By late 1974 very little of the stock market was left in the “upper tier” and the vast majority, including a number of perfectly good companies, were in the rubble below. When asked later about this period Warren Buffet replied, “1974 in terms of buying opportunities—that was the best period I have seen.” Market prices had crashed but businesses were still growing. In the words of Fortune, “If one focused on companies rather than on stocks, a good case can be made that there are excellent values around.” This comes right back to what Graham was talking about with sub-asset stocks and is also a reminder to investors that not only are they paying for a share of the future earnings of a business but they are also paying for a share of the business itself. The ability to buy at or below the cost of a business’ assets is a unique opportunity for investors to acquire a firm for less than it cost to build it in the first place. From there all investors need to do is look at which firms are most likely to succeed and reap the rewards when economic conditions improve.
Only five years earlier in 1969, economist James Tobin formalized this kind of approach to valuation with his Q value which is the market value of a firm’s assets divided by their replacement value. The Q value of a stock gives investors a rough estimate of whether a stock is undervalued or overvalued. In theory, Q values greater than 1 should signify an overvalued stock and Q values less than 1 should signify undervalued stocks. However, in practice, this cutoff value appears to be a little lower with the long term average Q value for the market as a whole is right around 0.8. When looked at from a market perspective it shows how the market value of the economy fluctuates in response to the various bear and bull markets. In the bear markets of the early 30s, late 40s and early 70s the decline in market value is painfully obvious. It also clearly demonstrates the effects of extreme market optimism during the late 20s and 90s.
It would make sense then that as P/E ratios market rise, so would the market Q value and this graph demonstrates just that. At a market level, it’s simple to see how exorbitantly high P/E ratios, extreme market optimism, signify an overvalued market and a low P/E signifies a significant drop in investor expectations and thus an undervalued market.
Fundamentally earnings are at the core of a stock’s value. Investors try to weigh the expected rate of return against a discount rate that takes into account interest rates and the inherent risk associated in an investment. As the expected returns drop or the discount rate increases the price an investor is willing to pay must drop in order for it to be a profitable investment. However these are expectation of future earnings which are based on current day projections and as economic conditions change, these projections can swing wildly. In order to outperform the market an investor needs to choose stocks based on the companies themselves. The highflying stocks have always been companies which are fundamentally better than the rest. As an investor you don’t have to try and beat the market all by yourself. You beat the market by investing in companies that outperform the market. The trick is finding companies that outperform at a reasonable price. In the end Buffett spells it out pretty well, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
So, our challenge is to determine the nature of today’s market. Are bonds yields going higher or lower. What do you believe is the direction of earnings—and do you believe that today’s price/earnings ratios are going to expand or contract?
I believe the short term risk of lower interest rates are high, and my gut is that this establishes a floor on equity valuations. However, Richard Berner, Morgan Stanley’s Chief Economist, and Goldman Sach’s Chief economist, Jan Hatzius, are in significant disagreement the most significant threat to our investment and economic future.
This is why we believe that fixed index annuities, considered by many to be a new asset class, represent a terrific opportunity. Investors can participate in interest rate credits which are related to stock market performance, so when the market increases, the fixed interest credits to the annuity increase. However, and for many this is the key point, if the market tumbles, the owner of a fixed index annuity contract has a guarantee of principal. There can be no decline in the investor’s principal account.
The markets have suffered substantially over the past decade—achieving little nominal returns and achieving significant real return losses. The market is significantly more reasonably priced than it was in 2000, and depending upon earnings and interests, it could expand or contract from here. If this level of market participation is appropriate, then there are numerous options. However, if your key goal is short term accumulation with both principal risk and the potential for credited interest rates above todays’ CD rates, then you should look at fixed index annuities.