "PEG ratio." The factor of 100 is included to convert the growth rate from a percentage to a number of percentage points (e.g., 15% = 0.15, becomes 0.15 x 100 = 15). Since PE ratios are typically around 15 to 20, and growth rates are often in the 10% to 15% range, the PEG ratio is often numerically around 1 or 2 (note that the S&P 500 has a PEG ratio of 1.64, according to data from the Yahoo! Finance Stock Screener). As with PE ratio, a lower PEG ratio generally indicates a "cheaper" stock.

  • To run through an example for Apple (Nasdaq: AAPL): In the earlier post that you refer to, from back in early September, when Apple was priced at $144 per share, the trailing 12 months (July 2006 to June 2007) of reported earnings were $3.55, the one-year forward (to Sep-2008) consensus earnings estimate was about $4.40, and the consensus earnings growth estimate for the upcoming five years was 22.5%. At that time, I calculated the PEG ratio for Apple as follows:

    PEG = {$144/[($3.55 + $4.40)/2]}/(100 x 0.225) = 1.6 (as of close on 04-Sep-2007),

    where I use the average of the trailing 12 months (ttm) and one-year forward earnings to generate a proxy for "current" earnings on an annualized basis.

    Today, with Apple trading 21% higher at $174 per share and the one-year forward consensus earnings estimate having been raised to $4.58 through revisions reported by the 27 analysts covering the company, the PEG ratio calculates to:

    PEG = {$174/[($3.55 + $4.58)/2]}/(100 x 0.225) = 1.9 (as of close on 18-Oct-2007).

    The higher PEG, caused by the rise in the stock price, reflects Apple's richer valuation, versus a month and a half ago. Surely, we would be measurably wealthier today if we had bought Apple in early September at $144 (corresponding to the lower PEG of 1.6) and held our shares through today's close of $174 (corresponding to the higher PEG of 1.9).

    PEG and Returns

    Now, if succeeding at investing were as simple as buying low-PE or low-PEG stocks and selling out at higher PE and PEG ratios, it would seemingly be easy to make money. Generally, what we, as investors, really want to do is maximize our return-on-investment. In other words, while PE and PEG are convenient price ratios that help to describe a stock, ultimately we are more concerned with the compounded annual return, R, in the formula:

    (Price at 5-Year Horizon) = (Price Today) x (1 + R)5,

    where we select a five-year investment horizon to match up with the standard five-year term used in earnings growth estimates provided by Wall Street analysts.

    It is instructive to understand how PE, growth rate and PEG all relate to return-on-investment. By definition of the PE ratio (i.e., PE = P/E), we can write:

    (Price at 5-Year Horizon) = PE5 x E5 = PE5 x E0 x (1 + G)5,

    applying, in the second equality, the definition of earnings growth from today to the end of year five. Setting the right-hand sides of the above equations equal to one another and rearranging, we can write:

    (1 + R)5 = (PE5/PE0) x (1 + G)5,

    recognizing that (Price Today)/E0 = P0/E0 = PE0.

    Although analysts report estimated five-year earnings growth rates (G), the terminal PE ratio at the end of the five-year investment horizon (PE5) is not a commonly reported figure. Since the purpose of this discussion is to look at five-year returns, I am going to assume for the scope of our calculations that the terminal PE ratio equals the analyst consensus five-year earnings growth rate (multitplied by a factor of 100). To see why this is a reasonable assumption to make, let's again look at numbers for Apple: since G = 22.5%, we are assuming that PE5 = 100 x G = 22.5. Today, Apple's PE ratio based on current earnings is about 43. We are essentially assuming that over the next five years, as the company's iPod and iPhone product lines mature and both revenue and earnings growth decelerate, Apple's relatively high current PE ratio of 43 will fall to a terminal five-year value of 22.5, which is about half of where it is today.

    Our terminal PE assmption allows us to rewrite our return equation as:

    (1 + R)5 = (100 x G/PE0) x (1 + G)5 = (1/PEG) x (1 + G)5,

    which tells us that return, R, is high when the PEG ratio is low and the earnings growth rate (G) is high. In other words, in order to maximize our investment return, we are concerned not only with low PEG--we will also want to pay close attention to companies that have high earnings growth rates.

    While our last result is conceptually appealing, it turns out that PE and PEG ratios are more readily available in online databases than the growth rate, G. Consequently, for convenience we use the definition of PEG to rewrite the return equation as:

    (1 + R)5 = (1/PEG) x [1 + PE0/(100 x PEG)]5,

    or, solving explicitly for the return-on-investment:

    R = [1 + PE0/(100 x PEG)]/PEG0.2 - 1.

