How to Overvalue a Company: Use Discounted Cash Flow Analysis

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Discounted Cash Flow Rationale

Discounted cash flow (DCF) analysis is the most popular method of business valuation.  It is taught extensively in most finance classes.  The goal is to find a reasonable price for a future stream of cash flows and compare it to a risk-free rate of return, usually US treasuries.

It’s also fraught with peril because it usually results in overvaluing businesses.  It is the preferred method of valuation in investment banking.  I suspect this is because investment bankers can easily game the numbers and make companies appear more valuable than they actually are.  Allow me to explain.

Apple Valuation (AAPL)

To show the power of assumptions, let’s try a real world valuation example.  Let go with Apple (AAPL) using this method.

Free Cash Flow

Let’s start with a fact: in the 2016 fiscal year, Apple’s free cash flow was: $65.844 billion in operating cash flow – $13.548 billion in capital expenditures = $52.296 billion in free cash flow

At the end of the 2016 fiscal year, there were 5.336 billion shares of Apple common stock.

$52.296/5.336 = $9.80 of free cash flow per share of Apple stock.

So what’s the value of $9.80 in discounted cash flow?  Let’s use DCF analysis to figure it out.

Zero Growth Example

For example 1, let’s take an extreme approach.  Let’s say Apple won’t grow at all (unlikely).  For the interest rate, we’ll use US treasuries.  The 10-year US treasury currently pays 2.38%.  Here is a link with a detailed explanation of the math.

If you want to do this quickly, Gurufocus has a calculator tool that you can use here.  Another nice shortcut is a formula that can be used in Microsoft Excel or in Google sheets.  Simply input the following formula into a cell:

=NPV(discount rate, cash flow 1, cash flow 2, etc.)

Now, let’s try to find the present value of a $9.80 stream of cash flows.  Based on no growth and 10 years of cash flows and using the 2.38% rate, we get a value for Apple of $86.30.

Growth and Different Discount Rates

2% Growth, 2.38% rate, 10 years = $96.02

What if instead of using the 10 year treasury as our base, we used the 10 year average AAA corporate bond yield, 2.96%

2% Growth, 2.96% rate, 10 years = $93.11

Terminal value

Most likely, Apple isn’t going to go out of business in 10 years.  For this reason, most DCF analysis adds a terminal value to the value after the 10 years of cash flows.  Let’s proceed with our assumption that there will be 2% growth for 10 years, then let’s say after 10 years the growth rate drops to 1%.

Present value of 10 years of cash flows + Terminal Value = $173.52

Now, what if we increased our assumptions?  Let’s say Apple grows by 5% a year, and then the terminal value grows earnings at 3% into the future?  Now the value goes up to $228.54!

With DCF analysis, you can make the data say whatever you want.  That’s great for investment bankers but it’s not very good for investors.

Conclusion

By messing around with different assumptions, I produced valuations for Apple that ranged from $86.30 to $228.54.  All of these assumptions are debatable.  You can’t say with any degree of certainty where interest rates are going, what Apple’s cost of capital will be, what their growth rate will be, how long the business will be viable, etc.  All of these are assumptions.  Also keep in mind that I produced this wide range of values with one of the the largest and most recognizable company in the United States.  If we can’t safely value Apple, how can we safely value a micro-cap stock?

For this reason, I avoid discounted cash flow analysis.  It is simply too easy to twist around the data with your assumptions and get the result you want.  If you want to find a margin of safety with DCF analysis, you’re going to find one.  I suspect that this is what the investment banking community does when they want to convince corporate managers to make acquisitions that may not be in the best interests of the acquirer.

A simple ratio (i.e., the stock trades at 10 times earnings) is a far more simplistic . . . and far more telling . . . statistic than DCF analysis.  The cheapness of something should hit you over the head and should be abundantly obvious.  If it’s not, move onto something else.  There are plenty of publicly traded companies.  Torturing the data to get the result you want is not a prudent path.

I prefer the Graham approach and focus on what’s actually known in the here and now without making so many assumptions about the future.  This is why the Grahamian balance sheet approach (because what’s more clear cut than the value of a balance sheet?) of net-net’s is a nearly foolproof method of investment.

