Category: Investing

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Why invest in stocks?

Some clients are understandably nervous about investing in stocks because of the volatility. Invest at the wrong time and you can experience a draw-down that takes years to recover. Many shy away, preferring the security of term deposits or the bricks and mortar of real estate investments.

The best argument for investing in stocks is two of the most enduring long-term trends in finance.

First, the secular down-trend in purchasing power of the Dollar.

Dollar Purchasing Power

Inflation has been eating away at investors’ capital for more than ninety years. Purchasing power of the Dollar declined from 794 in 1933 to 33 today — a loss of almost 96%. That means $24 today can only buy what one Dollar bought in 1933.

The second trend, by no coincidence, is the appreciation of real asset prices over the same time period.

The S&P 500 grew from 7.03 at the start of 1933 to 4546 in June 2023 — 649 times the original investment.

S&P 500 Index

Gold data is only available since 1959. In April 1933, President Franklin Roosevelt signed Executive Order 6102, forbidding “the hoarding of Gold Coin, Gold Bullion, and Gold Certificates” by US citizens. Americans were required to hand in their gold by May 1st in return for compensation at $20.67 per ounce. Since then, Gold has appreciated 94.5 times its 1933 exchange value in Dollar terms.

Spot Gold Prices

Over time, investing in real assets has protected investors’ capital from the ravages of inflation, while financial assets have for long periods failed to adequately compensate investors in real terms (after inflation). The chart below compares the yield on Moody’s Aaa corporate bonds to CPI inflation.

Moody's Aaa Corporate Bond Yield & CPI

Conclusion

Purchasing power of the Dollar depreciated by 24 times over the past ninety years due to inflation. Adjusting for inflation, the S&P 500 has grown to 27 times its original Dollar value in 1933, while Gold gained 3.9 times in real terms.

We would argue that the consumer price index understates inflation. Gold does not grow in value — it is constant in real terms.

If we take Gold as our benchmark of real value, then the S&P 500 has grown 6.8 times in real terms — a far more believable performance.

Stocks are a great hedge against inflation provided the investor can tolerate volatility in their portfolio. How to manage volatility will be the subject of discussion in a further update.

Acknowledgents

 

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Forecasting risk

The danger with forecasting is that our analysis may be accurate, based on the evidence at hand, but the outcome may be completely different because of some unforeseen event. Someone at a live food market in Wuhan develops a respiratory fever, crude oil falls to minus $37 per barrel, the Fed dumps $3 trillion into financial markets in just three months, China imposes economic sanctions on Australian coal, and Russia launches a full-scale invasion of Ukraine — all of these events are unforeseeable and likely interconnected.

So why do we persist in making forecasts and basing investment decisions on them?

Consider the alternative.

An inability to make forecasts would destroy the global economy. A farmer consults weather forecasts when planning what crops to plant, how much to plant, and what fertilizers are required. A retailer may similarly consult economic forecasts when making decisions to stock her shelves. Forecasts are necessary to plan for future events, whether they be crop harvests, retail sales or longer-term investments.

Conclusion

We need to recognize the uncertainty surrounding forecasts. The more complex the environment, the higher the degree of risk.

Attempting to accurately forecast future events is futile. And anchoring investments to a particular outcome is risky. It is safer to simply estimate whether the risk of a particular outcome is high or low.

For example, we may believe that the risk of a hard landing in the next 12 months is high and position our investments accordingly. But bear in mind that no particular outcome is certain and we need to retain sufficient flexibility to adjust our strategy if the probability of an alternative outcome should increase.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” ~ Samuel Clemens

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Strong hands or weak hands

“Nowadays people know the price of everything and the value of nothing.”  ~ Oscar Wilde

Strong hands are long-term investors, including most institutional investors, who focus on intrinsic value and are insensitive to price.

Weak hands and leveraged investors are highly sensitive to price. They follow the news cycle in an often unsuccessful attempt to to time purchases and sales according to short-term, often random, fluctuations in price.

Weak hands respond emotionally to price movements — making it difficult to be objective in  their decisions to buy or sell — while strong hands focus on dividends and other measures of long-term value.

Strong hands recognize that the biggest obstacle to sound investing is their own emotional response to rising or falling prices. Weak hands submit to the psychological pressure, make frequent buy and sell decisions, and find it difficult to be objective. Strong hands detach themselves as far as possible from the price cycle and the emotional pressures that accompany it.

At the peak of the investment cycle, weak hands pay way above fair value for stocks, while strong hands resist the urge to buy when price exceeds their own objective view of long-term fair value.

Fair Value

As confidence decays and prices fall, weak hands are shaken out of their positions. Margin calls force some to liquidate while others sell through through fear — failing to recognize that anxiety is the primary cause of falling prices. Some try to hold on to their positions but eventually succumb to the pressure. The mental anguish of watching their stocks fall often drives them to sell at way below fair value — just to end the pain.

