Disclosure: The article was first written on Saturday, November 13, 2010 at 12:53am. It reflects the writers personal opinions based on own analysis. The writer is not responsible for decisions taken on the basis of this article. Send your views at kh.asif@gmail.com.
The two kinds of adverse impacts on stock prices
During a market correction/crash there are two kinds of adverse effect on listed stocks.
One is what we call the “beta affect”. Most stocks are positively correlated with the market and since the market falls they fall as well. This would mean that when there is a significant correction there would not be a single stock that will be safe. However, the extent of the decline in stock prices would vary from company to company.
The other effect is the “earnings” effect. The companies that depend on the capital market for earnings will fall in this category. These would include banks, non banking financial institutions, insurance companies, brokerage houses and merchant banks. These should be the worst affected because not only are they seeing the beta affect but also they see earnings fall.
Breaking down the stock price
One very common ratio we use in the stock market is the Price/Earnings ratio. Basically, it shows how much price we are willing to pay for 1 taka of earnings for any specific company. Companies with higher p/e are ones that are expected to have higher earnings growth figures. Another way of looking at the ratio is to say that high P/E stocks are more expensive. Now,
“ stock price”=” earnings per share” x “the P/E people are willing to pay”
Now we can relate the stock price with the earnings effect and the beta effect. Because of the correlation with the overall stock market people will be willing to pay less (a lower P/E) for the same amount of earnings.
Any other effects
For companies with earnings effect we can also think of something similar to a Keynesian multiplier. If we go back to introduction to macroeconomics and relate to the financial sector of Bangladesh we can see a surprising similarity. This one would apply to companies who earn profits from trading in stocks. Let me explain through an example.
Suppose there are 5 banks in the stock market. Each of them start buying the stocks of the other ones. Due to higher demand stock prices will rise. Then, they will sell some of these shares for a profit and now because they are having higher profits their stock prices will rise even further. This way the cycle goes on and on. This was probably a very simplified and crude example. But the point I am trying to make is that if you can see stock prices going up due to multiplier effects so can they go down due to multiplier.If the first banks price declines, then the profit of all the other banks will fall and so will the stock prices. Then the profit of the first bank will fall because it holds the shares of the other 4 banks.
The only silver lining is that the financial institutions in Bangladesh record stock prices at cost in the balance sheet. So as long as market prices of their stock investments remain above cost their book values/shareholder's equity would not decline. However earnings would definitely take a hit. (I know these two lines are slightly complicated to understand for non accounting/finance based students but I had to put them here).
Conclusions
1.If you have a broad market correction no single stock will be a safe investment. However, the extent of the price reduction will differ across companies.
2.Companies with earnings exposure to the capital market will be the most risky ones.
3.The companies to hold should be those that are undervalued and are likely to report good profits in 2011 and 2012(How to determine whether a stock is undervalued or not is beyond the scope of this small note). These stocks will not only fall less compared to other stocks but will also bounce back faster because of better earnings figures.
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