Monday, July 11, 2005

The Power of 11

In this week’s Barrons (July 11, 2005) is a great article on the merits of investing at the market’s current valuation. Jeff Murphy and I joke about the Power of 11. This is our own spin on the common advice of saving / investing 10% of income for a comfortable retirement. Just to be different, we have updated this “saw” to 11% invested in the market for an 11% return (compounding will cause the amount invested to double every 6.5 years, growing in an exponential fashion).

Well, what should I find this week but some academic research that not only reinforces the number ‘11’, but also makes a very compelling case for the fact that the market is currently overvalued, and that the 11% market return is “baked into the cake” over the very long term. What was eye-opening for me was the way this number was derived: from backing out of “Return on Equity”. Of Course! The ROE is a ratio of the profits (Return) as a percent of equity (Book Value as calculated by Assets minus Liabilities). The results are inherently “normalized” because book value should be inflated or deflated by the value of the currency, maybe not in one year, but over a period of years, say twenty.

Not only does the market provide a consistent 11% ROE over long periods of time, but it also grows very dependably at a 5% rate: Very encouraging for the long run. However, in the short run, using the same metrics, it can be shown that the DOW is more than double its historical value based on this analysis. It should be 4500, not 10,500. How does it get back to its long run average? Does it collapse by 50% or more? Probably not. But this builds the case for sideways trading for another decade while the Return catches up with the Equity.

Why is this 11% number so constant? People (the market) determine the price of the assets that comprise the aggregated “Stock Market” through the bidding process. People have the same sense of valuation over long periods of time, all other things being equal, like currency. To make this point from a different perspective, human beings have essentially the same fundamental needs requiring satisfaction: air, water, food, shelter, etc. These survival needs are programmed into us by our basic genetic code. Most of us, statistically, must make decisions on what to buy, how much to pay, for those basic necessities of life: Adam Smith’s “Invisible Hand”. It can be reasoned that since we all have the same genetically wired perspective on how the essentials should be valued, in the aggregate we end up valuing all market assets in a similar way.

Competition amongst us dictates that we will bid the price of a basket of financial assets to a return of no more than 11.6% and no less than 10.5%, in the long run. If short term exuberance or discourage gets the best of us for a period of time, we will inherently wait until the return adjusts to our required comfort zone or norm.


Read On:



The 11% Solution

Forecasting broad market earnings creates new problems for investors

By ADAM BARTH


EVERY BUSINESS DAY, INVESTORS ARE BOMBARDED with new economic data, macro and micro, all of which supposedly affect the value of U.S. stocks. While some investors may dismiss macroeconomic information such as quarterly gross domestic product, initial jobless claims and factory orders as irrelevant in the making of portfolio decisions, few probably would file this year's and next year's earnings estimates for the Dow Industrials or Standard & Poor's 500 under a "More Useless Information" heading.

But that's what they ought to do: Insights about individual firms are valuable; fixation on broad measures of current or future earnings isn't. Not because predicting corporate earnings is an impossible task, but because future long-term macro-earnings can be predicted with almost complete precision.

Examine the Dow's annual return on equity for each 20-year period since 1920 (that is, 1920 through 1939, 1921 through 1940, and so on): Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor.

For the 34 consecutive 20-year stretches between 1934-1953 and 1967-1986, the return fell in an incredibly narrow range of 10.5% to 11.6% -- or an average of around 11%. Furthermore, the Dow's book-value growth rate has remained near its 4.8% historical average from 1920 to 2003 for every 20-year period on record.

A Simple Calculation

Finding the Dow's normalized earnings in any given year is as simple as multiplying 11% by the Dow's book value at the time. These earnings will grow at a little under 5% per year -- the Dow's steady and predictable 20-year book-value expansion rate.

Although almost all analysts focus on the current or following year's earnings forecast in valuing stock indexes such as the Dow, the approach is primitive and misleading. While earnings gyrate from year to year, the Dow's earnings over the coming 20 years or any 20 years is virtually preordained.

The popular notion that the long-term earnings growth rate is highly variable and affected by the daily news that speculators, economists and the media slavishly focus on is a great red herring.

