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Stock valuation is also determined by its trading liquidity

Asia Analytica
Asia Analytica • 7 min read
Stock valuation is also determined by its trading liquidity
Aside from the macro implications, liquidity is also an important factor behind individual share price movements and valuations.
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Much has been written on how the current stock market rally is one that is driven by retail investors against a backdrop of massive liquidity, the trillions of fiat money injected into economies from unprecedented fiscal and monetary stimulus measures to counter the effects of the Covid-19 pandemic.

Owing to the urgency of the situation, many of the aid measures implemented were blunt. While these measures were deemed necessary to mitigate the fallout by protecting productive capacities, jobs and livelihoods, a good portion of the money also found its way into financial assets, including stock markets. Hence, the strong and quick V-shaped recovery in stock prices around the world. We touched on this topic in our article last week.

Aside from the macro implications, liquidity is also an important factor behind individual share price movements and valuations. Empirical evidence shows that there is a positive correlation between trading liquidity and share prices.

In Chart 1, we tracked the historical share turnover (liquidity) for the 100 biggest companies listed on Bursa Malaysia against their PE multiples, both weighted by market caps to obtain the averages. In the years in which share turnover/liquidity was rising, there was corresponding PE multiple expansions — that is, higher share prices relative to underlying earnings — and vice versa.

In school, we were taught that the fair value of a stock is derived by discounting all of its future cash flows using the weighted average cost of capital. We still use this mathematical formula. But as seen in Chart 1, theoretical fair valuations on paper and market prices in the real world are oftentimes not the same things. In practice, there are qualitative factors involved in the pricing process, chief among which is liquidity.

Liquidity can drive share prices and support higher-than-otherwise market valuations. And this is to be expected. Higher trading liquidity implies lower risks of being stuck without the ability to liquidate. Lower risks, in turn, give the stock a higher valuation as the theory indicates.

For instance, it is widely accepted that most foreign funds will invest only in large cap companies with relatively high liquidity. The liquidity is important to allow for rapid exit, if necessary, without triggering a price collapse. This is one of the reasons why most big caps typically trade at higher PE multiples.

Conversely, a smaller illiquid stock — one that cannot be easily converted into cash — is riskier and will therefore carry a liquidity premium, usually in the form of lower market valuations.

For retail investors, holding a relatively illiquid stock may not be a bad proposition, if the market valuations are at a sufficient discount to underlying fundamentals. Positive news flow can lead to big upward re-rating, attract broader investor interest and, with it, greater liquidity that will reduce the previous liquidity premium — thus, enhancing total returns for shareholders.

For example, the sudden increased investor interest in Singapore-listed Avarga sent its share price and trading volumes sharply higher in late August (see Chart 2). The surge was triggered by rising lumber prices, which will boost earnings for its Canada-based building materials distribution business, as well as speculation of possible monetisation of its Malaysian paper manufacturing and Myanmar power generation businesses.

In other words, liquidity can be created, though it can also be transient. Excessive liquidity can also result in greater volatility in share prices.

Look no further than the glove-maker stocks. The sector is one of the very few that benefited from the pandemic — there was a huge surge in demand and selling prices for gloves, which boosted profit expectations. That, in turn, drew massive investor interest, raising both trading volumes and shares prices for glove-maker stocks. The effects of rising liquidity and share prices were exaggerated in a positive feedback loop.

As analysts, we are focused on discovering value. But in reality, analysts are equally guilty of chasing narratives.

Chart 3 shows the share price for Top Glove, the world’s largest glove maker, as well as analyst recommendations and target prices over the past months. Clearly, its share price had started rising fast and farther away from target prices, which then resulted in analysts raising target prices and “buy” recommendations, repeatedly, to keep ahead — in order to capitalise on the robust trading volumes. The same pattern is seen for Hartalega in Chart 4.

Momentum trading is a legitimate strategy that can be lucrative — provided you understand and accept the inherent risks. And be honest about it. To try to justify higher and higher target prices with fundamentals just will not wash.

Recall that we wrote about a broker report that postulated Top Glove’s fair value could be as high as RM110 (pre-stock split) in July, when its shares were trading at around RM25 (or about RM8.30 post-stock split).

That mind-boggling valuation is based on 52 times PE multiples on peak earnings, assuming that selling prices for gloves can rise 10% every month through FY2021. Forget the fact that the stock’s PE averaged only 24 times in the past 10 years. Any analyst worth his salt must know full well that the abnormal earnings are never going to be sustainable beyond the next few quarters.

Is it rational that Top Glove’s fair valuation could top RM296 billion, making the company more valuable than Maybank, Public Bank, Tenaga Nasional and Petronas Chemicals combined?

Even when it was obvious that their share prices were running so far ahead of what is justifiable by underlying fundamentals, there was no one brave enough to call a “sell” on either stock in the midst of the trading frenzy — and, it appears even today after the inevitable correction sets in.

Share prices for the seven listed glove makers on Bursa have fallen by more than 46% from their highs, on average. Investors unfortunate enough to read and follow these analyst reports would be sitting on substantial losses. While no one can predict the future, are investors made sufficiently aware of how these target prices are derived and the risks involved?

Following the sharp price correction, analysts were once again playing catch-up, or rather, catch-down in this case — some are starting to pare back lofty target prices and/or downgrading the stocks. A case in point: A foreign brokers’ report dated Sept 9 downgraded Top Glove from “outperform” to “underperform” and cut its target price by half, from RM10.13 to RM5.40. It begs the question, what has changed so drastically overnight, in terms of fundamentals, aside from the share price collapse?

The US stock market suffered a steep selloff over the past one week, which spilled over and dragged down stock markets globally. This may not necessarily be a harbinger of worse to come — a correction is healthy for the longer-term sustainability of the rally following the market’s record-breaking run.

This is particularly true for high-flying tech stocks, where valuations are stretched, some bordering on irrational exuberance, after strong gains since the March lows. Shares in Tesla fell more than 21% last Tuesday, its worst single-day loss in history. We have previously highlighted the company’s hugely inflated valuations relative to its underlying fundamentals. Cyclical stocks, on the other hand, fared comparatively well in this latest selloff.

Stocks in the Global Portfolio mirrored this broader market trend — with large tech stocks such as Adobe (-10.2%), Alphabet (-9.9%), Alibaba Group Holding (-7.7%), Microsoft (-8.8%), Qualcomm (-7.4%) and ServiceNow (-8.3%) among the biggest losers.

Shares in Johnson & Johnson (-2.7%), Home Depot (-3.5%), Builders FirstSource (-1.9%), BMC Stock Holdings (-2.1%) and Bank of America (-2.0%) were comparatively more resilient.

The portfolio fell 6% for the week ended Sept 10. The loss pared total portfolio returns to 31.5% since inception. Nevertheless, this portfolio is still outperforming the benchmark MSCI World Net Return index, which is up 19.8% over the same period.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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