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Slough of despond

Created:
17 June 2008
Written by:
Mr Bearbull

At times like these it pays to keep a close watch on the despondency index. This is my barometer of stock-market sentiment that gets its name from a famous investment aphorism by one of the 20th century's great investors, John Templeton. Amongst other things, he suggested that the contrarian way to investment success was "to buy when others are despondently selling".

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The implication is that in every bear market there comes a point when demoralised investors give up in despair. At that point, they crave the relief of not having to watch their net worth and/or their self esteem sink lower every day. So they sell at almost any price. As a result, they give away their stocks at silly prices. Simultaneously, according to the Templeton dictum, investors with "patience, discipline and courage" take this as their cue to buy.

Some months ago I suggested readers should monitor the despondency index since when, in some stock-market sectors, shares prices have been sucked deeper into a slough of despond. That said, in this bear market, more than any I can recall, short selling is confusing the issue. I suppose this is to be expected. After all, the bar has been raised from where it was even 10 years ago, so traders are compelled to find ways to make money from even the most unpromising situation.

In other words, share prices are being forced down by more than just despondency. And that extra factor is the fire-power of the hedge funds. Or, at least, that is what the City's regulator, the Financial Services Authority (FSA) would have us believe in issuing a rule that prescribes tough new disclosure requirements for anyone short selling shares in a company involved in a rights issue.

Perhaps the FSA's new rule will be a temporary solution, but that does not make it good. The FSA has allowed itself to be driven by the self-interest of the City's corporate finance departments and the whingeing of the institutions that effectively insure rights issues. Worse, the FSA is disingenuous. What it calls the "increased potential for market abuse through short selling during rights issues" (ie, collaboration by hedge funds) is more likely the collective self interest of a group that knows full well the shortcomings of the UK’s rights-issues process and is willing to exploit them ruthlessly.

Yet these shortcomings have been known since the City was a cosy club, and more than one enquiry has identified the problems only to see nothing happen. Still, perhaps we should look on the bright side - the consequences of Bradford & Bingley's rights-issue fiasco and the effective exclusion of, for example, Barratt Developments from the rights process looks like creating the resolve to do something about it.

Short selling aside, there seems to be no lack of despondency among some sectors, most obviously the banks and housebuilders. In addition, many retailers shares are not far behind. The price of all the sector-leading non-food retailers is at least 50 per cent below their all-time high and, in the case of electricals retailer DSG International (formerly Dixons), at 54p, it is 76 per cent off its peak.

In other words, for the year just ended the shares are trading at less than seven times the earnings that DSG’s bosses have forecast. Alright, we should not pay much attention to a backward-looking PE ratio, especially as trading is deteriorating group-wide. But what about the dividend yield? True, by the end of 2008-09 the dividend will have been cut three years running - DSG’s bosses forecast a payout of just 4.4p. But even that generates a yield of 8.2 per cent. I might argue, this is plenty to be going on with while management sorts out the unwieldy sprawl of the group.

Of course, DSG's treatment may be too expensive - management has already talked of the need to take almost £400m in write-offs in the year just ended, and capital spending will have to be raised by about a quarter over the next three years. Additionally, the patient may not even respond.

But, when all is said and done, the company’s shares are being offered at what looks like an incredibly low ratio of price to sales per share. DSG’s equity has a market value of £956m yet the group's annual sales are about £9bn, making the price-to-sales ratio just 0.1 times.

And, arguably, when share prices are trapped in the slough of despond, it is this ratio - price to sales - that is the one to focus on. That's because dividends and especially profits, by their very nature, are residual amounts that come and go easily. In comparison, sales may wobble but they are far more stable. As such, they indicate the potential of a group to make profits. It is that potential which gets forgotten - or at least badly underpriced - during times like these.

So DSG's shares are another to add to my Shares to Watch list. But one that has made it from watch list to portfolio is shares in nursing homes operator Southern Cross Healthcare (see Bearbull, 23 May 2008). The latest market jitters have pushed the shares below my buy target. So I have bought 7,500 for the Bearbull Growth Portfolio at 379p each. This is the first stock I have bought for nine months. But don’t take that as a sign that Bearbull is now stressing the second syllable of his name.

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