For the goal of finding the present value of cash flows in analysis of stocks, I think a more useful metric is one that is more simple: price to free cash flow or enterprise value to free cash flow. If you can find a decent company like Apple trading at a price to free cash flow of 10 or less, then DCF analysis would likely yield a number close to the current price even with very conservative assumptions. It is probably then a good candidate worthy further research.

In the world of finance, there is a tendency to make things more complicated than they really are.  I like to keep things simple.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Seth Klarman Interview

This is a great interview between Charlie Rose and Seth Klarman.

Seth Klarman is a value investing legend.  What fascinates me about Seth Klarman is that he never moved beyond the “cigar butt” deep value style of investing, while many value investors eventually adopt the Buffett-Munger style of finding quality companies at attractive prices.  His out of print book, Margin of Safety, sells used on Amazon for $765.  Since the early 1980s, his fund (Baupost Group) has been able to achieve a 19% rate of return.  There are many great insights in this interview and it is well worth your time.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Your Politics and Your Portfolio Do Not Mix

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Your Political Opinions are Emotional

Political opinions are powerful forces. Usually, they are more influenced by emotions and passion than they are by facts. The enemy of good investing is human emotion. Human emotion fueled the internet bubble. Human emotion drove people to buy homes they couldn’t afford (it’s the American dream!). Human emotion took the Nasdaq to 5,000 in 2000 and took the stock market to a 15 year low in the spring on 2009. Most investors underperform because of their emotions.  They pile into stocks when they are overvalued and exit when they are at their most appealing level. Winning at investing isn’t about smarts, it’s about mastery of your emotions. If the market were made up of people like Spock, then Mr. Market wouldn’t be able to act so crazy. Fortunately the market is made up of people who are the opposite.

Making the Wrong Call

The emotional impact of politics is one of the key reasons it should be excluded from investment decisions. Case in point: I am sympathetic to a small government perspective. After the election of Barack Obama and a completely Democratic congress in 2008 during a financial crisis while the Federal Reserve was increasing the money supply like Weimar Germany, it was tempting for people of my orientation to think that the country was about to turn into a hyperinflationary socialist state. At this time it was more tempting than ever to shout “sell” from the rooftops.

Selling in late 2008 would have been a terrible mistake. It is a mistake made by many right wingers who loaded up on gold as they prepared for financial Armageddon. Since 2009, the S&P 500 is up 155%.  Gold is only up about 15%.  In 2009, the immediate year after the collapse, the S&P rose 28%.

Let’s examine another scenario. Let’s say you were someone of a more liberal orientation when Ronald Reagan was elected is in 1980. Many of the leading (liberal) economists of the time predicted that Reagan’s policies would be a complete failure.  They predicted that his fiscal policies would stoke instead of quell inflation. The Reagan years saw a 144% increase in the S&P 500.

The bottom line is that while you may try to convince yourself that your politics are hard grounded in facts and are as immutable as the laws of nature, you simply can’t use your political beliefs as a useful metric to predict future market returns. Your politics are grounded in emotion and for that reason they shouldn’t guide your investment thinking.

Does it Even Matter Who the President Is?

Nor do I think politics even matter that much to the economy. The popular news creates the impression that politics is the only thing that influences the economy, but the truth is that it doesn’t really matter all that much. American businesses are going to try to sell more products and be more productive no matter who is President.

My guess is that if Al Gore won the 2000 election, Alan Greenspan would have still cut interest rates in the wake of the internet bubble, homeowners would have still levered up, and the housing collapse was inevitable. Similarly, was Bill Clinton responsible for the surpluses and prosperity of the late 1990s, or was it simply a surge of computer-driven productivity gains that would have happened anyway?  The President and their party receive the credit for booms and the punishment for busts in the public’s mind, but their actual real world influence is limited.

Also, the United States political system is set up to resist radical change.  That may be frustrating when the President can’t implement their desired mix of policies, but it is a good thing for the health of the economy.  The Constitution is designed to derail radical change and it works most of the time.

Productivity

The Federal Reserve plays a more important role than the President in the direction of the economy. The Fed’s influence is still limited, though.  The Fed can only influence the short-term gyrations of the economy and the inflation rate. They can’t impact the long-run trend of the economy because the long-run trend is driven by productivity. Despite the attempts of policy makers to influence productivity, I doubt that public policy can have any impact at all on productivity rates.

