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If you can measure it, you can manage it

Apr 06 2016 12:53
Schalk Louw

Without numbers, terms such as “chances are” and “probably” would have no real meaning. Without chances and probability, the only way to approach risk would be through fate or destiny. Without numbers, risk would be based on nothing more than a hunch.

We live in a world full of numbers and calculations – from the clock that tells us the time on a daily basis and telephone numbers that can connect us to people all over the world within seconds, to how many teaspoons of sugar you put in your coffee or tea. It is difficult to imagine a life without numbers.  

With the availability of numbers and calculations we have been able to develop another very handy aid: the benchmark. This always reminds me of the very popular saying, “If you can measure it, you can manage it.”

Warren Buffett, one of the world’s most famous and successful investors, said that he is often labelled as a value investor, something that he does not necessarily agree with.

He sees himself as a focused investor who bases investment decisions on probability; with the historical data (numbers) at his disposal, how likely is a company’s share price to rise or fall? 

When we take a look at our own stock market, we also have historical data at our disposal to determine the level of risk we can take in this particular type of investment.

In effect, we are measuring the probability of a further rise or drop in the market or a specific share price. 

A very popular benchmark is the historical price-to-earnings ratio (P/E). The P/E is the ratio between the share price and earnings (profit) of the company.

It is calculated by dividing the company’s share price by the last reported earnings (usually released annually and bi-annually). The P/E usually moves in the same direction as the share price.  

Let’s suggest that share A currently trades at R10 and the most recently reported earnings per share (EPS) is R2. The P/E, therefore, would be 5 (R10 ÷ R2), or 5 times. If the share price rises to R12, the P/E will rise to 6.

If the company increases its earnings by 25%, the EPS will rise to R2.50. If the share price continues to trade at R12 per share, the P/E will drop to 4.8. This gives us a fairly good indication of how cheap or expensive a share is.  

Although the historical P/E (21.5 times) of the JSE’s All Share Index is currently trading at a 20-year high, it is rather the statistical scope of this number that has me concerned.

I am well aware of the fact that this data is historical and, as such, doesn’t guarantee any form of future performance, but with the historical P/E now trading higher than 19.9 times, it means that statistically, it is trading at two standard deviations above the 20-year historical average P/E.

Without unpacking the whole term, it basically means that the P/E has only been able to trade above 19.9 times on a weekly basis 0.63% of the time – less than 1%. 

If you want to base your decisions on historical data only (something you should be wary of), it means that at current levels, there is a 99% probability of a drop in the market.

The probability of further capital growth simply doesn’t look as rosy as it did four years ago and I expect that we will encounter an old friend called volatility this year.

I’m not saying you should abandon the stock market at all, just be cautious in making your decisions and guard yourself against overweight positions.

*Schalk Louw is a portfolio manager at PSG Wealth.

This article originally appeared in the 24 March 2016 edition of finweek. Buy and download the magazine here.   

warren buffet  |  companies  |  finance  |  investment
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