    To help visualize what this equation means, I provide the graph below, showing contours of constant PE. Observe that calculated returns are higher for lower values of PEG. Also, for a given level of PEG, a higher PE ratio (implicitly indicating a higher earnings growth rate) produces higher returns.

    We can also take a look at contours of constant return, as indicated in the plot of PEG ratio versus current PE ratio below.

    Back to our example for Apple: If we had bought the stock in early September at $144, when the current PE ratio was 36 and the PEG was 1.6, our pro forma five-year annualized return would be 11.4%. The same calculation today with Apple's share price at $174, current PE ratio of 43, and PEG ratio of 1.9 gives a pro forma return of 7.7%. Since the stock price has risen 21%, while our assumptions about future earnings growth remain unchanged, anyone buying the stock today should, of course, reasonably expect to earn a lower return, compared to having bought Apple shares when they were cheaper in early September.

    Application to Dow Component Stocks

    To build our intuition about the relationship of return to PE and PEG ratios, it is helpful to look at actual market data for familiar stocks, such as the 30 components of the Dow Jones Industrial Average. The scatterplot below shows the PE and PEG ratios for each of the Dow 30 component stocks. JP Morgan Chase (NYSE: JPM) has the lowest PE ratio, at 9.5, while McDonald's (NYSE: MCD) has the highest PE ratio, at 25.6. AIG (NYSE: AIG) has the lowest PEG ratio, at 0.78, while Pfizer (NYSE: PFE) has the highest PEG ratio, at 2.74.

    Using our expression for return, R, we can proceed to calculate the pro forma five-year returns based on the PE and PEG data, again assuming that the terminal PE at the five-year horizon equals the five-year earnings growth rate as projected by the analyst consensus estimate. Results are plotted below.

    Notice that there is a very strong correlation between low PEG and high pro forma return. AIG, trading at a low PEG of 0.78 (PE = 9.9, G = 12.7%) produces the highest pro forma return, a very respectable annualized rate of 18%. At the other end of the spectrum is Pfizer, with a PEG of 2.74 (PE = 10.3, G = 3.8%) that leads to a strongly negative pro forma return of -15%. It is the measly estimated growth rate of 3.8%, coupled with the assumption that the terminal PE equals this growth rate (indeed, a PE ratio of 3.8 is awfully low!) that produces the substantial loss on a pro forma basis.

    Cautionary Remarks

    As with most (maybe even all) analytical frameworks for valuing stocks, the formulation presented above has its shortcomings. The pro forma returns are calculated by relying on two key underlying assumptions to make the otherwise formidable problem tractable:

  • Consensus Earnings Growth Estimates: Analysts periodically revise their earnings and earnings growth estimates, based on new information about a company's business plans, the competitive landscape, industry pressures, and the overall economic outlook. Five-year growth estimates, though the "best available" at any point in time, can and do vary considerably from quarter to quarter and year to year.

  • Terminal PE Ratio: While our assumption that the terminal PE ratio at the five-year horizon equals the five-year earnings growth rate may be a reasonable one that allows for a "ballpark" comparison of pro forma returns for investment in many different stocks across diverse industries, it simply is not possible to determine PE ratios so far forward in time with any degree of confidence and accurary.

  • Consequently, we cannot and should not expect the calculated pro forma returns to end up closely predicting the actual returns that will materialize over the next five years. The financial world is complex and continually changing and, with this change, our assumptions themselves need to shift as the months and years go by. Think of stock forecasting models as being like "the man who is always 100% confident, except that his opinion changes from day to day." You see, on any particular day it is possible to peer five years into the future; but you must realize too that our predictions today about future years will generally be very different from our predictions next month about these same future years.

    Nevertheless, the PE and PEG ratios, while having limited predictive power, do remain useful tools for assessing the cheapness or richness of stocks--at least in the current market environment, and at least relative to other stocks in the same or similar industries. For an analysis of potential returns offered by leading U.S. and Chinese Internet stocks, applying techniques explained in this article, please see my recent post highlighting prospects for Baidu (Nasdaq: BIDU) and Google (Nasdaq: GOOG).