Productivity seems to be driven more by the forces of capitalism and the abilities of managers than it is by policy.  I doubt that laws can make a country more productive any more than a law can change the weight on my bathroom scale.  Productivity is the true driver of economic performance and it appears to be out of the hands of policy makers.  That’s probably a good thing.

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Source: United States Department of Labor.  Productivity does not seem to care who the President is.

Right now we’re in a productivity slump and everyone is losing their minds over it. I think this productivity slump is much like the slump that occurred in the 1970s: it’s temporary. Much like the boom in productivity from 1995 to 2005 was also temporary. Productivity appears to be stubbornly mean reverting. It has a tendency to revert to its 2% long term trend and there is little we can do to change it.

There was a belief in the late 1990s that information technology had permanently increased the productivity rate.  That’s what the “New Economy” talk and hyper optimistic federal government budget projections were driven by.  It wasn’t permanent and productivity is reverting to the mean.  Similarly, the worry now is that the productivity slump is a sign of permanent stagnation in the US economy.  That’s probably just as wrong as the 1990s optimism was.  At some point in the next 10 years when productivity starts surging due to mean reversion, we’ll hear that we are in a new economic era of higher productivity driven by artificial intelligence, social media, cloud computing, 3-D printers, etc.  Then it will revert to the mean and everyone will start wondering if we are in a permanent slump again.

There is very little that politicians do to change desire of individuals and businesses to earn more money, which is really the driving force behind productivity.

Ignore It

The lesson of history seems to be that the safest long term bet is to leave your politics at home when making investment decisions.  There is a human tendency to believe that if there are people you disagree with in power, then the world must be headed to hell in a handbasket.  If there are people that you agree with in power, then there is a tendency to believe that manna will begin to come down from the heavens.  It’s your emotions talking and emotions are the enemy of capital gains.

Besides, your political beliefs should be deeply held as a result of moral conviction.  They shouldn’t be formulated based on the impact that a policy will have on the S&P 500.  They’re for the voting booth, not your portfolio.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

What is the Best Stock Valuation Ratio?

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Value investors use a number of ratios to assess whether a stock is cheap.  Everyone has their favorite.  Everyone debates the merits of one versus the other.  I backtested some of the popular ratios to see how they would perform if you simply split the market up into deciles and compared the cheapest to the most expensive deciles.  The population I used for this analysis was the S&P 1500.  In this case, we are comparing the most expensive 150 stocks to the cheapest 150 stocks.  These are the total returns since 1999, with the 150 stocks re-balanced annually, because re-balancing monthly is impractical.

Below is a list of the ratios that I tested:

EBIT/Enterprise Value – This is the ratio identified by Joel Greenblatt in The Little Book that Beats the Market.  EBIT is “earnings before interest and taxes”.  Tobias Carlisle refers to this as the “Acquirer’s Multiple” in Deep Value

The Enterprise Value is the total cost of the firm to an acquirer.  Enterprise values are the total cost of the firm to an acquirer at the current market price.  In other words, if you were to buy this company in its entirety, you wouldn’t simply pay the market price.  You would also assume all of its debt obligations and would inherit all of its cash on hand.  It is the cost to acquire the entire company.  EV gives you a good idea of the true size of the business.  The calculation for Enteprise Value is:

EV = market value of common stock + market value of preferred equity + market value of debt + minority interest – cash and investments.

Price/Cash Flow – The price per share divided by the total trailing twelve month cash flow for the last calendar year.  In other words, how much total cash is the stock generating for what you are paying?

Price/Sales – The price per share divided by the total revenue per share.  This ratio was popularized by Kenneth Fisher in his 1984 book Super Stocks.

Price/Free Cash Flow – Free cash flow is the company’s operating income minus its capital expenditures.  Free cash flow strips away the company’s other financial performance variables and looks simply at how the core business is doing.  This ratio looks at how much free cash flow is being generated per share relative to the price of the stock.

Free Cash Flow/Enterprise Value – This is the same thing as price/free cash flow, but instead compares free cash flow to the total size of the business.

Price/Book Value – Book value is the total balance sheet value of the company.  It’s the simple equation Assets – Liabilities = Shareholder Equity.  The goal of many asset-based value investors is to buy company’s that are trading at or below book value.

