What drives stock
prices? In this sound bite world of media and academic pundits what drives
stock prices is earnings per share. The progress of e.p.s. determines the
appraised value and therefore the future price.
What is the most
massaged number of all that is published? You guessed it, earnings per share.
When was the last time that a modern chief financial officer or CEO knew one
year in advance the number of shares that will be divided into the reported net
income on an average number of shares or year-end number of shares outstanding?
To be honest, net income, at best, is a representation of a perceived reality.
Revenue recognition is a semantic guess. The value of inventory consumed and
the remaining value as to what is left is heavily influenced by current or
year-end prices and the recognition of taxes currently owed to various taxing
authorities. In truth e.p.s. numbers are not manipulated necessarily with
malice.
This reality suggests
to me earnings should not be the sole measure of a stock’s value or perhaps not
even the leading measure of future prices.
I am led to this view
after reviewing Berkshire Hathaway’s* investment experience and looking at a
number of 13f reports reviewed by John Vincent as well as my own long-term
portfolios. In each there are some losers. In general from the time the losers
become big losers they disappear or have a greatly diminished percent of the
portfolio due to the rise of the winners.
*Held in the private
financial services fund I manage
Warren Buffett claims
he does not make future earnings projections. Even if he did I doubt that he
would have much confidence in ten and twenty year projections. Then what is the
rubric or rubrics he uses? I believe staying within his circle of competence it
would be based on his understanding of the nature of the business that the
company is considering acquiring. In 2000 he purchased a big position in
Moody’s Corp. that was spun out of Dun & Bradstreet. The current price
of Moody’s is fifteen times his cost. This is a clear example of thinking
long-term, with an understanding of the functions and quality of a potential
investment.
Not long after
Berkshire’s purchase of Moody’s, I independently bought the stock for the
private financial services fund that I manage. When I bought this stock I
believed that I understood the nature of the credit rating business and the
essential need of the company’s clients for its services. I also knew a little
about its management compared to its main competitor. It was the quality
choice. Thus, investing in the highest quality of an essential business worked
well for me. I did not project earnings, recognizing that most of the analysts
reporting on the company regularly underestimated current earnings. As I was a
bit late in my purchase, the current price of Moody’s is only eight times our
cost.
There is another lesson
from this experience. It is not just finding a great investment, but continuing
to hold on through both the changes within the investment, the market, and the
needs of the account. Both Berkshire and I sold some of the original position
along the way for reasons that proved to be wrong. Thus the same level of
diligence needs to be practiced as we, in effect, re-purchase our liquid
investments everyday.
Challenge Ahead
Perhaps too many of the
portfolio managers that I speak with, while concerned about the near-term
future due to the identified unpredictability of events, are not raising their
cash levels. In numerous cases the hesitation to act dynamically is due to career
risks. As a contrarian long-term thinker I have already accepted the
realization that there will be a stock price decline ahead of us which may be
combined with a recession, fixed income collapse or military actions.
There remain two
critical questions. First, the size and duration of the decline, and second,
should we trade in and out of the decline or do we stay pretty much fully
invested to benefit from both the recovery and the expansion beyond?
As usual I look at the
current data and the misdirection that most are following. Economists and
politicians are being led by the lack of sufficient productivity, actually
labor productivity. This is defined as revenues divided by wages. Governments
around the world have found within their constitutions a “requirement” to
create jobs. In particular they want to create jobs for union workers and other
politically active individuals with eyes on the next election.
While these are
important, they are not addressing problems that are broader and deeper in
scope than unemployment which can be summed up in different measures of
productivity.
In all of our societies
there are more consumers than workers. What has happened all over the world is
that consumers are buying more and better quality products and services due to
both technology along the way and world trade. I suggest, unaided by government
or perhaps in spite of government, consumers are better off today than ever.
Clearly more is desired. If we create jobs that raise prices and/or reduce
quality, that is a step backwards.
The second productivity
measure which is not highlighted globally is the productivity of capital,
particularly retirement capital. I do not know of a large government retirement
plan that is fully funded against any standard, let lone the fact that we are
all living longer and our last years are very expensive. We must support
increased investment into retirement capital vehicles but this will have the
effect of lowering current consumption.
Net Flows into Mutual
Funds and ETFs
The next set of numbers
that is not getting enough attention is the net flows into mutual funds
combined with flows into ETFs. Domestic Equity funds particularly Large-cap
Growth and Large-cap Core funds have been in net redemption for a considerable
length of time. Despite the average performance of Large-cap Growth funds this
year is close to a gain of 30%, they are in net redemption. This is largely an
aged base, as the fund holders who were sold Growth and Core funds years ago
are at the stages of life where they need the money for other purposes. This is
not new and has been happening for decades. What is new is that the long- term
profitability of selling funds and managing accounts invested in funds has
changed.
But there is a more
important message from net flows. Global and International funds are adding
assets at almost the same rate as the Domestic-oriented funds are being
redeemed. What this is saying is that the Domestic funds are suffering from the
lack of sufficient retirement capital. Plus today’s active fund buyers are
hedging their retirement against a perceived long-term decline in the value of
US assets. This is backed up by the current yield on long-term government
bonds. There are ten large countries with ten year government bonds. The yield
on the US ten year is second highest of the ten. This means that the market
participants view that there are eight better places to invest their bond money
and will take lower yields to insure their safety on a post-inflation basis.
Equity = Opportunity/Risk
At the current global
level of interest rates we will be far short of filling the retirement capital
deficit. The best opportunity to fill the gap is equity. Equity has imbedded
within it both opportunity and risk of loss. In general the larger, more mature
corporations have the least risk but also the least investment returns, as
shown below utilizing the three S&P market capitalization indices’
investment performance since 12/31/1999:
S&P “Market
Cap” Indices
Index
|
Average %
|
Range: High to Low %
|
S&P
500
|
+80.20
|
+ 194.89 to (51.36)
|
S&P
400
|
+327.10
|
+ 874.74 to (69.38)
|
S&P
600
|
+376.74
|
+1198.12 to (95.89)
|
This table suggests
that mid and smaller market cap companies can produce higher returns than the
more mature, larger companies in general. The market risks are greater also,
but not relative to the size of the gains.
Betting on Change
None of us know for
sure what the future may bring, but the wise equity investor hopefully
recognizes changes earlier than many others. There are many possible disruptive
changes which could impact all of us. I am not sufficiently knowledgeable to
have an appropriate view on autonomous driving vehicles but they could change
or disrupt almost every element in our societies. It is the marriage of
technology and lifestyle changes.
There are a number of
other disruptive forces that can change our world, hopefully for the better by
addressing the two missing productivity measures. Because I believe that
some of these changes will occur, I will continue to be largely an equity
investor.
Question: What are the
changes that you are expecting?
__________
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A. Michael Lipper, CFA
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