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Have you ever read any stock analyst’s recommendation reports that ends with stock ratings like this?
“This stock has a fair value of $13. With a last done price of $10, we see an upside potential of 30% for this stock. We reiterate a conviction BUY on this stock”.
When I was still working as a technical analyst in a stock research firm, I often see my fellow fundamental analyst colleagues publishing stock reports that ended with such favourable stock ratings.
Very often, investment calls like these are all that is needed to convince the hundreds of thousands of retail investors and traders out there to rush in blindly to purchase such “good and cheap” stock.
After all, who else other than those stock gurus from Wall Street is more capable to offer better stock advice ?
Who in the right frame of mind wouldn’t want to own a stock that has an upside potential of 30%?
Unfortunately, the outcome might not be as straightforward as you might expect.
What kind of returns would you prefer?
Let me start off by asking you a set of hypothetical questions:
1) Would you prefer a +20% potential upside return on the stock you invest in?
2) Or would you prefer a +5% potential upside return on the stock that you invest in?
You must be thinking, “Of course it’s the stock with a 20% potential upside! Who in the right frame of mind will buy a stock that only has a 5% potential upside return compared to one with 20%?”
Just like the stock ratings with the 30% upside potential that I shared earlier on, the answer to my above hypothetical questions seems like a no-brainer to most people.
But before you tell me your preference, let me rephrase my questions slightly so that you can see things more clearly:
1) Would you prefer a +20% potential upside return on the stock you invested in, over a total period of 10 years?
2) Or would you prefer a +5% potential upside return on the stock that you invest in, over a total period of 1 month?
Have you now started to shift your stand? Why is that the case?
A 20% potential upside return over a total of 10 years is actually just a small return of 2% return per annum, while a 5% potential upside return over a single month is in fact a huge return of 60% per annum!
Now, who in the right frame of mind will choose the option of the 20% potential upside return over the one that has a 5% potential upside return?
How following strong stock ratings can make you lose 65% of your capital
The chart that you see below is a very useful piece of information that you can get if you subscribe to the US$2000/month Bloomberg Financial Data Terminal.
It is a compilation of the stock ratings by all the fundamental analysts who has a research coverage on SembCorp Marine, a blue-chip oil and gas stock listed on the Singapore Exchange (SGX).
And mind you, these stock ratings were researched and published by fundamental analysts from all the top notch stock research powerhouses including Goldman Sachs, Bank of America Merrill Lynch, J.P. Morgan, Morgan Stanley, Credit Suisse, Deutsche Securities, HSBC etc.
Let’s take a look at the period in Jun 2012, when the stock price of SembCorp Marine was around $4.90.
About 90% of the fundamental analysts covering SembCorp Marine were recommending a BUY stock rating with an average price target of about $5.90.
This meant that the stock analysts were on average, implying an upside potential return of about 20% for this particular counter.
Don’t that sound like a fantastic opportunity to accumulate this stock?
Ironically, even as the price of this stock trended lower subsequently, most of the stock analysts continued to recommend their clients to accumulate this “great” and “cheap” under-valued stock,
Despite the persistently falling traded price, the average target price by the analysts consistently averaged a 20% upside potential throughout 2012 to 2013. God knows maybe beyond 2013 as well.
Sadly, the stock never lived up to its upside potential. The stock did not come anywhere close to the price target of $5.90 over the next three years.
The stock did not even see any form of a 20% rally or recovery at all.
The stock simply trended lower persistently and by 11 Dec 2015, SembCorp Marine has plunged to an 8-year low of $1.73.
That was a paper loss of around 65% while most of the Wall Street gurus were calling for a 20% upside potential throughout those years!
By the way, would you like to guess how much will SembCorp Marine has to recoup from this 8-year low of $1.73, in order to reach back its break-even level of $4.90?
A whopping 183%!!
What disillusioned investors tell themselves
Many disillusioned investors or even those stock gurus who made the BUY recommendation 3 years back would have told themselves, “Don’t worry. This is a good stock. It will head back to break-even price and climb even further to our original target price of $5.90 sooner or later.”
For the sake of satisfying these investors’ hopes, let’s just theoretically assume that SembCorp Marine miraculously halt its current decline immediately (if it ever happens) and start to embark on a strong recovery over the next 2 years.
If things go according to what we have hoped for and assumed, the stock price should overcome the original break-even price of $4.90 and reach its original target price of $5.90 by 2018.
On paper, we would have finally achieved this 20% upside potential after a total holding period of 6 full years.
Now, let’s calculate what is your per annum return on this particular investment, shall we?
An investment return of 20% over 6 years, averages out to be around 3.3% return per annum.
Considering the painful and uncertain ride over those 6 full years, does this upside potential return of 20% (or 3.3% per annum over 6 years) still sound that attractive to you?
Moreover, imagine the missed opportunities to buy other rising stocks while your capital was locked up in this uninspiring SembCorp Marine investment over that 6 years?
Timing is of the essence
So what is the moral of the story that I am trying to share with you in this article?
Potential upside has no meaning, if you do not take into consideration, the amount of time you will realistically need to take, to capture that upside return
Yes, the keyword here “Timing”. In fact, timing is of the essence in any investments or trades.
After all, your investment returns is equal to:
(Your exit price – your entry price) x number of shares you bought, DIVIDED by the number of years that you held on to that stock.
Your returns have nothing to do with how much upside potential yout stock has at any point in time.
This is something that many of the fundamental stock research analysts do not spend enough time thinking about when they issue their investment calls to those pitiful retail investors, who look up to them for sound and supposedly, TIMELY investment advices.
Regardless how attractive a stock might appear to be from a valuation point of view, these fundamental stock analysts failed to establish for their clients whether it was indeed the right timing to start buying.
Or how long it might realistically take for their customers to realise those “upside potential”.
So what should you do for yourself?
So what can you, as a responsible investor, do in the future when you come across other stock ratings that have upside potential return of 30%, or even 40%?
I’m not saying that you should write off the validity of those stock ratings, or invalidate how good those stocks are fundamentally.
What I’m suggesting is that you should determine whether it is indeed the right time yet, to start buying the stock.
There are a few simple things you can do to make sure you do not repeat the same mistakes again, like in this SembCorp Marine case study.
In the future, before you make the decision to buy a stock that has a very positive stock ratings that suggests a strong upside potential return, please do the following:
Pull out the stock chart of that particular counter for a look, with the use of an intuitive stock charting web application.
Draw your trend lines and make sure that the stock that you are intending to buy is not falling persistently.
If the stock price is falling persistently, don’t touch it!
Set a technical alert to inform you when there are clear signs of a bullish reversal from a downtrend to an uptrend.
Consider buying the stock only when the uptrend is forming.
That will set you up to buy a stock with a strong fundamental upside potential at the BEST POSSIBLE TIMING.
Still, plan for the worst outcome.
However, even with the both the technical signs and fundamental valuation giving you the conviction to enter, things might not always work out in the end as well.
You should always have a predetermined level to exit with a small loss should the trade reversed south suddenly and sharply.
This is a risk management strategy to conserve your capital, so that you will still have enough ammunitions to participate in the next better opportunity that might come along in time to come.
If you are disciplined enough to practice what I’ve shared above, you are already way ahead of the millions of inexperienced retail traders and investors out there.
Good luck and please share this piece of investment knowledge with your friends!
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