Buy Below 12 and You Could Be Rich!

The trade tensions continue. But the ASX 200 and the Dow Jones haven’t even blinked. We’re up 2.4% for the year and 8.9% since 2017.

Investors in China, however, are copping it on the chin.

The Shanghai and Shenzhen Composites are both down 15–16%. Hong Kong’s technology index, the Hang Seng, is down about 13% from its high earlier this year.

And this could be just the start.

Chinese investors aren’t the only ones worried. Economists also fear the worst. The trade tensions could slow down global growth, just when central bankers thought it was picking up.

It might even force the Reserve Bank of Australia’s (RBA) hand to prolong any future interest rate increase.

So many things to think about…

The ones who love it all are Chinese companies. They haven’t had a chance to buy back stock at these prices in years.

Buy-backs head to record levels

According to South China Morning Post (SCMP), buy-backs on the Hong Kong exchange are heading for a historical high. This means companies are using cash to buy their own shares.

A total of 52 companies posted 363 transactions worth a whopping HK$6.73 billion (US$857 million) in the first eight trading days of July. The buy-back figures so far this month are already more than the averages for July from 1992 to 2017 of 24 companies, 211 trades and HK$761 million,’ SCMP wrote.   

After purchase, these shares are retired. It’s a bit like buying share certificates and then ripping them up, reducing the total amount of shares in existence.

SCMP continues:

If the heavy buy-backs continue, will record highs in July translate into a sustained rebound in the Hong Kong market in the medium-term?

Not likely as the buy-backs so far this month are far below the record highs of 127 companies and 1,783 transactions in October 2008. The buy-backs then were preceded by a sharp drop in the market from 31,492 points in November 2007 to 11,015 points in October 2008.

The market rebounded sharply following the record buy-backs in October 2008 to 22,914 points in November 2009, an increase of 108 per cent.

Comparatively, the fall in the market in the past month of 11 per cent is small compared to the 65 per cent drop from the fourth quarter of 2007 to the fourth quarter of 2008.

MoneyMorning 17-07-18

Source: SCMP
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And I’ll bet savvy investors are joining companies in the buying activity.

In fact, following companies that buy back their own stock can be a winning strategy. In December 2016, investor Mohnish Pabrai wrote a whole article about it in Forbes.

He called it the Uber Cannibals. The idea was to invest in companies that aggressively bought back their own stock.

With a portfolio of five uber cannibals (rebalanced every 12 months) Mohnish has shown you can do far better than ‘the average’. The five stocks in January 2017 included:

  • Lowe’s (LOW)
  • NVR (NVR)
  • The Hackett Group (HCKT)
  • Select Comfort (SCSS)
  • Willis Lease Finance (WLFC)

And in a little over a year, Mohnish’s uber cannibals returned 30.6%.

MoneyMorning 17-07-18

Source: Chia with Pabrai
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But what’s behind this remarkable return? How can you earn returns far higher than the market by doing little to no work?

One reason might be that investors simply like companies that buy-back their own stock. If they see an aggressive buy-back plan, they’re eager to jump on for the ride.

Another reason might be the repurchases themselves. Aggressive buy-back plans can sometimes number a few billion dollars. Such demand for the stock could push up the shares over the short-term.

But I suspect an Uber Cannibal strategy is effective because it follows an important value principle — buy when stocks are cheap.

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Why should you buy below 12?

I’m not one for charts. But I’d like to show you one. Below is a chart of the Hang Seng. I’ve drawn little circles of when the index’s price-to-earnings (PE) ratio fell below 12-times.

MoneyMorning 17-07-18

Source: Bloomberg
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Easy rule to follow. Just buy below 12. And had you followed this rule you could have made (assuming you sold on the ending year):

Year Return
94-97 85%
98-00 120%
05-07 87%
09-11 73%
11-15 49%
16-18 45%

Does this mean you should buy any and all assets trading under 12-times earnings? No. The point I’m trying to get across is not pattern recognition or to blindly follow indicators.

There are many times when a company buying back shares won’t produce the returns you expect. The same goes for indexes and stocks trading at low PEs. More often than not, these low multiples can be justified by poor future prospects.

But the message I want you to take away is what both of these strategies try to accomplish. And that is to buy assets for less than they’re worth.

Your friend,

Harje Ronngard,
Editor, Money Morning

PS: If you’ve got an interest in the share market, but completely new to the whole deal and don’t know where to start…this report is for you. Get started now.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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