Are you getting scared by another potential Chinese stock meltdown? On Tuesday 27th February 2007, Shanghai stock market plunged by 8.8% and it brings the world market with it. Back home, the Dow Jones Industrial Average plunged more than 400 points while the Nasdaq Composite index weakened by 99 points. It is long overdue. Chinese Exchange Traded Funds such as Xinhua China 25 index (FXI) and Greater China Fund Inc. (GCH) plunged 9.9% and 13.7% respectively. The Chinese market has leaped 130% in 2006 and trading at all time high before the precipitous fall. As an investor, what adjustment should you make in case similar drop occur in the future?
Well, the answer is nothing. If you have been investing in stocks below fair value, the recent drop should make your stock is a more compelling opportunity. Let me revisit what fair value of a common stock is quickly. When interest rate in your local bank is 4% and the 10 year treasury bond yields 5%, your common stock should yield more than that. Some wants 6%, others may want 7% from their common stock yield. In the case of 7% yield from a common stock, the fair value of a common stock under this circumstance is when it reaches a Price Earning ratio of (1/ 7%) = 14.28. This means that for a stock trading at $ 14.28, its profit per share should be at least $ 1.00.
That is fair value in brief. Our job as investors however is to buy stocks that is trading below fair value, not at fair value. Fair value is the point when we sell our investment. Thus, even when other markets are doing bad, your stock is already trading below fair value anyway and other investors may in fact flee to undervalued common stocks when things turn sour.
Therefore, during the market correction, you should watch out for potential investments that you have always want to buy but at a lower price. For example, some potential common stocks for investment that fell include: Novell Inc. (NOVL), Dell Inc. (DELL), Advance Micro Devices Inc. (AMD) or perhaps OmniVision Technologies Inc. (OVTI). You can be sure that stocks with highest Price Earning ratio tends to fall the hardest in a brute sell off.
The moral of the story is don't get scared. You also need to know the fair value of your common stock before pressing that buy button. Once you have done the proper research, you will be less likely to be panic and sell at an unfortunate time. Oh yes, it does take time. There is no free lunch.
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