By TEH HOOI LING
SENIOR CORRESPONDENT





HERE's a happy situation most investors would love to find themselves in. You discover a stock. It is only a tiny company, but the fundamentals are very good. It has put in place new capacity and you are confident the company will be able to make four cents a share this year - an increase of 60 per cent from the 2.5 cents it made last year.

In the market, the shares of the company are trading at 16 cents a share. That works out to be 6.4 times its historical earnings, and four times your expected earnings for this year. With 250 million shares outstanding, the company has a market capitalisation of $40 million.

Convinced of your analysis, you buy the stock. Fast forward to a year later. Your analysis proves spot on, and the company turns in earnings per share of four cents. Its strong earnings growth is reported in the newspapers, and more investors take notice of the stock and a few more people are convinced that the company can continue to grow. The expectation is that it will expand its bottom line by 40 per cent in the coming year, and another 30 per cent the following year.

So its share price is bid up to 34 cents - 8.5 times its last year's earnings, and six times its forecast earnings for this year.

Now its market capitalisation has risen to $85 million. With a more decent size in terms of its market cap, the stock begins to appear on the radar screen of analysts and institutional fund managers.

In the meantime, the company continues to execute on its strategy and is doing all the right things amid a conducive macro environment. It again delivers a strong set of earnings.

That convinces a few analysts who begin to issue research reports on the company. Professional fund managers also start to buy the stock on expectation of its 30 per cent earnings growth next year.

Given that the company is of a more substantial size, analysts and fund managers reckon it deserves a high price-earnings multiple. So its share price is bid up to 73 cents. That's 13 times its this year's earnings and 10 times its forecast earnings for next year.

By this time, the market cap of the company is in the region of $180 million. And if its prospects remain good, even bigger funds will be attracted to it and its PE multiple is likely to expand even further.

So if you are fortunate enough to spot such a company early on, don't make the mistake of selling out too early. In addition to the earnings growth, also look for the PE expansion - that is, as long as the prospects remain good.

From the charts of FerroChina, Advance SCT, Hongguo and FJ Benjamin, you can see that the market caps tend to climb pretty fast after certain thresholds have been hit.

Just like all living things, there is a life cycle for stocks as well. As a company grows, the market's perception of it will change over time and this will often affect valuations and the stock price.

Citigroup Global Markets' equity research team has this radar screening which aims to model both the fundamental 'valuation' component of a stock's returns and the behavioural or 'market perception' element.

A stock can be in one of four categories: contrarian, attractive, glamour and unattractive.

A stock is a contrarian buy when it has a sound business with good earnings prospects, but is inexpensive because it is overlooked by the investment community.

Then perhaps one or two quarters of good results later, investors became aware of a stock's potential and buy it. Price momentum improves and analysts start to follow the stock. Earnings revisions are positive and momentum improves more. That's when it enters the 'attractive' quadrant.

The strong performance of the stock's share price attracts even more investors - be it institutional or retail. And it becomes fashionable to own the stock. Here's how Citigroup describes it: 'Investor interest helps drive the stock price and valuation higher. The stock no longer looks inexpensive (it has got ahead of its fundamentals), yet it remains in favour and momentum remains strong. It now sits in the 'glamour' quadrant.' Arguably Raffles Education and Olam International could be said to be in this quadrant.

And if investors continue to bid up the shares, at some point, some investors will recognise that valuations are stretched. They will start selling and momentum will deteriorate. The stock falls into the 'unattractive' quadrant until fundamentals catch up, when it might again become 'contrarian'.

A stock can slip into the 'unattractive' quadrant if its fundamentals, or the industry it operates in, begin to deteriorate. Then the company will have to sort its operations out, or ride out the down cycle. During that time, investors will forget about the stock, and at some point, the stock - unless it falls into severe distress and goes bankrupt - will eventually slide into the 'contrarian' quadrant again.

This is obviously an idealised path, and at any time fundamentals or perception can change, says Citigroup. For example, anticipating future earnings, investors might buy a stock, and in so doing push the stock into the 'glamour' category. However, if the company delivers earnings, valuation will improve and the stock would move back into the 'attractive' quadrant.

Similarly, a stock in the 'contrarian' category might start missing its earnings and/or earnings growth estimates may fall. This would lead to justified valuations falling - and hence it may start looking expensive, that is, it would migrate into the 'unattractive' quadrant. There are a few drivers that affect the share price and its position in the four quadrants.

As mentioned, rising stock prices attracts attention and that creates momentum. All else being equal, it will propel a stock from the contrarian quadrant to glamour.

Also, large-cap stocks are more highly valued than small-cap stocks. This could be due to the liquidity premium accorded to larger stocks, since that will allow institutional funds to buy into them. So as the stock price rises, so too its market cap. And as a result, there will be an increase in the justifiable valuation of the stock. Thus, a glamour stock can move back to being an attractive stock now that its valuation is justifiable.

Meanwhile, the raising of growth estimates by the analysts community will lead to higher justified valuations for certain stocks. This could move a stock from unattractive into the attractive quadrant.

And finally, rising interest rates will translate into lower theoretical valuations, making most stocks unattractive based on their previous price levels.

This framework allows investors to appreciate the dynamics of a stock's market value relative to its fair value. As shown, one has to constantly review the numerous variables at play.

Using that framework, Citigroup has categorised Korea and Thailand as contrarian. Hong Kong and Australia are attractive. China, Singapore, Malaysia, India and the Philippines are in the glamour bracket. And finally, Taiwan is deemed unattractive.

For Singapore stocks, those in the contrarian quadrant include Singapore Petroleum, MobileOne and Macquarie International Infrastructure Fund. SingTel, Venture, StarHub and Jardine Cycle and Carriage are attractive. In the glamour quadrant are OCBC, Singapore Exchange, F&N and CapitaLand. And finally, Chartered, StatsChipPac and Parkway are in the unattractive quarter.

The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg