Investment Knowledge

You always work hard to earn more. But shouldn’t your earnings also work hard for you?

Sun Life MPF, dare to innovate, we work harder to make your hard-earned money work harder for you

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You always work hard to earn more. But shouldn’t your earnings also work hard for you?

Sun Life MPF, dare to innovate, we work harder to make your hard-earned money work harder for you

There is a common saying “Good companies may not always be good investments”. Even if you have done in-depth fundamental analyses and identified a good company with sound business, strong management, long-term growth prospect, good profitability and solid financial strength, buying at excessive valuation could still lead to severe loss. Valuation is of crucial importance to successful investing.

Price to earnings ratio
Price to earnings (P/E) is a widely known and popular valuation tool used by investors. It is calculated by dividing a company’s share price by its earnings per share in a year. So if the share price is $10 and earnings per share is $1, the P/E ratio of that stock would be 10. It helps provide a quick comparison for determining whether a stock is cheap or expensive as it measures how long it would take, in years, for the company to earn sufficient money to justify its current valuation. Assuming profits remain the same, a P/E ratio of 10 indicates a ten-year cost recovery. There are two types of P/E ratio, namely trailing P/E and forward P/E. The former one is based on the most recent reported one-year earnings of a company, whilst the latter one refers to the forecasted earnings (one or two years ahead) by analysts. It appears that a company traded at a trailing P/E of 30 is somewhat expensive, but its forward P/E may be as low as 15 if earnings is expected to double over the next year. While the forward P/E ratio takes into account the prospect and earnings growth of a company, we should be mindful of analysts’ aggressive assumption of earnings forecast.

Relative valuation and historical comparison
There is no absolute answer as to what P/E ratio should be, so that we can conclude whether it is high or low. What constitute reasonable ratios also vary from sector to sector. For instance, P/E ratios of high growth technology companies may reach 20 or above, whereas public utilities with stable earnings normally trade at much lower P/Es. It is not right to simply compare the two P/E ratios to say one of them is undervalued because of the difference in business nature. A better way is through comparison in the same industry or with key competitors. Given their comparable business and size, we can compare P/Es among peers and industry average and further determine the value of a company in relation to that of others. This is known as relative valuation approach. Another way is looking into historical P/E over the past ten or twenty years and figuring out where the current P/E stands along the long term trend. If it deviates from the average by one or two standard deviation, one should note that the market may be overly optimistic or pessimistic in valuation and should beware of mean reversion over time.

Do not rely on just one gauge
Investors should look at a broad range of valuation metrics and financial ratios, in order to form a more comprehensive view of any company. Besides P/E, there are a variety of valuation measures, including price to sales, price to book and price to cash flow, and various profitability margins such as gross profit margin, operating profit margin and net profit margin. The level of return on equity and return on capital employed are key measures to give an indication of the efficiency of the management. It is equally important to look into debt to equity ratio and cash flow to net financial costs, which specifically indicate the strength of a company’s financials. 

Important Note:

1 This article, which is for informational purposes only, sets forth the views as of the date published. The foregoing information provided is for illustration purpose only. It is not a recommendation to purchase, sell or hold any particular products/funds. The underlying assumptions and these views are subject to change without notice. There is no guarantee that any forecasts expressed will be realized. The information contained in the above article is obtained and/or compiled from sources believed to be reliable and current. The Company cannot and does not warrant, guarantee or represent, either expressly or impliedly, the accuracy, validity or completeness of such information. The Company makes no express or implied warranties or representations with respect to any performance data contained herein (including its accuracy, completeness and timeliness). The Company accepts no liability whatsoever for any direct or indirect consequential loss arising from use of any information, opinion or estimate herein.
2 Investment involves risks and past performance is not indicative of future performance. Investment return may rise as well as fall. You should advise the prospect(s)/client(s) to read the relevant principal offering document for further details and risk factors prior to making investment decision.
3 This document has not been reviewed by the Securities and Futures Commission in Hong Kong or any regulatory authorities.

A terminology we always hear when talking about investment is diversification. The concept of diversification was popularized by Nobel-laureate Harry Markowitz which he first introduced in the Fifties. Markowitz’s mathematical-based model is commonly known as Model Portfolio Theory (MPT). But despite its long history, not everyone have a good grasp as to what diversification really means. An often used analogy to explain the virtue of diversification is “Don’t put all your eggs in one basket” – in order to spread or reduce your risk. In some people’s mind, reduction of risk is equivalent to reduction of return, which is an inaccurate yet unfortunately fairly prevalent interpretation. We would like to take this opportunity to explain the concept of diversification.

