On Sat, Jan 04, 2003 at 09:38:58AM -0500, Kevin Tarr wrote: > Can I ask a question, hoping for a 10 word answer? ;-) What do you > really think of the stock market, the last three years and the last > eight? I'll add my answers below.
You can hope, but since the question was more than 10 words.... I tend to be a business-value seeking investor, in the Buffett/Graham style. So I generally look at individual businesses that I can understand (or learn to understand) and try to determine their intrinsic value using a discounted cash flow model. I look for businesses with an excellent and predictable return on invested capital (what Buffett calls a deep and wide moat with lots of alligators) with honest and competent management, that are selling at a discount to my estimate of their intrinsic value that provides an adequate margin of safety (somewhere in the range 20%-40%). For the past 4 years or so that I have been seriously investing, I was finding almost no businesses that met these criteria. I had most of my investments in cash accounts and in bond funds. But recently, I have been finding some businesses meeting the above criteria (in fact, I just bought several new stock positions in the past 2 weeks). So, looking from the bottom up it seems that my experience indicates that the past 4 years the market was generally overvalued, and recently it has been coming down from being overvalued. I'm less confident of my ability to comment on the market from the top-down, but that never stopped me from giving an opinion before! Just don't take this as investment advice, take it as my opinion which is worth what you paid for it! Looking at some market index funds (Vanguard S&P500, Vanguard Total Stock Market index) on morningstar.com, I see that the aggregate P/E of the market is moving towards about 15 or 16, with a dividend yield of 2%, and a price-to-cash-flow of 5 to 6. Also, earnings and cash flow growth have recently been about 6-7% per year. Now, as I said, I like to look at individual businesses, so I will pretend I am looking at a business with those numbers. First problem is that if I really were looking at such a business, I would need a lot more information to predict future cash flows and sustainability of that cash. Also, I would study the business and the books carefully to see if I believed the numbers the management was reporting or whether they were fudged a little (or a lot). Since I can't do that here, I will just have to take things at face value, which means that I have little confidence in my conclusion. Anyway, a business that has a P/E of 15.5 is earning about 6.4% of its share price per year. If the number of shares is constant (I don't know if it is for the market now, stock options could add a lot, but some companies are buying back shares now instead of issuing dividends because it is more tax-efficient), then that 6.4% is about what we would expect to earn on our investments if we owned all the businesses in the market. If the "business" were well managed, then we could conclude that the 2% dividend was returned because the managers could not invest that cash above the cost of capital, and the other 4.4% was reinvested in the businesses because the managers COULD beat the cost of capital with that bit. My guess is that isn't what really happened, probably some of the 4.4% went to (unexpensed) stock options, some went into managements pockets, and maybe some was used for legitimate share buybacks. But I can't substantiate any of that, so I will assume all 4.4% was reinvested in the business. If 4.4% is being reinvested, but earnings are growing by 6.5%, then the marginal return on invested capital is much higher than the average return on invested capital (about 50% higher). On the other hand, if I assume that the marginal ROIC is the same as average ROIC, that suggests either more than 4.4% will need to be invested in the future, or the 6.5% growth will not be maintained. At a guess, 6.5% isn't sustainable, maybe guess a real GDP growth rate of 3.5% and 2% inflation for a total of 5.5% growth. So the reinvestment has to increase by from 4.4% to 5.5%. So either the dividend has to drop from 2% to 0.9%, or the P/E has to drop to about 13. The uncertainty in this estimate is large. If I am wrong about the growth and it actually stays at 6.5%, then if the dividend stays at 2% then the P/E goes to 12, but if the growth actually goes up to 7.4%, then the P/E goes to 11. If, on the other hand, the current P/E is correct and reinvestment stays at 4.4%, then the growth comes down to 4.4%, which could mean real GDP growth of 3.5% and inflation of 0.9%, or some other combination adding up to 4.4%. Since historically GDP has grown at a real rate of 3.5% per year for the past 200 years, I will use that rate. So, what will inflation be? I don't know, some people predict deflation, right now it looks like it will be 2 or 3%, though. Therefore, with all this uncertainty, I wouldn't be surprised if the correct P/E is anywhere from 11 to 17. Which means the market is either correctly valued or still needs to come down by 30%. All I can say with any degree of certainty is that it must have been way overvalued a few years ago. But even if it is correctly valued now, that doesn't mean the market won't bid it lower. Historically, the P/E usually undershoots the average value after a correction. Since it has probably been over the correct value for about 5 years now, I don't see any reason to assume it couldn't stay UNDER the correct value for the next 5 years. Well, I guess I won't be investing in any index funds soon. I like to get a 20% to 40% margin of safety, so unless the market drops by 40%, I won't be buying it soon. Fortunately, I am finding some individual businesses that look undervalued, so that doesn't bother me. > I really think it was over exuberance, too many people who didn't > know what they were doing, seeing 'other people' doing great, trying > to make a quick buck themselves. They kept buying and buying thinking > everything would go up forever and when it didn't, they wanted > to blame everyone else but themselves. Now it's back on a normal > course. Okay three years of drops may not be normal. And who knows, > the war or another terrorist attack may send it even farther down but > with semi clear headed people now in the market, it should be better. What is normal? The 80's and 90's gave us the longest bull market in the century, is that normal? If so, then dropping for 3 years afterwards would certainly not be abnormal. It took a lot longer than that to recover after 1929, but slightly less than 3 years after 1974 and 1987. I'm not sure there are so many "semi clear headed people now in the market". At least I hope not. I'm grateful for all of the "investors" in the market who do technical analysis, momentum investing, and also for those who invest in index funds. If everyone did a good job of analyzing the value of businesses and buying the undervalued stocks, then I would never be able to find an undervalued stock myself because everyone would beat me to it and bid the price up to par. But as long as enough people irrationally or blindly invest money in the market, there will be an opportunity for some people to find undervalued (or overvalued) stocks and profit from it. -- "Erik Reuter" <[EMAIL PROTECTED]> http://www.erikreuter.net/ _______________________________________________ http://www.mccmedia.com/mailman/listinfo/brin-l