The portfolio strategy of "relative value" is based on this red herring. The many purveyors of this strategy tout their "bargain" investments in companies trading at price-earnings ratios in excess of 20 and well above any asset conversion or private-market value.

Where is the margin of safety for these investments? According to these investment managers, it exists in how underpriced their investments are, relative to the market. While these managers claim to be "bottom-up" value investors, they actually have tied their fates to that of the broader market.

A major reason for these managers' decision to shadow an index is the belief that stocks' superior performance in the past proves that they have been mistakenly undervalued, and should now command a richer valuation. As a result, most money managers have rejected traditional equity-valuation standards as overly demanding, and have replaced them with newer measures.

A Peculiar Notion


The most popular and influential of these new approaches is the "Fed model," which holds that U.S. stocks' earnings yield should equal that of the federal government's 10-year bond.

This Fed model rests on the absurd proposition that corporations' equity -- their most junior and risky obligation -- should be equated with U.S. government debt. This approach is nonsensical, as it completely ignores companies' priority of obligations and posits that U.S. public corporations' equity cost of capital should be the same as the risk-free rate. The Fed model pretends that the cardinal risk-and-return principles of finance do not exist.

In the rush to create valuation models that justify current stock prices, investors and economists have missed the clear evidence that historical valuations are not only logical, but virtually necessary.

The 11% solution demonstrates why this is so. Of the Dow's 11% ROE, 5% has consistently been retained -- thus allowing the Dow's 5% earnings-growth rate. The remaining 6% has been free cash flow available for distribution to shareholders in the form of dividends and stock buybacks. As such, the Dow is a perpetuity that can be easily valued by dividing its current free cash flow (6% of current book value) by its expected rate of return minus its long-term growth rate (9% minus 5%).

With the Dow's current book value a little under 3000, its normalized free cash flow is roughly 180. Dividing 180 by an expected return of 9% minus free cash flow growth of 5% (.09 - .05) yields a valuation for the Dow of 4500, less than half of its current market valuation. To justify a Dow value of 10,500, one has to lower the future expected investment return for the Dow to 6.7%.

From 1920 to 2003, Moody's Aaa corporate-bond yield averaged 5.9%. Recently, Barron's Best Grade Index has shown a current yield of 5.24% for top-grade corporate bonds. Assuming a forward rate of return of 6.7% for the Dow would imply an equity-risk premium of just 0.8% to 1.5%.

The preceding analysis will probably shock most investors. Conventional wisdom is that the Dow's earnings are much higher, and that its P/E ratio is much lower. Conventional wisdom, however, is based on some bizarre assumptions and beliefs.

A normalized 20 P/E ratio for the Dow would imply a normalized 18% return on equity (5% earnings yield x 3.6 book value multiple = 18%). While the Dow averaged an 18% return on equity over the prior decade, assuming a lasting return on equity anywhere near this figure is absurd, given the historical record.

Although there have been many short periods in the past during which the Dow Industrials' return on equity significantly exceeded 11% (such as the 1920s, when it also averaged 18%), an elevated return on equity has always come at the expense of future profits, and ROE has always reverted near its 11% average over each 20-year period. While the causes (excess credit creation, faulty accounting) may be contested, the results are incontestable.

Putting history aside, basic logic alone dictates that a sustained 18% ROE is impossible. A return of this magnitude would mean that American business as a whole is capable of lasting, monopoly-type profits. The truth is the exact opposite: Big Business' profit growth has consistently trailed broad economic expansion, with nominal GDP growth increasing at a 7% rate and Dow profit growth lagging behind, at near 5%, for nearly every 20-year period on record.

Small Margin of Safety

Current stock-market valuation levels have made the search for equities that possess a margin of safety a generally difficult task, and the job of professionally managing money even more difficult, given the myriad pressures and incentives to remain fully invested.

In response to this challenge, many investors have turned to a relative, rather than absolute, value approach.

The problem is that these investment approaches are radically different, despite some seeming similarities. In choosing relative value, investors subject themselves to the value of the broad market.

This is not a prudent choice, given the current valuation of large-cap U.S. stocks and the limits to these companies' profitability and growth, as demonstrated by the 11% solution.