Diversifying risks
A key benefit of diversification lies in risk reduction, i.e. lowering volatility and the overall risk in an investment portfolio. When investing in a security in Hong Kong, such as a bond or equity, investors are taking specific risk (non-systematic risk) and market risk (systematic risk). The former risk is more related to factors that apply only to that security, such as business, earnings, financial strength and so on. The latter one is more on macro level, stemming from economic, geographical, political, social factors of Hong Kong. As specific factors of an individual security may be unrelated to those of another security, a portfolio with a reasonably large number of securities can achieve reasonably good diversification of specific risk. But the portfolio remains exposed to the systematic risk of the market. To reduce market risk, investors may consider to expand the investment universe to include securities outside their home country – mitigating systematic risk of a single market.

One can further diversify across different asset classes. Defensive assets such as bonds and cash likely tend to perform better during periods of high market volatility, while growth investments like stocks may provide attractive returns when economic conditions are expected to be more favourable. By mixing different asset classes with low correlation can help to reduce systematic risk of a single asset class portfolio.

How to achieve diversification with investment funds
It is not easy for general public to construct a well-diversified portfolio of individual securities. An alternative way that is also gaining in popularity is through the use of investment funds, which are professionally managed forms of portfolio. There are investment funds that invest in equities by capitalization and sectors, and by markets and styles. There are funds that invest in bonds with various credit ratings and maturities from different bond issuers. Regional funds or even global funds can possibly further enhance diversification with exposure to broader markets. These days, investment funds, whether they are direct retail funds or MPFs, are being offered with very low minimum investment amounts. Hence, they can form readily assessable building blocks for people who wish to construct their own unique investment portfolios.

Prior study suggests that when pension plan participants are presented with a wide array of self-directed investment choices, they have a tendency to follow a simple, yet somewhat naïve, diversification strategy1. This is known as the “1/n diversification rule”, where n is the number of different fund choices, or specifically they placed 1 share in each and every available investment choices. While this may appear as a way to achieve wide diversification, it is highly subjective to the variety of fund choices being offered. For instance, if the majority of investment choices in the plan are equity funds, placing 1 share in each fund might still result in a portfolio that skew towards higher risk. The key to diversification is not so much the number of funds we invested, but how well investments are spread across different asset classes, different countries, and different sectors.

Not a one-time task
Diversification is not a done-once-and-forget exercise. On the one hand, day-to-day market movement could lead to significant change to the investment mix over a period of time that deviates from the initial weightings and probably increase concentration risk. On the other hand, during major financial crisis like the one occurred in late-2008 and 2009, markets saw a dramatic increase in correlations among risky assets. These assets’ value plunged sharply and concurrently and in turn undermined the effectiveness of diversification. As market dynamics change from time to time, asset correlations do not stay constant. Such dynamism should be tested and investment portfolio should be reviewed on a regular basis so as to better manage portfolio risk.

1 Bernartzi, Shlomo and Richard H. Thaler. ‘Naive Diversification in Defined Contribution Savings Plans.’ American Economic Review 91(1), (2001): 79-98.

Important Note:

1 This article, which is for informational purposes only, sets forth the views as of the date published. The foregoing information provided is for illustration purpose only. It is not a recommendation to purchase, sell or hold any particular products/funds. The underlying assumptions and these views are subject to change without notice. There is no guarantee that any forecasts expressed will be realized. The information contained in the above article is obtained and/or compiled from sources believed to be reliable and current. The Company cannot and does not warrant, guarantee or represent, either expressly or impliedly, the accuracy, validity or completeness of such information. The Company makes no express or implied warranties or representations with respect to any performance data contained herein (including its accuracy, completeness and timeliness). The Company accepts no liability whatsoever for any direct or indirect consequential loss arising from use of any information, opinion or estimate herein.
2 Investment involves risks and past performance is not indicative of future performance. Investment return may rise as well as fall. You should advise the prospect(s)/client(s) to read the relevant principal offering document for further details and risk factors prior to making investment decision.
3 This document has not been reviewed by the Securities and Futures Commission in Hong Kong or any regulatory authorities.