    Data Source

    A comprehensive source for stock data is Yahoo! Finance. The Key Statistics page for any listed stock includes the trailing 12-month PE, forward 1-year PE, and PEG ratio. From these PE and PEG ratios, we can obtain the five-year earnings growth rate, G, by working through the definition, PEG = (P/E)/(100 x G). The consensus five-year earnings growth estimates, G, are given on the Analyst Estimates page for any listed stock, along with PE and PEG ratios.

    (Disclosure: Among the stocks mentioned in this article, the author holds or manages long positions in Baidu and Google.)

    Sunday, October 14, 2007

    Is Baidu worthwhile buying now?

    Reader's Question: Baidu (Nasdaq: BIDU) set an all-time record high of $359 (intra-day) on Thursday, before plummeting 14% on news of an analyst's reduced revenue forecast. Despite the sharp price swing, the stock closed on Friday at $323, essentially unchanged for the week. Is the stock now a buy? What do you think about future prospects?

    First of all, regarding the JP Morgan analyst's 2007Q3 revenue cut from $67.9 million to $65.7 million (that's just 3%), I tend to agree in principle with Jim Cramer's comment that it "means nothing to me"--since it's the company's underlying business that drives the stock price in the long run, not what analysts say or write, and, in any event, the analyst, Dick Wei, maintains his overweight rating on Baidu (Nasdaq: BIDU) with a price target of $400. I also think there's a lot of truth in Cramer's remark that "the stock is going to $500,"--however, I do not know if it will take months or years to get there and, if Baidu's recent trading pattern is any indication, the ride from here to $500 is likely to be a very volatile one.

    Revenue Growth Matters

    Although cash flow, earnings and the prospect of future dividends are what determine whether a particular stock will rise or fall in the long run, the key driver of growth is top-line revenue, without which there can be no bottom-line profit. As is very clear from the graph below, between 2004 and 2006, Google (Nasdaq: GOOG) overtook Yahoo (Nasdaq: YHOO), Amazon (Nasdaq: AMZN) and eBay (Nasdaq: EBAY) in revenue generation, catapulting the global search leader into first position among Internet companies. Analogously, as if in a Chinese sequel to Google's success story, during 2007 and 2008, Baidu is expected to sprint past the current Chinese Intenet revenue leaders, Sina (Nasdaq: SINA), Sohu (Nasdaq: SOHU) and Netease (Nasdaq: NTES).

    Among these U.S.- and China-based Internet companies, only Google and Baidu still show annual growth rates exceeding 50%. For 2007, Google's revenue is expected to expand to 58% above its 2006 level, while Baidu's revenue is forecast to surge 108%. For 2008, while consensus estimates show Google's growth slowing to 37%, Baidu's growth is projected at 78%. The message here is that China, being a younger Internet market with still only about 10% of its 1.3 billion population online, exhibits higher growth. A careful look at the graph below also reveals that revenue growth for the other Chinese Internet companies--Sina, Sohu and Netease--is generally expected to accelerate going into 2008, presumably boosted by the positive impact of the upcoming Beijing Summer Olympics on online ad spending by corporate customers.

    Pro Forma Returns

    Clearly, Baidu is growing the fastest among the Internet leaders. However, with its stock price having tripled from its 2006 close of $113, it is now trading around a PE of 145 based on expected 2007 earnings, which most people consider nosebleed territory. Before jumping to conclusions based on PE ratio alone, however, let's see how the expected investment return from holding Baidu over the next few years compares to that for the other companies.

    Using analyst consensus EPS figures for 2007 and 2008, along with the consensus five-year earnings growth forecasts, we can project where earnings are expected to be five years from now for each company. Letting the five-year growth rate also serve as a proxy for the terminal PE ratio at the five-year horizon (consistent with PEG = 1), we can then calculate a terminal stock price for each company, from which we can derive the pro forma return figures shown in the table below.

    Notice that, largely due to their higher expected growth rates, Google and Baidu show the highest pro forma returns, each being a little above 30% per annum. Even if it turns out that the terminal PE ratios end up being just half of what we have assumed, the five-year returns for Google and Baidu will be around 15% per annum, which is still a very respectable long-run rate of return.

    Baidu Is Still a Buy

    Compared to where we were a year ago--when Baidu was trading around $85 on 2006 EPS of $1.08 and revenue of $105 million--the stock trades at a much richer price today. During the past 12 months, Baidu's stock price has almost quadrupled (to $323 at Friday's close), while expected 2007 EPS at $2.22 is a little more than double the level a year ago, as is expected 2007 revenue at $225 million. No longer can we say that Baidu is cheap; however, it does not look outrageously expensive either.

