Are stocks cheap enough to buy now?

Markets have also been swooning since the week before (Feb 24 - 28), with the USA experiencing its worst week since the Global Financial Crisis when the Dow Jones Industrial Average crashed 12.4 per cent.

Our local Straits Times Index fared just slightly better, falling "just" 5.3 per cent the week before. That Friday, Feb 28, saw the index dive by 100 points, an event not seen since May 2019.

With bad news still swirling around, investors are understandably nervous and wondering if markets could crash further.

The million-dollar question now is whether stock prices are cheap enough to buy as valuations have accounted for the effects of the viral outbreak.

Could prices dip lower, or is this the turning point where stocks bottom and then reverse direction?

Let's dig deeper in order to provide a realistic assessment for the current situation.

GETTING A GRIP ON VALUATIONS

At the heart of fundamental investing are valuations.

Valuations represent how cheap or expensive a share is in relation to its earnings and cash flow generation capability, and serves as a sanity check when investors approach the market to either buy or sell.

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As share prices tumble, valuations will obviously look cheaper. However, investors should remember that earnings will also correspondingly tumble as the virus disrupts supply chains and negatively impacts various industries around the world.

So, how does an investor know when valuations are "reasonable" enough for them to be able to buy?

There are a few ways of looking at this.

One method is to look at the dividend yields for companies that generate consistent free cash flows. As share prices tumble, dividend yields head higher as they are an inverse function of the share price.

However, in order to buffer against potential dividend cuts, factor in a 20 per cent to 25 per cent cut in dividends and then recalculate the dividend yield.

If the yield still looks attractive and the company has a great track record of weathering crises, investors can consider buying some shares.

An example to use may be SATS Ltd. For fiscal year 2019, the group paid out a total annual dividend of $0.19. This translates to a yield of 4.6 per cent based on the share price of $4.14.

As SATS is one of the companies directly affected by the Covid-19 virus, we can assume a 25 per cent cut in dividends as earnings will get pressured.

This translates to an annual dividend of $0.14 along with a dividend yield of 3.4 per cent.

Investors need to decide if they are happy with this level of yield, keeping in mind that business could recover strongly once the virus situation blows over.

Another method is to look at the average price-earnings ratio (PER) for the company over the last five years. If the PER dips below this five-year average, it could mean that the company is cheap and could signal an opportunity to buy some shares.

SPACING OUT YOUR PURCHASES

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Valuations are just one aspect of the stock market, though.

Sentiment could always push share prices down to bargain-basement levels.

That's why it's important to space out your purchases, rather than going "all in". Using up all your cash at one go means you will have no opportunity to continue buying should share prices fall further.

Buying at regular intervals is also a good method for assessing new events as they crop up.

These events may or may not affect the investment thesis, but at least they allow the investor a chance to consider if he is doing the right thing.

Going all in at once leaves you vulnerable to unexpected events that could invalidate your original thesis, possibly forcing you to lock in a larger loss than if you had pumped in smaller amounts.

CHEAP COULD GET CHEAPER

Finally, it's important to keep a cool head.

As share prices and valuations continue to crash due to persistent bad news, there's always a chance that cheap could become much cheaper.

Investors who buy at periodic intervals need to be psychologically prepared for temporary losses as bad news drives down sentiment further.

However, as long as you are confident that the company is fundamentally sound and that its business can recover post-crisis, you should just sit tight and not let this bother you.

BEING MENTALLY PREPARED

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So, you have decided that stocks are cheap enough to buy a little. Remember to space out your purchases as valuations could plunge further as more bad news is reported.

Being mentally prepared for short-term losses is also important as keeping your cool will allow you to continue to buy as the market falls.

Market corrections are great opportunities to accumulate shares in strong companies at beaten-down valuations. Don't miss out as such opportunities do not come often!

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This article was first published in The Smart Investor. All content is displayed for general information purposes only and does not constitute professional financial advice. Disclaimer: Royston Yang owns shares in SATS Ltd.