Thanks to continued efforts of the government and the industry in retirement education, people in Hong Kong are more concerned with and take more responsibility towards their own retirement. There has been much more focus on the accumulation stage, during which people accumulate wealth through continuous savings and discipline investment.  While that’s all well and swell, it is only half of the task. The decumulation stage is as important as the accumulation stage to assure savings are sufficient to cover many years of retirement living. Below we highlight some key aspects in post-retirement arrangement.

Longevity risk
When planning for retirement, it is quite common to refer to life expectancy at country of birth, both as a starting point to estimate an individual’s length of retirement and as one of various parameters to project overall retirement needs. Without due attention, any underestimation of lifetime could lead to outliving retirement resources, which in turn put retirees at risk of cutting back on expenditures or curtailing their standard of living. However, lifetimes are difficult to predict with accuracy as life expectancy figure is merely an average, with some people living longer and others living shorter. One more point is that the figure measures how long, on average, a person is expected to live (taking into account infant, child and adult mortality). Statistically speaking, the elderly alive at this point in time will likely live longer than the average of all people who are born in the same year.

As per the Department of Health of HKSAR Government, life expectancies at birth for both sexes have steadily increased during the past decades, from 67.8 years for males and 75.3 years for females in 1971 to 81.1 years and 86.7 years respectively in 2013. In this sense, people should deal with life expectancy statistics prudently and provide factor of safety for their own lifetime estimation.

Investment of retirement assets
The strategy for investing at retirement should be different from investing for retirement. In accumulation stage, people generally invest in risky assets and take advantage of market volatility so as to achieve long term capital growth and appreciation. Over time, investment portfolio gradually shifts allocation mix to lower risk investments and aims for delivering more stable capital growth as well as minimizing risk. Heading into retirement, the primary investment objective is no longer growth-oriented but capital preservation and income generation.

High quality government bonds and corporate bonds with strong financial position and proven interest and principal payment record commonly form a core part of retirement investment. Laddering strategy, which spreads investment among multiple bonds with increasingly longer maturities, is commonly used. Interest and principal payment from bonds in a ladder can provide scheduled cash flows to meet day-to-day expense. Bond funds investing in high quality government bonds and corporate bonds are also viable option, especially for retirees who have less experience in bond investment.

Inflation is an ongoing concern. Given retirement life spanning 20 years or more, even low rates of inflation can erode purchasing power of retirees who live on fixed income. Inflation-indexed bond, which provides a hedge against inflation, could be a solution. But such investment vehicle is subject to very limited issue each year in Hong Kong and comes with rather short-term maturity period. Indirect method to protect against inflation through equity is another option. Despite their higher price volatility, a combination of high quality bonds with a minor allocation in equities generally forms a good diversification and adds value in risk-adjusted return from a portfolio perspective.

Ageing population is not a cause of concern for Hong Kong alone, but also for most of developed countries or regions. Post-retirement planning stage is a seriously important matter. Longevity and investment arrangement of retirement assets are two of major issues that retirees-to-be and retirees have to carefully deal with. In addition to that, others such as healthcare and medical costs, housing needs, change of family situation, legacy, unforeseen needs, and etc, are worthy of detailed consideration.

Important Note:

1 This article, which is for informational purposes only, sets forth the views as of the date published. The foregoing information provided is for illustration purpose only. It is not a recommendation to purchase, sell or hold any particular products/funds. The underlying assumptions and these views are subject to change without notice. There is no guarantee that any forecasts expressed will be realized. The information contained in the above article is obtained and/or compiled from sources believed to be reliable and current. The Company cannot and does not warrant, guarantee or represent, either expressly or impliedly, the accuracy, validity or completeness of such information. The Company makes no express or implied warranties or representations with respect to any performance data contained herein (including its accuracy, completeness and timeliness). The Company accepts no liability whatsoever for any direct or indirect consequential loss arising from use of any information, opinion or estimate herein.
2 Investment involves risks and past performance is not indicative of future performance. Investment return may rise as well as fall. You should advise the prospect(s)/client(s) to read the relevant principal offering document for further details and risk factors prior to making investment decision.
3 This document has not been reviewed by the Securities and Futures Commission in Hong Kong or any regulatory authorities.

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