    Today Baidu's market cap is about $11 billion, still just 5.5% of Google's $200 billion, and still inside of the ratio (8.8%) of number of Baidu (3.25 billion) to number Google (37.1 billion) worldwide searches, as reported by ComScore for the month of August If Baidu's market cap quadruples over the next decade, it will approximately reach the level where Yahoo ($38 billion), Amazon ($38 billion) and eBay ($54 billion) presently are--which seems very possible based on the potential size of the Chinese Internet market. Also, as another general indicator of rational valuation, note that Baidu is about four or five times the size of Sina ($3 billion), Sohu ($1.7 billion) and Netease ($2.3 billion), which is in line with the multiple of Google's market cap to that of Yahoo, Amazon and eBay.

    For anyone already long or interested in buying in at today's levels, I would suggest taking a long-term view, not letting the wild day-to-day gyrations of this particularly volatile stock in a volatile market sector ravage your emotions. Potential upside factors to pay attention to are: incremental growth of Baidu's current 58% Chinese market share (versus Google's 23%), in a leader-grab-more manner, mirroring Google's success in the U.S. market; the possibility that Baidu's deployment in Japan begins to show meaningful revenue; future search enhancements following establishment of new research centers in Shanghai and Tokyo. We should also keep in mind, however, the risk that Google, through its partnership with Sina, could begin to wrest market share away from Baidu.

    All in all, I think that Baidu today is still a buy, but with the stock price up some 300% in 12 months, versus year-on-year revenue and profit growth of a "mere" 100%, I cannot be as bullish as I was a year ago. That said, I do see potential for another 300% rise, which would vault Baidu to around $1,300 per share, though this is likely to take another five or ten years. So, unless you like being disappointed, I wouldn't start looking for anything north of $1,000 per share until the Olympics following Beijing, i.e., five years from now in 2012, when the Summer Olympics are in London. Bear in mind, too, that if the Shanghai stock market is a bubble which bursts over the next year, we are likely to have trouble even reaching Wei's target of $400, let alone Cramer's bogey of $500. Let's hope that a year from now we won't find ourselves looking back and reluctantly having to admit that Warren Buffett's recent sale of PetroChina (NYSE: PTR) was prescient--for, at least in the short run, it appears the market is still headed higher.

    (Disclosure: Among the stocks mentioned in this article, the author either owns or manages long positions in Baidu, Google, eBay and Netease.)

    Saturday, October 06, 2007

    Is the Chinese stock market a bubble?

    Reader's Question: What causes asset price bubbles? Have Chinese stocks reached bubble levels? Can you share your perspective on the potential for a Chinese stock market crash?

    The Logic of Asset Bubbles

    Given the commonly accepted conclusion (with 20/20 hindsight, of course!) that the Japanese stock and real estate markets around 1990, dot-com stocks in the year 2000, and current U.S. housing market (now beginning to deflate) are all notable examples of asset price bubbles, and that at least some people are smart enough to learn from the past, it would seem logically to follow that either:

    1) All market players ought to be wiser now and should behave more rationally (i.e., "arbitraging away" bubbles by selling overly rich assets and buying whatever is cheaper), so that future bubbles caused by psychological polarization and excessive asset buying do not have a chance to form, or

    2) Even if not all market players have learned their lesson, at least the more alert and perceptive investors among us ought to have learned from prior bubbles and should now know when to buy and sell to profit from any bubble currently underway.

    If #1 above is true, then the Chinese stock market is not a bubble, since investors are collectively "smarter" now and behave as a group to "nip any bubble in the bud," so that it never forms. Alternatively, if #2 above is true, then there's an opportunity for at least those who have learned from the past (that's both you and I, right?) to become a little richer. . . .

    Before getting too carried away with theory, however, let's see if we can learn anything by looking at some actual Chinese market data.

    Shanghai Premium

    From the vantage point of a U.S.-based investor, the most readily accessible Chinese stocks are those that are listed on U.S. stock exchanges. Some of these companies are listed only in the U.S., like China's dominant search provider Baidu (Nasdaq: BIDU), even though their businesses are inherently Chinese. Others are listed in both the U.S. and Hong Kong, like oil giant PetroChina (NYSE: PTR), whose domestic IPO in Shanghai has been approved but not yet launched (incidentally, PetroChina is also a stock which Warren Buffett has been (for better or worse?) incrementally divesting of late). Still a smaller group of companies is triple-listed: in the U.S. as ADRs (or ADSs), in Hong Kong and also in Shanghai.

