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Investors: Do This 2 Things to Avoid Sickening Losses

Stock markets as a whole tend to march upwards over time – this is probably old news to many investors and is reflected by the experience of market indexes like the Straits Times Index (SGX: ^STI) in Singapore and the S&P 500 in the U.S.A.

For instance, the duo has gained some 122% and 478%, respectively, since the start of 1990 despite the world having faced near-constant dangers.

But, beneath the veneer lies a darker truth. Although the market as a whole might be marching slowly and inexorably upwards, individual companies can have vastly different experiences. How different? Consider these statistics:

  • According to a study by the bank J.P. Morgan, more than 40% of all the shares that ever existed in the Russell 3000 index (an American share market index that’s made up of 3,000 of the largest American companies; it represents a very large slice of the entire U.S. stock market) since 1980 have declined permanently by 70% or more from their respective peak values.
  • I looked at all 818 shares listed in Singapore which data provider S&P Capital IQ has data on currently (this excludes shares which have been de-listed for one reason or another prior to today) and found that 44% of those shares are currently still down by 50% or more from their all-time highs; the respective peaks for those shares occurred prior to 1 January 2010, so it’s likely that their losses are permanent too.

The widespread number of shares with massive long-term losses makes it vitally important that we, as investors, aim to avoid potential landmines as much as we can. And to do so, here are two things you can do.

1. Run from exorbitantly-priced stocks

When the Nikkei 225 index in Japan was near its peak of 38,900 points in late 1989, it was valued at around 100 times its earnings. That’s an absurd situation of paying $100 for every dollar of profit that Japanese companies earn. The index subsequently – and unsurprisingly – collapsed and even today, sits more than 50% lower at 17,900 points.

In Singapore, egregious examples would be Blumont Group Ltd (SGX: A33) and Asiasons Capital Limited (SGX: 5ET). Both were part of an infamous trio of penny stocks which crashed by up to 96% in value in the space of less than a week back in October 2013; near their peaks, both shares carried price/earnings (PE) ratios of more than 500.

Penny stocks are not the only ones susceptible to overhyped valuations – even blue chips which are part of the Straits Times Index can fall prey too. The property developers CapitaLand Limited (SGX: C31) and City Developments Limited (SGX: C09) are great examples.

CapitaLand and City Developments' valuations and busines growth

Source: S&P Capital IQ

Both shares had only managed to eke out pitiful compounded annual growth rates in their per-share book values prior to 2007, but yet had carried really high PB ratios in that year. At today’s prices, CapitaLand and City Development have fallen by 45% and 59%, respectively, from their all-time highs in 2007.

2. Scrutinise really cheap shares

Buying shares when they’re cheap gives investors good odds of success – that’s an obvious thing about investing. But, shares with really low valuations can still be expensive mistakes for investors if they have really poor businesses.

A great case in point would be the frozen fish supplier Pacific Andes Resources Development Ltd (SGX: P11). It had an incredibly low PE ratio of 2.1 back in early December 2008 when its shares were at S$0.14 each. But, investors who had bought into the company’s shares back then because they thought they were getting a bargain would instead have acquired a rude shock – the company’s shares are now down by a massive 57% at S$0.06 each.

Pacific Andes ROE and TDE ratio

Source: S&P capital IQ

Pacific Andes’ poor business-economics (as reflected in the chart above depicting the company’s incredibly low returns on equity despite the use of sky-high leverage) and precipitous drop in per-share earnings from 6.825 Singapore cents in December 2008 to 3.265 cents today had been massive drivers for investors’ dismal experience with the company.

A Fool’s take

It’s a lot easier to end up with duds than investors likely have imagined, and that’s why it’s vital that we aim to side-step potential landmines. And although avoiding absurdly-valued shares and being very careful with shares carrying “dirt-cheap” valuations are certainly not the only way we can insulate ourselves from losses, they are still valuable tools we can add to our investing tool kit.

For more investing analyses, stories, and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.