JEDDAH, 19 June 2006 — To determine a proper price for a firm’s stock, the analyst must forecast the dividend and earnings that can be expected from the firm. This is the heart of fundamental analysis — that is, the analysis of the determinants of value such as earning prospects. Ultimately, the business success of the firm determines the dividends the firm can pay to shareholders and the price it will command in the stock market.
Because the prospects of the firm are tied to those of the broader economy, fundamental analysis must consider the business environment in which the firm operates. For some firms, macroeconomic and industry circumstances might have greater influence on profits than the firm’s relative performance within its industry. It often makes sense to do a “top-down” analysis of a firm’s prospects. Analysis starts with the broad economic environment, examining the state of the aggregate economy also considering the international economy. From there, one has to consider the implications of other outside environment on the industry, in which the firm operates. Finally, the firm’s position within the industry has to be critically reviewed.
The macro economy is the environment in which all firm operates. The importance of the macro economy in determining investment performance can be easily analyzed looking into the Tadawul All-Share Index (TASI) to projected earnings per share of the TASI 80 companies. Stock price tends to rise along with earnings, while the exact ratio of stock price to earnings varies from factors such as interest rates, risk, inflation rates, and other variables, as a general rule the rates tends to be in the range of 15 to 25. Given “normal” price-earnings ratios we expect the TASI index to be around 10,000 as for fair market value. Although the earnings multiplier clearly is not perfect, the dramatic increase in the price-earnings multiple in recent years is difficult to sustain. Despite last two week’s return to optimism in the stock market; markets are jittery, week ending May 18 the market was up by 9.96 percent followed by week ending May 25 down by 5.98 percent. Nagging concerns continues to confound the Tadawul. Last week the market acted poorly. At times it feels it needs one shot of espresso or latte first thing in the morning to wake-up the sleepy market. Recent volume increases reflects the additional need of some buzz. With positive economic signals and hopefully positive quarterly earnings release, investors still find themselves in a quandary. Given the market volatility it is crucial to determine near-term investment decision. Trimming the exposure to stock market and into money market may provide a temporary recourse. If one maintains a healthy exposure to the stock market, emphasis should be to the financial sector along with economically sensitive stocks such as housing related and insurance stocks.
Recommended exposure to building an investment portfolio: Equity 60 percent, fixed income 20 percent and the remainder in cash 20 percent. Equity should be further invested 60 percent in the TASI and 40 percent in international stocks. Domestic equity, exposures by sector: Banking 15 percent, industrial 15 percent, cement 15 percent, service 15 percent, electrical 10 percent, telecommunications 10 percent, insurance 10 percent, and agricultural 10 percent.
Create a benchmark for each sector and allocate funds to meet the risk adjusted investment objectives. Manage and change sector allocation as economic conditions change on a quarter by quarter basis. Strategy is to gain access to a comprehensive equity exposure to the portfolio and consider “absolute return” with “rebalancing” over an economic cycle-typically 18-months to 36 months.
(Faisal Alsayrafi is president & CEO of Financial Transaction House.)