Strong hands are patient, independent of the herd, and unmoved by the wild emotional swings of bull and bear markets. They wait for stock prices to fall to below fair value, when opportunity is at its maximum. Stocks that are gradually recovering from a steep sell-off and scarce retail buyers are signs that a bottom has been reached.

Recency bias

One of the key benefits of years of investing, through several stock market cycles, is the ability to recognize the familiar signs of euphoria in a bull market and despondency in a bear market. When it seems that the bull market will never end, that is normally a sign that risk is elevated. Conversely, opportunity is at its maximum when an air of despair and despondency descends on the investing public.

Don’t confuse price with value

Price seldom equates to value.

Short-term investors confuse price with value, making them vulnerable to wild price swings which can weaken the resolve of even the most hardened investors.

Long-term investors hold the majority of their investments through several  investment cycles, pruning only those stocks where long-term revenue growth or profit margins have been permanently affected and are unlikely to recover.

Supply and demand

Many readers are familiar with supply and demand curves from basic economics. For those who are not, here’s a quick refresher:

  • The supply curve, represented by the red line on the chart below, represents the quantity available for sale (bottom axis) at any given price (left axis). The higher the price, the greater the supply.
  • The demand curve, represented by the blue line on the chart below, represents the quantity that buyers are willing to purchase (bottom axis) at any given price (left axis). The lower the price, the greater the demand1.
  • Price is determined by the intersection of the two curves, maximizing the value achieved — at quantity sold (Q1) and price (P1) — giving value of Q1*P1.

Supply & Demand

Bear markets

In a bear market, the supply curve moves to the right as weak hands are influenced by falling prices and a negative media cycle. Note that the bottom end of the curve shifts a lot more than the top — strong hands are relatively unmoved by market sentiment.

Price falls steeply, from P1 to P2, as weak hands increase the quantity available for sale. Volume sold increases from Q1 to Q2.

Bear Market

We need to be careful not to equate the price at P1 or P2 with value. They may reflect the marginal price at which you can acquire new stock (or sell existing holdings) but they do not reflect the price at which strong hands are prepared to sell. That is why takeover offers are normally priced at a substantial premium to the current traded stock price. If you had to increase the quantity that you want to purchase to Q3, you would have to move up the supply curve, to the right, and price increases to P3 in order to attract more sellers2.

Market capitalization, likewise, is simply the number of shares in issue multiplied by the current traded stock price and is not a reflection of the intrinsic value of a company.

Conclusion

Investors need to have a clear idea of their investment time frame and adjust their approach accordingly.

One of the worst possible mistakes is indecision. If undecided, you are likely to be caught between two stools, buying late in an up-trend and selling late in a down-trend.

If you are a weak hand, it is far better to recognize that. Resist buying near the top of the cycle; apply sound money management — position-sizing is vital if you are focused on price; sell early, at the first signs of a bear market; and never, ever trade against the trend.

If you are a strong hand, never confuse price with value. Focus on dividends and other long-term measures of value; stay detached from the herd; and have the patience to wait for opportunity when prices are trading at way below fair value.

“The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.”

~ Warren Buffett

 

Notes

  1. Discussion of inelastic supply curves and negative-sloping demand curves is beyond the scope of this article.
  2. P3 will shift to P3′ in a bear market.

Acknowledgements

Hat tip to RBC Wealth Management for the investment cycle chart to which we added fair value.

 

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Long-term trends: Battery electric versus hydrogen

Scania EV

The shift towards sustainable transport systems is growing, with progress being made in electric vehicles and hydrogen fuel cells as alternatives to carbon fuels.

Heavy Transport

The major obstacle with heavy transport has been low battery range and lengthy charging times for electric vehicles (EV), leaving hydrogen fuel cells as the obvious choice.

Now, Sweden’s Scania AB, one of the world’s largest truck and bus manufacturers, is shifting emphasis to EV. Citing progress in battery technology — energy storage capacity per kg, charging times, charging cycles and economics per kg — Scania expects electrified vehicles to account for around 10 percent of their total vehicle sales volumes in Europe by 2025. And as high as 50 percent by 2030.

Hydrogen Fuel Cells

“Scania has invested in hydrogen technologies and is currently the only heavy-duty vehicle manufacturer with vehicles in operations with customers. The engineers have gained valuable insights from these early tests and efforts will continue. However, going forward the use of hydrogen for such applications will be limited since three times as much renewable electricity is needed to power a hydrogen truck compared to a battery electric truck. A great deal of energy is namely lost in the production, distribution, and conversion back to electricity.

Repair and maintenance also need to be considered. The cost for a hydrogen vehicle will be higher than for a battery electric vehicle as its systems are more complex, such as an extensive air- and cooling system. Furthermore, hydrogen is a volatile gas which requires more maintenance to ensure safety.” (Scania, January 19, 2021)

The Volkswagen AG-owned heavy vehicle manufacturer does, however, note that stationary fuel cells will still play an important part in electric charging systems. Especially in areas with abundant renewable energy, and in rural areas off the main electricity grid.