Price/Earnings – This is the most basic and common valuation metric.  It takes the per share price of the stock and divides it by the earnings per share.

Price/Tangible Book Value – The same thing as price/book value, with a twist.  When calculating shareholder equity, intangible assets are taken out of total assets.  The goal here is to look at what assets can actually be sold and turned into cash.

The results are below:

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I think it is best to look at the effectiveness of the ratio based on the difference in return between the cheapest and most expensive decile, rather than looking at its total return for the cheapest decile.  A ratio that is effective in identifying cheap stocks should be equally effective in identifying expensive stocks.  Based on the backtesting, the acquirer’s multiple popularized by Tobias Carlisle is the most effective.  Tobias maintains a nice screener here.

Here is a visualization of the value premium in chart form:

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The important takeaway is that no matter which ratio you prefer, they all work to some extent and buying expensive stocks is a risky bet.  Value investors can debate about which ratio works best, but they all work!  No matter how you slice it, cheap beats expensive.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Bruce Greenwald on Globalization

This is a fascinating and thought provoking video with Bruce Greenwald on globalization and the future of the economy.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

 

Greenbrier (GBX)

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Greenbrier, one of my holdings, is poised to benefit from a recovery in oil prices.  Greenbrier manufactures, leases and repairs rail cars.

Greenbrier was a beneficiary of the fracking boom and was negatively impacted by the bust in the last two years.  Much of the oil that is being drilled throughout the US must to be transported via rail.  Greenbrier’s stock peaked at $75 a share in mid 2014 around the same time that oil prices peaked above $100 and then began its decline to $50.

GBX’s Performance

Meanwhile, amid the decline in oil prices, Greenbrier has been humming along and generating profits while the stock has been disconnected from the actual performance of the company and slid to the current $41.85 price level.  Take a look at the operating income for the last few fiscal years:

2016: $408 million

2015: $386 million

2014: $239 million

They have also been paying down debt.  Long term debt has been reduced from $445 million to $303 million.

Saudi Arabia & Oil Prices

With that said, it appears that oil prices are bottoming.  Saudi Arabia engineered the decline in oil prices to kill their competition.  Their mission is now accomplished and they want to see oil prices go back up.  They are now organizing OPEC to cut production and raise oil prices again.

I suspect Saudi engineered higher oil prices will simply mean that US production will increase in response, which will benefit the train industry and companies like Greenbrier.  The only way that it wouldn’t benefit would be if the US invests in oil pipelines.  It appears unlikely that any pipelines will be built.  In addition to the environmentalists, there is a strong resistance from NIMBY citizens.  Any struggle to get these pipelines built will probably be akin to the Bush administration’s efforts to drill in ANWR, efforts that were abandoned because they were deemed to be too much of a political pain.

Personally, I don’t see how transporting all of this oil via train and truck is any better for the environment than putting it in a pipeline, but I don’t think it is good investing to think in terms of what should happen.  Even if the new administration fights the political pressure and gets a pipeline built, it will be years before it actually happens.  In the meantime, we will need a way to transport all of this oil and rail will benefit.

Margin of Safety

Greenbrier presents an excellent margin of safety at the current price.  Even without higher oil prices, Greenbrier has been performing well while the stock price has fallen amid speculation that ignores the fundamentals of the business.  My guess is that betting against rail while oil goes down has been fashionable on Wall Street, thereby creating attractive prices.  It is a great value even if my prediction about oil prices doesn’t come true.  I feel the same way about Valero, another stock I own as a play for an oil resurgence.

That’s the idea behind the margin of safety — even if I am wrong, the stock was purchased at a wide enough margin of safety that I should still do ok.  I can bet on higher oil prices in a safe way, as opposed to buying a leveraged ETF or oil futures.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

Don’t Try This At Home! DIY investing is not for everyone.

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I post a disclaimer on every post that this site is not financial advice and I don’t recommend people simply copy my strategy. Buying individual stocks carries significant risk that most people aren’t cognizant off. 90% of investors have no business buying individual stocks. I often tell people that if they can’t withstand a 50% loss of the amount invested, then they have no business investing in stocks. 50% losses (or worse) are going to occur roughly once a decade and most people behaviorally can’t handle them. With that said, many people wonder if they should try buying individual stocks for themselves.  My advice would be: for most people, absolutely not.