    Because current Chinese government policy severely restricts both investment by domestic Chinese in markets outside of mainland China and investment by non-Chinese investors in the domestic Chinese market, the Shanghai stock market is effectively isolated from the Hong Kong and U.S. markets. Consequently, domestic pricing in Shanghai is driven by a different set of supply-demand curves, while U.S. and Hong Kong prices for a particular stock move more or less in tandem, after translation through the foreign exchange rate and ratio of shares per ADS.

    Historically, the Shanghai market has traded at a premium to Hong Kong and the U.S., indicating a higher level of overall demand by domestic Chinese investors for the same stocks. This "Shanghai premium" is most evident if we focus on the handful of triple-listed stocks:

  • Yanzhou Coal Mining (NYSE: YZC, $101.70; Hong Kong:, HKD 15.32; Shanghai:, CNY 22.92), 50 shares per ADS

  • China Petroleum & Chemical Corp., "Sinopec" (NYSE: SNP, $126.81; Hong Kong:, HKD 9.77; Shanghai:, CNY 18.94), 100 shares per ADS

  • Huaneng Power International (NYSE: HNP, $52.48; Hong Kong:, HKD 9.90; Shanghai:, CNY 17.42), 40 shares per ADS

  • Guangshen Railway (NYSE: GSH, $42.30; Hong Kong:, HKD 6.40; Shanghai:, CNY 9.93), 50 shares per ADS

  • China Life Insurance (NYSE: LFC, $95.97; Hong Kong:, HKD 48.35; Shanghai:, CNY 62.41), 15 shares per ADS

  • Aluminum Corp. of China, "Chalco" (NYSE: ACH, $76.85; Hong Kong:, HKD 23.10; Shanghai:, CNY 47.75), 25 shares per ADS

  • (Prices shown above are closing prices on October 5, 2007 for New York and Hong Kong, and September 28, 2007 for Shanghai due to holidays last week. Exchange rates: 7.76 HKD/USD, 7.51 CNY/USD.)

    The graph below shows in percentage terms how the Shanghai premium for these stocks has varied over time, beginning with Yangzhou Coal Mining in 1999 and joined by the other companies as they later became triple-listed, the most recent being Chalco with its Shanghai listing in the middle of this year. Notice how the Shanghai premium contracted from the 200%-400% range in 1999-2000 to zero, on this scale, at the end of 2005. Then, beginning in 2006, the premium resurfaced, gradually building in conjunction with the outperformance of the Shanghai market, to the 50%-100% range where it sits today.

    Taking a broad-brushed approach to highlight general trends, we can see from the graph below that over the past eight years the New York-listed, per-ADS share values of these companies have consistently marched higher, with some price acceleration over the past year or two. There is, of course, plenty of variation among the particular stocks, but the basic trend is as stated--up.

    Examination of the Shanghai-listed per-share values of the stocks, on the other hand, presents a different picture, as shown below. From 1999 through 2005, these stocks in the Shanghai market traded sideways, followed by a quick ascent beginning in 2006. The flatness of Shanghai prices while New York and Hong Kong prices steadily rose during 1999 to 2005 corresponds to the falloff in the Shanghai premium during this time period. The relative outperformance of the Shanghai market from 2006 coincides with the reappearance of the premium over the past two years.

    Which Market Is Right?

    Now, with two strikingly different indications of value--the higher one in Shanghai and the lesser one in Hong Kong and the U.S.--being the source of the Shanghai premium, it would seem that both markets can't be right. Either the Chinese on the mainland are, relatively speaking, paying too much for these stocks, or investors outside of China are not yet paying enough. A common explanation of the situation, based on pent-up domestic Chinese demand chasing too little domestic supply of shares, attributes the valuation "error" to the restricted Chinese investor, suggesting that Shanghai pricing is more overvalued than Hong Kong and U.S. pricing is undervalued.

    Over the years ahead, as the Chinese government fully opens the gates and allows unrestricted two-way capital flow in and out of China's stock market, the Shanghai premium must vanish, since it will then presumably be possible for traders to arbitrage small pricing differences between markets. In the meantime, there is an opportunity, albeit risky, for investors outside of China to go long Hong Kong- and New York-listed shares, based on the expectation of continued upward price pressure through increasing demand from mainland Chinese investors for cheaper offshore shares as Chinese financial policy liberalizes.

