The coronavirus has plunged the stock market over the past weeks. Stock valuations are nearing lows last seen since the Global Financial Crisis. While others panic, the successful investor would seize onto this great opportunity to buy great businesses at a cheap price.
First, we recognise that great businesses are resilient and will start reaping handsome profits once the economic downturn ceases. So identify high-quality businesses to invest in, never mind the prevailing fearful economic mood. But before investing during this COVID-19 crash, here are five things an investor should consider.
Note: This is neither a recommendation to purchase or sell any of the shares mentioned in this article, and the information here is for educational purposes and/or for study or research only.
1. Income vs growth
An important consideration before investing in the stock market is to decide whether you are investing for growth or income.
If you are investing for income, a number of Singapore stocks and REITs pay out pretty decent dividends. For example, if you invest in Netlink NBN Trust or Ascendas REIT, you can expect to reap an annual dividend yield of around 5.5% and 6.3% respectively (as of 20 March 2020). In fact, the recent comedown in Singapore REITs have seen their average yields rise as high as 10.5%. And unlike U.S. stocks, the dividends you receive from investing in SGX-listed stocks are tax free.
However, it is important to remember that a high dividend yield stock doesn’t necessarily mean it’s a good business. The plunging share price of a stock due to poor fundamentals can cause its dividend yield to look deceptively high.
If you are investing for growth, U.S. stocks like Amazon, Alphabet, and Facebook are fundamentally good businesses that would be resilient enough to bounce back even stronger from the COVID-19 crisis. Their room for growth is huge given their global reach and the economic moats they have established for themselves.
2. Home or foreign stocks
Another aspect you need to consider is your comfort level towards investing in overseas markets. While investing in your home market gives one the added advantage of localised knowledge, investing in foreign markets like the U.S. gives you huge growth opportunities that may not be possible in your home market.
For example, if you are going for capital gains rather than dividends, investing in U.S. stocks like Amazon gives one a lot more potential upside. The potential capital upside of Singapore companies is limited given the small domestic consumer base which they predominantly serve.
It’s fair enough to say that the choice between investing in the local and overseas market need not be a binary one, and you can always invest in both.
3. Capital allocation
If you prefer a dividend-leaning portfolio as opposed to a growth-oriented one, you could allocate 70% of your capital to dividend stocks and the rest to growth. The reverse is true if you prefer a growth-oriented portfolio. Keep in mind that which way you lean depends on your personal financial situation, investment goals, and risk profile.
You’d also want to diversify your portfolio across 10-20 stocks. In the book Modern Portfolio Theory and Investment Analysis, authors Edwin J. Elton and Martin J. Gruber concluded that portfolio volatility is reduced by 70% by owning six stocks in your portfolio, by 76% with 10 stocks, and by 81% with 20 stocks.
4. Stock valuation
Assuming you have done your due diligence and identified some great companies to invest in, the question is: When do you go in?
Remember, a low stock price does not always mean that the stock is undervalued. To find out, we need to have a look at a stock’s valuation. One way of valuing a stock is to compare its price-to-earnings (P/E) ratio with its long-term historical average. It reflects how the market, as a collective, prices the stock with regards to its earnings.
For example, Apple’s historical average P/E over the last 10 years is 15.8. (Based on Apple’s latest annual earnings per share of US$12.66, that would give Apple an ‘intrinsic value’ of US$200.03.) As a value investor, we prefer to invest in Apple if it trades below its historical average — and especially when there’s a significant margin of safety. In Apple’s case, that would be near one standard deviation below the historical P/E average (12.3).
Apple P/E chart. Chart: YCharts
As you can tell, despite the recent crash in prices, Apple’s P/E is still above its historical average — because it was overpriced to begin with — and you may prefer to wait some more to see if Apple’s stock price corrects further.
5. Investing bit by bit
A black swan event in COVID-19 has sent the market spiralling downwards. Even if I invest with a margin of safety, the market could still be southward bound. In other words, I catch a falling knife. But it’s also hubristic to think I can anticipate when the market has bottomed.
So don’t invest all your capital at one go; deploy your capital in tranches. I’ll illustrate this point here:
Let’s say I have $10,000 to invest and choose to allocate my capital equally among 10 stocks. That would mean I have $1,000 set aside for a single stock.
We can first invest 40% of our capital ($400) in a stock when it trades 10% below its intrinsic value. If the stock price falls another 10%, we deploy half of our remaining capital ($300). If the stock price falls another 10%, we deploy the rest of our remaining capital ($300).
However, unlike SGX-listed dividend stocks which can trade below S$1 per share, some U.S. companies like Amazon and Alphabet trade in excess of US$1,000 per share. In this case, given our limited capital, there’s no way we can deploy our investment using all three tranches, so you may have to make do with one or two.
Using lower cost brokerages like Interactive Brokers, Saxo Markets or FSMOne can also help to reduce fees when you’re deploying multiple tranches. For example, Saxo Markets charges a minimum of US$4 per trade for U.S. stocks (compared to US$20 for brokerages in Singapore), and FSMOne charges a minimum of S$10 per trade for Singapore stocks (compared to S$25 normally). You can compare the fees among brokerages when investing in Singapore, Malaysia, and the U.S. here.
The fifth perspective
It’s understandable why we are fearful in these uncertain times, but it’s also during these moments where the best opportunities arise. As long as you do your due diligence and pick high-quality companies to invest in during this market crash, you’ll be able to ride out the volatility and set your portfolio up for sizeable gains down the road.
In the immortal words of Warren Buffett:
‘Be fearful when others are greedy and greedy when others are fearful.’