But . . . if you are insistent on buying individual stocks, I recommend that you first get your financial house in order and make sure that you have sound investing knowledge.  There are some great personal financial blogs out there chronicling how to pull this off.  Mr. Money Mustache is one of my favorites.  Dave Ramsey gives great advice as well.

So, before you open a brokerage account and start buying individual stocks, I would say that the below items should be taken care of first:

  1. Get out of debt.  Seriously, if you have debt, especially high interest rate credit card debt, your #1 priority in life right now should be getting out of it.  You should treat it as if you are on fire and need to stop, drop and roll.  Compound interest is a mesmerizing thing when it works in your favor as it does for stock investors.  For credit card debtors, compound interest can ruin your life.  As someone who made a number of stupid financial decisions in my 20’s, I speak from experience.  The same goes for other kinds of debt: student loans, car payments, etc.  Get that stuff paid off before you start even thinking of messing around with buying individual stocks.  Start coupon clipping.  Start cutting your expenses.  Get a side hustle.  Whatever you need to do, do it!  Get out of debt as soon as possible!  Life isn’t meant to be lived in chains.
  2. Set up an emergency fund.  Stock market investing only works over long stretches of time.  In other words, you have to lock the money up for years before you even think of using it.  If you’re constantly withdrawing money from your brokerage account, then compound interest will never have a chance to work its magic.  To be prepared for life’s hiccups and keep you from dipping into your brokerage account, you need to have a savings account covering at least 6 months worth of expenses set aside.  Be prepared for life’s unexpected emergencies, otherwise you’re going to dip into your investments and no strategy will work.
  3. Buy a house.  Rent is throwing your money away.  For what you’re throwing away in rent, you could have a mortgage.  With a mortgage, you build equity in a home and get tax deductions for the interest you pay.  Homes really are a great investment over long stretches of time.  Don’t buy dumb, ridiculously expensive homes that you can’t afford and don’t need.  Don’t try to keep up with the Joneses.  Do find a house with a mortgage payment that you can easily afford and is beneath your means.
  4. Invest in mutual/index funds.  You should have money already invested in the stock market via your company 401(k) or set up in mutual funds.  Vanguard has some great options. The IRA account I am tracking on this blog does not constitute my full net worth or investments. I invest in index funds and any stock investor should devote some of their equity investments to this approach.
  5. Read and learn about investing.  An entire section of this website is devoted to books about value investing.  You should read them all before you decide to buy an individual stock.  If you refuse my advice and only read one book about investing, then my choice would be The Intelligent Investor in its entirety before you even think about opening a brokerage account.
  6. Develop your own philosophy about investing.  Value investing isn’t for you?  That’s fine!  However, pick a philosophy.  You must have  an intellectual foundation.  One of the worst mistake that investors make is shifting between philosophies of investing and chasing recent returns with no real commitment to one philosophy over another.  This is a mistake because all styles go in and out of vogue at different times.  After one style has a nice run, that’s probably the worst time to pile in.  The key to winning in the market is finding a style that makes sense to you and sticking with it.  Consistency is key.  You’re not going to be able to stick with it unless you believe in it and it makes logical sense to you.  There will be times when you are losing money and you will want to throw in the towel.  You’ll be less likely to throw in the towel if you can look at your portfolio and remember why you made your decisions.  If you believe in your philosophy, you can weather the storm.  The mind is the true source of investment gains and folly.  Figure out a philosophy that you can believe in and stay committed to it when times get tough.

A good example of consistency being critical is Peter Lynch’s Magellan Fund.  Peter Lynch is one of the greatest money managers of all time.  From 1977 to 1990, he achieved an astounding 29% rate of return for his investors.  However, most investors lost money because they piled into the fund when it was hot and sold when it was cold.  They had no patience and the lack of patience made them lose money even though they were in one of the greatest performing mutual funds of all time.

With that said, once your financial house is in order and you have a sound knowledge and philosophy about investing, then you can feel free to roll up your sleeves and attempt do-it-yourself investing in individual stocks.

Should you do what I’m doing?  No.  

