Construction of a sound
portfolio of stocks or portfolios of funds is accomplished through the use of
effective tools used properly. One of the many tools discussed in Graham and
Dodd’s basic investment primer Security
Analysis is the P/E ratio, the price divided by earnings per share. I suspect that this measure, or similar tools,
has been used by professional investors ever since financial disclosures were
available.
As with any tool, one
first must examine how the tool is constructed and when it can be used
propitiously. Otherwise, to the amateur carpenter (investor) with a hammer,
everything looks like a nail to drive into a surface. If there are lots of
hammers around and everyone is using them chaotically, not many houses
(portfolios) will be built that will give the eventual owners a competitive
advantage.
These concerns surfaced
to me after this weekend reading “Dissecting the Variety of Price-Earnings Ratios” by Liz Ann Sonders of
Charles Schwab. She raises concerns about three approaches; 12 month Forward
P/E, Trailing 12 month P/E and Robert Shiller’s Cyclically Adjusted P/E (CAPE).
I share her concerns with all three approaches, but particularly CAPE. All of
them are the product of statistics, not analysis. In each case the data used is
as reported, with the good professor using it ten times regardless of the
lengths of the business or market cycles. Most of the time most markets seem to
be more selective in utilizing published results in terms of stated and
unstated non-recurring events, including tax and accounting changes. Further,
none of these measures as used by commentators take into consideration non-recurring
events as to the competitors. I agree with her when she quotes the esteemed Howard
Marks of Oaktree Capital who prefers to use the inverse of the P/E or earnings
yield, which is often used in the UK. The advantages of the earnings yield is
that it is easy to attempt to get a real return by deducting an inflation rate
and them comparing it to yields available in the bond market.
The whole concept of
using the level of earnings in a valuation model is to be able to compare over
time whether a stock, market, or fund is more highly valued or less, compared
to the past. In his attempt to give a longer term view of earnings, Professor
Shiller used a passage out of the before-mentioned Security
Analysis authored by Benjamin Graham and my old professor, David Dodd when
they were attempting to use history as a guide to the present. When they wrote
their seminal text they focused on the average business cycle which by 1934 was
running at least 6-10 years. (In more modern times the average business cycle
has gotten shorter.) Perhaps more importantly is that market cycles play a
significant role in valuations. As regular readers of this blog know, the
statistics one of the more astute mutual fund managers uses for incentive compensation is four years. In general
investors in the stock markets should pay more attention to the market cycles while
remaining conscious of the business cycles.
The
proper use of earnings yields when building portfolios
In putting together
investments to be purchased or repurchased today, I am more concerned about
future valuations than selling opportunities. First as an analyst I attempt to
copy the great John Neff’s approach of estimating the earnings power of a
company. (Actually, it would be wise to estimate a range of earnings power in
both good and bad years.) In the current environment, operating earnings is a
better starting point than reported earnings.
When constructing
portfolios, I believe they should be focused on different time horizons. A
trading portfolio would have a time horizon of perhaps one year and in some
cases the remaining portion of a calendar year. A portfolio designed to meet
certain cash income needs should possess a time horizon to meet the next two
years’ funding. A third portfolio designed to replenish the cash, needs a portfolio
that might have a time horizon of five years. A longer term, almost an endowment
approach would have a minimum of a ten year focus, or more appropriately it would
be tied to a life expectancy or until the next major capital campaign is fully
funded. Ms. Sonders is appropriately skeptical; but long-term focused
investment professionals should be skeptical. A liberal use of discounting
future earnings may help participants to sleep better. With this kind of thinking
the endowment and other long-term accounts will be growth-oriented. To the
extent that dividend and interest income is generated, the key analytic
question is: “What will be the future
yields on this income that is not consumed?”
What to do in an aging market
We are four years from
the last major stock market bottom, with the apprehension that we are more
likely to suffer a meaningful decline than any time in the last four years.
Today, there is a new seasonal factor that some traders and market technicians fear. They are questioning
whether the current April is replacing the normal May when they hear the
old chant “Sell in May and Go Away.” This is a seasonal pattern that appears to
have worked in the London markets since 1694, according to Mark Hulbert.
However the period between the beginning of
May until Halloween (October 31) is typically most negative for manufacturers
with little harm done to stocks of consumer goods, financial services,
technology and telecom.
For most investors I
would accept the periodic dips we have in the market particularly for the longer-term
endowment type accounts. For the shorter-focused accounts I would gravitate to
the highest available quality in each of the appropriate investment universes.
Make sure you are not
using faulty tools, particularly as we head into more difficult markets.
What do you think?
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