Valuing Markets
I'm a big fan of CAPE (cyclically ad
justed price earnings) and Tobin's Q as tools for understanding expected future risk and returns from a stock market. I'm an even bigger fan after reading Wall Street Revalued: Imperfect Markets and Inept Central Bankers
The logic is simple. Market valuations must be tied in some way to earnings (the discounted cash flow that I hear so much about from earnings based investors). Earnings for an entire market, over the long term, are somewhat predictable using past earnings. These earnings are generated by assets and so market values are tied in some way to assets. CAPE seeks to value markets using earnings and Tobin's Q does it with assets (or net assets to be more precise).
More important than valuing markets is the idea that higher valuations give lower expected returns for greater downside risk, while lower valuations give greater expected returns for lower downside risk. Smithers uses a 'hindsight' value, the average returns over 1-30 years from any given point in history, to give some indicator as to what the returns were from that time. This is overlaid with CAPE and Tobin's Q, both of which would have provided investors with a pretty good guide to their expected future returns.
I invest some of my money passively, using a FTSE 100 ETF and a UK Bond ETF. These valuation metrics have given me plenty of food for thought with regard to asset allocation. Typically, using MPT (Modern Portfolio Theory - see The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk
So without going into too much detail here I use a function to decide my bond allocation for me based on the value of the market using CAPE, or CAPE10 as I call it which instead of using the last 10 years real earnings in the P/E ratio it uses the average of the last 10 years 10 year real average earnings. I then work out the long term average and see where the market currently is in relation to that long term average. The lower the CAPE10 value the more I allocate to stocks, the higher the value the more I allocate to bonds.
The same kind of thinking can be applied to individual companies, and that's basically how I do my value investing.
In a perfectly competitive market a company must be worth its net assets, or at least cannot be worth much more or much less for long. If a company is earning so much that it is worth more than its assets then competitors would enter the market, replicating the successful company in order to achieve the same high earnings. This added competition would decrease earnings and the company's value. If a company is earning so little that it is worth less than its assets then the owner would either sell the company in order to put his capital to work more effectively; fix the company so that its earnings improved and therefore its value; or if the particular market sector was affected by poor earnings a competitor may sell out thus reducing competition and increasing earnings and therefore the value of the company.
Of course in the real world it doesn't work out like this given the time and effort and cost involved in both setting up, changing, or closing down a business. But, on average, over the long haul, perhaps company valuations do mean revert to some typical multiple of their net assets. Buying low price to book companies allows you to ride the mean reversion wave back to fair value. On average, over the long term, of course.
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5 comments
UK Investor
I am also a fan of CAPE. However I struggled to know how to use it in practice: it is difficult to sell your entire portfolio off in one hit. Likewise it is difficult to time your self back in.
I have evolved into the following methodology. I pick stocks on criteria that exclude valuation - competitive strength, balance sheet etc. This gets them on a potential buy list. I then use SharelockHolmes statsitics to assess value against the stock's own history. Sharelock gives six years PE history. I buy if the current PE is materially below its long run average. Likewise I sell if it gets ahead of its long run average.
It is not a mechanical panacea. You have to think about why its valuation is below its long run average. But it helps - particularly on the sell side where I find I need most help.
What would be nice is a source of ten year statistics for companies.
Siesta
Please could you disclose whether the book links are affiliate links.
What is the evidence for this assertion, which is rather central to the argument?
Personally, I am very sceptical about MPT and, in particular, to the way it equates volatility to risk. Over the last 2-3 years volatily has been very high but that does not equate to me to high risk - unless you have a need to liquidate investments in the short term. If one can take a longer term view, then the risk I am concerned about is the risk of irrecoverable loss. Volatility, OTOH, when related to exaggerated market reactions - in either direction - can, in my experience, create great opportunities to acquire fundamentally undervalued assets or sell assets that have become overvalued.
Does the use of CAPE take any account of growth - at either a market or company level?
Regards,
Mark
Hi Mark
Thanks for your comment. I did start to answer your excellent question with some lengthy waffle about probabilities. But all I meant by predictable is that if you average earnings over at least 10 years as Shiller does (and preferably up to 30 years, which is what I meant by long term), then it becomes easier to say what that average long term earnings rate will be in the future, i.e. the standard deviation of E10 or E30 (real average earnings over 10 or 30 years) is much smaller than the standard deviation of 1 year earnings.
CAPE in itself doesn't say anything about growth at the market level, but by looking at changes in E10 or E30 over time you can see that there is some average rate of earnings increase or growth, although of course it is far from being a smooth increase.
And I totally agree with you about risk. Volatility is only relevant as a measure of risk if you have to sell. For example, if you are a buy and hold dividend investor it has no meaning (as long as you never look at your portfolio!). As a value investor my whole strategy is built on what you said about undervalued opportunities.
Mark
I basically invest in two separate portfolios. One is an index based portfolio, investing in the market with as little frictional costs as possible, split between stocks and bonds using CAPE to decide on the allocation. The other portfolio is a deep value portfolio of about 10 individual companies based largely on book value and debt.
For the deep value portfolio I don't use CAPE at all, for that portfolio I have no opinion about the market in general, I just look for undervalued companies to buy.