| Home |
The first quarter of 2006 is over. Now is a good time to reflect on stock prices and the opportunities they present.
Bargains are scarce. Equities are expensive. In recent weeks, Ive heard several fund managers say valuations are still attractive. I dont agree. Generally speaking, valuations are unattractive. Returns on equity are higher than historical levels. A market-wide return on equity of 15% is unsustainable. Price-to-earnings ratios may not fully reflect how expensive stocks are. Price-to-book ratios are more alarming.
There are two additional concerns. Most discussions of the relative attractiveness of equities focus on the S&P 500 and forward earnings. The S&P 500 is not the most representative index. It may not be the best index to consider when looking at market-wide valuations.
Forward earnings are (necessarily) estimates. Where current returns on equity are unsustainable, projected earnings that use similar returns on equity may overstate the earnings power of equities in general. This can occur even where the estimates appear reasonable given current earnings. If you start with unsustainable base earnings, you are likely to overestimate future earnings even if you truly believe you are assuming very modest earnings growth.
Assets in general are pricey. Value investors have few places to turn if they continue to insist upon a true margin of safety.
Bonds are unattractive. Long-term inflation risks make U.S. treasury, corporate, and municipal bonds a fools bet. There is little to gain and much to lose. The know-nothing investor who buys a top-quality bond today and holds it for decades may very well find his purchasing power diminished.
There may be some select opportunities in foreign equities. But, these are difficult to evaluate. Foreign government obligations are also difficult to evaluate, but that isnt much of a problem for value investors, because most foreign government debt is priced to perfection. Youll have to be willing to take a lot of uncompensated risks if you want to own such bonds.
Of course, there are exceptions to every rule. There may be a few bonds out there that are attractive. There certainly are a few attractive stocks out there. But, even those stocks that look very attractive relative to their peers dont look nearly as attractive when compared to past bargains.
Value investors face a difficult choice. They can assume stock prices will return to historical levels, and hold cash until the correction comes. Or, they can accept the reality they currently face.
There is no logical reason stock prices must necessarily return to historical levels. During the twentieth century, real after-tax returns in diversified groups of common stocks were very high relative to other investment opportunities. There have been various reasons given for why this occurred. Many have said these returns were possible, because of the higher risks involved in holding equities. Over the long-term, risks were somewhat higher than todays investors seem to remember, but they were hardly severe enough to justify the kind of performance spreads that existed during much of the twentieth century.
True, if you bought at inopportune times, it was possible to remain in a fairly deep hole for a fairly long time. But, if you gave no real consideration to the timing of your purchases or the prospects of the underlying enterprises, you did better than many bondholders who chose their investments with the utmost care.
This is a disconcerting problem. It may be that most investors are overly sensitive to the risk of an immediate paper loss in nominal terms, and therefore overlook the much greater risk of a gradual loss of purchasing power. Issuing fixed pound obligations may be the best bet for any business or government that seeks to swindle investors.
For the sake of the common stockholders, I hope many of the best businesses continue to issue such obligations when money is cheap. Corporate debt gets a bad name, because it tends to be overused by those who dont need it and shouldnt want it (and, of course, by those businesses that do need it but won’t survive even if they get it). The businesses that would benefit the most from the use of debt usually appear to have more cash than they could ever need. But, its best to think ahead. For truly high quality businesses, the cost of capital will fluctuate far more wildly than the likely returns on capital.
If, during the last hundred years, stocks really were far cheaper than they should have been, is there any reason to believe stock prices will return to past levels? The past is often a pretty good predictor of the future but, not always. Its difficult to say whether, over the next few decades, valuations will, on average, be higher or lower than they are today. However, it isnt all that difficult to say whether, at some point over the next few decades, valuations will be higher or lower than they are today. The answer to that question is almost certainly yes. They will be higher and they will be lower. Maybe for a few years or a few months. Maybe for a full decade. I dont know.
What I do know is that value investors will have opportunities to make investments with a true margin of safety. But, should they wait?
Thats the most difficult question. Today, I am not finding opportunities that look particularly attractive when compared to the best opportunities of past years. But, I am still able to find a few (in fact, a very few) situations where the expected annual rate of return is greater than 15%.
That will be more than enough to beat the market. It will also likely be enough to provide a material increase in after-tax purchasing power. Thats not guaranteed, but it hardly seems holding cash would offer the better odds in this regard.
So, is an expected annual rate of return of 15% good enough? Is it reasonable to bet on the good opportunity that is currently available instead of waiting for the great opportunity that may yet become available?
Ill leave that for you to decide.
If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for but a moment, you will recognize how truly foolish it is.
A stocks earnings yield is the inverse of its PE ratio. So, a stock with a PE ratio of 25 has an earnings yield of 4%, while a stock with a PE ratio of 8 has an earnings yield of 12.5%. In this way, a low PE stock is comparable to a high yield bond.
Now, if these low PE stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low PE stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.
All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical. Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; its false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; hes comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitchers handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitchers handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You neednt determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is attractive. Likewise, you neednt determine whether the market is undervalued or overvalued; you need only determine that a particular stock is undervalued. If youre convinced it is, buy it the market be damned!
Clearly, the most prudent approach to investing is to evaluate each individual security in relation to all others, and only to consider the form of security insofar as it affects each individual evaluation. A top down approach to investing is an unnecessary hindrance. Some very smart investors have imposed it upon themselves and overcome it; but, there is no need for you to do the same.