Do your own homework and choose a style that you are comfortable with. Don’t just buy something because someone else is buying it. Think independently.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Are Markets Efficient?

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My high school interest in the stock market led me to major in Finance in college.  Hoping to learn juicy insights into beating the stock market, I was instead taught the efficient market hypothesis, or EMH.  The efficient market hypothesis states that markets are largely efficient at assessing risk and dishing out returns.  Over time, equities perform better than other asset classes because equities are riskier than other asset classes.  Returns are a compensation for risk.  Basically, business students pay a lot of money to learn that they don’t have a chance against an index fund.  Fortunately, I went to a state college for this advice.

Eugene Fama and Kenneth French, the architects of EMH, performed research which showed that value investing delivers higher rates of return but attributed this to the increased riskiness of value investing.  Value investors disagree and contend that their approach actually reduces risk because they demand a margin of safety from their investments.

I don’t have  PhD.  I don’t have a Nobel Prize. I’m just a working stiff with a blog and a brokerage account.  My analysis is lacking in sophisticated mathematical modeling, but I agree with the value crowd based on common sense.  Just look at the price ranges from the last year of a few large and stable American companies:

Apple: $118.69 to $89.47 – 24.62% difference

American Express: $75.74 to $50.27 – 33.63% difference

Caterpillar Inc: $56.36 to $97.40 – 43.47% difference

I find it difficult to believe that the underlying value of these business experienced such a wild fluctuation in the last calendar year.

One could also look to the entire market as a whole.  Look at the performance of the S&P 500 over the last 26 years:

1990 – 2000: Up 318.42%

2000-2003: Down 27.66%

2003-2007: Up 47.26%

2008-2010: Down 19.88%

2010-2016: Up 90.43%

Did the actual underlying economic output of the United States experience such wild swings over that time period, as the markets seemed to believe?

Here is the total economic output of the United States since 1990:

U.S. Bureau of Economic Analysis, Gross Domestic Product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDP, December 31, 2016.

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It certainly doesn’t look like the actual economy of the United States experienced anywhere near the wild volatility that the United States markets experienced from 1990 to 2016.

I don’t believe that the markets are efficient.  It seems to me that Ben Graham’s characterization of Mr. Market, the crazy manic depressive shouting prices for businesses based on his mood, is closer to reality than the efficient market popularized by EMH.

I believe that astute investors can find mispriced stocks.  Fortunately, most of the investing community believes in EMH because this is what is written in Finance textbooks.  This a good thing.  The more people that believe that markets are efficient, the less competition there will be for value investors.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

 

 

Is Retail Dead?

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Value investing requires one to defy conventional thinking.  It requires independent thought.

Right now, the conventional wisdom is: brick and mortar retail is going to be dead soon.  Most physical retailers are going the way of Blockbuster Video and Borders books.  People are going to buy everything online.

You can see this conventional wisdom in the valuations that the market assigns to the following stocks:

Wal-Mart: 14.98 times earnings

Dillard’s: 11.38 times earnings (a stock I own)

Gamestop: 6.79 times earnings (a stock I own)

Amazon: 171.87 times earnings (!)

Clearly, investors are wildly optimistic on the prospects of Amazon and downbeat on the future of more conventional retail operations.  Like most things, I think that the market is getting ahead of itself.  They have taken a trend (the rise of online retail) and are getting carried away with it.  The amazing innovations that Amazon churns out definitely fuel the optimistic forecast.

For Gamestop, the logic is a bit more easy to understand.  Consumers are going to buy more of their video games online directly to their console rather than shop in the store.  Maybe.  When I look at Gamestop’s actual operating income for the last four fiscal years, I see a much different story:

FY ending 2016: $648 million

2015: $618.30 million

2014: $573.50 million

2013: -44.90 million

In other words, Gamestop has been delivering consistently better results while the market has been losing faith in its prospects as a result of speculation.  I do not see a business that is dying.

The point of value investing is to ignore the speculation and focus on what is actually happening and what the company is actually earning.  At 6.78 times earnings, Gamestop presents a tremendous margin of safety regardless of its future.  In other words, 6.78 years of earnings can pay for the entire company’s market capitalization.