    How to Play the Bubble, If There Is One

    To resume our bubble discussion: If the Chinese market is not a bubble (scenario #1 above) and the future GDP and earnings growth implied by current price levels actually does materialize, then anyone long needn't worry so much, since the market is behaving rationally and Chinese stock prices should not collapse, despite their recent run-up. On the other hand, if the Chinese market is a bubble (scenario #2), then, although it is extremely difficult to know when the bubble will burst, investors in Hong Kong- and New York-listed shares can find some degree of comfort in the upward price pressure from the Shanghai premium. In this regard, the New York-listed ADS shares of Chalco and Sinopec, with Shanghai premiums currently around 100%, offer a larger "cushion of safety" than the other four companies, all of which are trading at significantly smaller, though still very sizeable, Shanghai premiums.

    (Disclosure: Among the stocks mentioned in this article, the author has been and remains long at the time of this writing shares in the following companies: Baidu, Chalco and Sinopec.)

    Monday, October 01, 2007

    Have you read the new book, An American Hedge Fund?

    Question: What do you think of Tim Sykes' newly released book, An American Hedge Fund?

    Below is a review I wrote up earlier in the year. Read the book for insight into the hedge fund business, from the point of view of an outsider looking in. It's a captivating story about wealth-building and a young day-trader's tenacity and entrepreneurial spirit.

    A Modern Odyssey: Young Day-Trader Turns Hedge Fund Entrepreneur

    Timothy SykesAn American Hedge Fund is the candid autobiography of a young, spectacularly successful day-trader, chronicling his rapid ascent from $12 thousand in Bar Mitzvah gifts in 1998 to $2.75 million in hedge fund assets at the end of 2005—and his equally dramatic, ego-deflating slide over the next 15 months, halfway down the financial mountain he single-handedly built.

    Mainly, as told from the perspective of a “little guy” newcomer struggling to gain a toehold in the exclusive New York-centric hedge fund scene, this captivating book is a personal finance story, offering a vicarious educational experience for aspiring traders and budding entrepreneurs. From our front-row seat, eyes glued to Tim’s triplet of high-tech trading screens, we follow him on the way up as he nimbly advances from trading publicity plays to overnight gap-ups to short-selling microcaps, and on the way down when he diversifies away from his trading niche through a venture capital investment that unfortunately turns sour. During the Internet craze of the late 1990s, dot-com crash in 2000, post-9/11 market volatility and subsequent bull market, we see play-by-play examples of intraday trades that work for a while but, sooner or later, stop being profitable. In spite of (or perhaps because of) his strikingly high trading volume (annual turnover rate of 200 times fund size!), Tim shows remarkable adaptability, uncannily discovering new market opportunities whenever old ones fade away.

    Parallels exist between self-appointed hero, Tim Sykes, and well-known “giants” of finance. As Tim’s story unfolds, we find him engaged in: trading baseball cards and reselling lost tennis balls, reminiscent of Warren Buffett’s many childhood business ventures; playing high school tennis with a fervor akin to Victor Niederhoffer’s in pro squash, and experiencing a similar reversal of fortune (though thankfully not as shattering as Niederhoffer’s); switching from the long side to the short side of trades, with the agility of George Soros; and suffering through investor withdrawals precipitated by unexpected fund losses, though fortuitously without the crippling leverage that ultimately led to the demise of colossal hedge fund, Long-Term Capital.

    Similarities with the world’s wealthy and famous aside, however, the true richness of An American Hedge Fund lies in Tim’s honest, inspirational and, at times, entertaining portrayal of his personal aspirations, struggles, triumphs, defeats, admission of mistakes and, ultimately, wholehearted tenacity—something the underdog in all of us can easily relate to. Despite misfortune—elbow pain stymies his pro tennis dreams, spotty high school grades preclude him from admission into Ivy League colleges, size requirements prevent deep-pocketed institutions from investing in his small hedge fund, and straying into venture capital brings heavy losses—Tim always finds a way to pick himself up and move on.

    Having battled the microcap market with the fortitude and intensity Odysseus displayed fighting the Trojans, Tim, still a youthful 20-something, now enters the next leg of his life quest, this time in the public spotlight as financial media celebrity and up-and-coming author. Are these latest developments a temporary distraction, or the beginning of a longer-term wandering like Odysseus’s circuitous, decade-long journey home from battle across the Aegean Sea? Whatever Tim’s future may bring, following his formative years of nearly incessant buying and selling of stocks, I find it hard to fathom how he could be content for long without trading.