Amazon is the sexiest of growth stocks with amazing prospects for the future.  But the stock offers no margin of safety.  Gamestop does.  That’s why I am taking the unconventional route and owning brick and mortar stores like Dillard’s and Gamestop that the market hates (or is ambivalent to) and passing on incredible story stocks that the market loves.

Keep in mind that Amazon is up 332% in the last five years.  Those are tantalizing returns that attract attention and investors.  However, following the crowd and chasing returns is not investing.  It is speculation.  Investing is considering what you, as the owner of the company, are paying for what the company is earning.  The logic is that Amazon will continue to grow and continue to be an amazing company.  Perhaps it will.

“Perhaps” and “maybe” have no place in an investment operation.  Those words are for the track, not for investing.  When it comes to my investments, I demand a margin of safety.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

Projecting Market Returns

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Market prognosticators frequently opine in the direction of the markets based on public policy, what Millennials are doing, whether Euro will do this and the Yen will do that, who won the Super Bowl, if it is an election year, etc.  They have no idea what they are talking about.

The more accurate forecast models take a hard look at value.

Shiller P/E

One method is the Shriller P/E.  It was designed by Yale economist Robert Shiller.

Looking at the market in terms of the current P/E can be misleading depending on where we are in the business cycle.  For instance, during a recession, earnings plummet and P/E ratios rise even though the market may be undervalued.   During a boom, earnings are temporarily inflated, which can cause the market to appear cheap when it may in fact be quite expensive.  Shiller accounted for this by comparing price to average earnings over the last 10 years, accounting for the impact of economic gyrations.

Gurufocus maintains a nice  tracker of the Shiller P/E here.

Market Capitalization as Percentage of GDP

A better method is looking at the market in terms of its value in relation to GDP.  Buffett popularized this method in a 1999 article in Fortune.  Buffett was able to use market valuation as a percent of GDP to assess market values.  He assessed the market correctly at the time and declared the market to be overvalued.

The methodology is easy to understand.  The market derives its value from earnings and US companies can only earn what the US economy can actually produce.

Gurufocus maintains a tracker for this metric here.

A Better Method

The GDP method is more accurate than the Shiller PE, but it is still an imprecise instrument.  For instance, the GDP model predicts a range of returns over the next 10 years of +4.6% to -8.2%.

Recently I came across a market valuation model that was even more compelling at the Philosophical Economics blog.  This model instead looks at the average equity allocation.  The idea is that during a bull market, valuations increase as investors move their money from other asset classes into stocks.  As the equity allocation increases, the market runs out of fuel for higher valuations and future returns are diminished.

The key reason this makes sense is the relationship between interest rates and returns.  As interest rates rise, it seems natural that investors would decrease their equity allocation and put more of their funds towards bonds.  If bonds are dishing out high rates of return for little risk, why take the risk of owning equities?  This is precisely what happened in the 1970s and early 1980s, when interest rates soared and equities were punished.  It also set the stage for an extraordinary period from 1982 to 2000, in which declining interest rates from historic highs fueled one of the greatest bull markets in history.

Interestingly, as Buffett pointed out in the earlier referenced 1999 article, earnings and economic growth were actually less in the 1980s and 1990s than they were in the 1960s and 1970s.  The only difference between the two periods is the direction of interest rates.

The model can actually be plugged into a simple equation:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

Looking at the most recent data, the current average equity allocation is 40%.  Plug this into the equation and we get the following result: (-.8 * 40) + 37.5 = 5.5% expected 10 year rate of return

The metric is tracked here and is updated quarterly.  If the equity allocation were to rise to 45%, that implies that the next ten years will deliver a paltry 1.5% return.  That would hardly seem sufficient compensation for the volatility risk in equities.

So What?

Generally I like to remain agnostic about the market and focus on bargain stocks.  However, my 401(k) plan is dedicated to index funds and I think it makes sense to look at market valuations.  An overvalued market combined with an overheating economy is certainly cause for concern and something investors should remain cognizant of.

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They heard that the average equity allocation went down in the most recent quarter

The model described in this post should reduce your fears when the market drops.  A market drop simply means that future returns are going to be higher.  Drops in the market are cause for celebration, as you can now buy stocks that will deliver a higher rate of return.  I would certainly buy more if the market were to plunge 50% tomorrow.  I’d also probably start scrounging whatever cash I had on hand and piling into the market.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.