Conclusion

Electric vehicle technology has progressed much faster than hydrogen fuel cells and is the clear leader in the race for sustainable transport systems.

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Price-Earnings versus Growth

A comment at lunch today about high price-earnings multiples got me started on one of my favorite topics: investment returns.

Most of us use the basic price-earnings ratio (PE or P/E) as a rough measure of how highly priced a stock is. The higher the P/E, the higher the risk.

But P/E only focuses on current earnings and ignores future growth which can make a huge difference to the return on your investment.

The PEG ratio, popularized by Peter Lynch in One Up On Wall Street, attempts to address this deficiency by dividing the price-earnings ratio by expected long-term growth rate of earnings.

  • more than 1.0 is poor;
  • less than 1.0 is good;
  • less than 0.5 is excellent.

Comparing P/E to long-term growth is a step in the right direction but the PEG ratio has two notable deficiencies:

  • It ignores dividends; and
  • It assumes that the relationship between P/E and growth is linear.

Dividends

It is fairly obvious that two stocks trading on the same P/E, and with the same expected long-term growth rate, do not present the same value if one pays regular dividends and the other does not. PEG can be adjusted to compensate for this deficiency, by adding the dividend yield to the expected growth rate. If we assume Computershare (ASX:CPU), for example, has a long-term growth rate of 10%, this should be adjusted to 12% to include the expected 2% dividend yield.

P/E versus Growth

The relationship is not linear. Take a look at the graph below which compares P/E ratios on the vertical axis to Growth (including dividend yield) on the horizontal axis.

PE versus Growth

The gray line plots stock prices at a PEG ratio of 1. A P/E of 10 intersects with growth at 10%, a P/E of 20 with growth at 20%, etc.

The green line plots an internal rate of return at 12.5% p.a. on investment. Here is a brief explanation of my calculation:

I project earnings of $1 at varying growth rates for a period of 20 years. Then I discount this at 12.5% p.a. to arrive at a present value which equates to the P/E ratio (PV/$1 earnings in Year 1). I assume an exit value of zero for two reasons: (a) to simplify the model; and (b) to compensate for declining growth rates over time. I can give you ten different alternatives but this seems the most effective treatment (and I am trying to avoid this reading like a PhD thesis).

The relationship between P/E and expected growth rate is clearly exponential. If we require an annual return on investment (ROI) of 12.5% :

  • A growth rate of 15% would justify a P/E of 22; while
  • A growth rate of 30% would justify a P/E of 97.

What is clear is that price may be dictated more by high expected earnings growth than by current earnings.

How do we estimate long-term earnings growth? With difficulty.

But this is the most important factor in determining a stock’s value so we need to make our best effort. Factors to consider include:

  • Past revenue growth (earnings growth without corresponding revenue growth is difficult to sustain);
  • Cash flow to fund future growth
  • Market position
    • Market growth or market saturation
    • Market share
    • Ability to withstand competition (rising profit margins are often a good pointer)

Conclusion

The next time you look at a PE ratio, remember that earnings growth may be more important than current earnings.

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PEmax and why you should be wary of Robert Shiller’s CAPE

Robert Shiller’s groundbreaking works, Irrational Exuberance and Animal Spirits, led to a Nobel prize in 2013 but we need to be careful of placing too much reliance on his CAPE as an indicator of stock market value.

What is CAPE?

CAPE is the cyclically adjusted price-to-earnings ratio, normally applied to the S&P 500, to assess future performance of equities over the next decade. CAPE is calculated by dividing the S&P 500 index by a moving average of ten years of inflation-adjusted earnings. Higher CAPE values imply poor future returns, while low values signal strong future performance.

Economists John Y. Campbell and Robert Shiller in 1988 concluded that “a long moving average of real earnings helps to forecast future real dividends” which in turn are correlated with returns on stocks. Averaging inflation-adjusted earnings smooths out short-term volatility and medium-term business cycles in the economy and, they argued, was a better reflection of a firm’s long-term earning power.(Campbell & Shiller: Stock Prices, Earnings and Expected Dividends)

Shiller later popularized the 10-year version (CAPE) as a way to value the stock market.

S&P 500 CAPE

Strengths

CAPE correctly identifies that the S&P 500 was over-priced in the lead-up to Black Friday (October 1929) and ahead of the Dotcom bubble in 2000. It also correctly identifies that stocks were under-valued after the Depression of 1920-21, during the Great Depression of the 1930s, and during the 2008 Global Financial Crisis.

Weaknesses

Some CAPE readings are rather odd. The rally of 1936, in the midst of the Great Depression, shows stocks as overvalued. Black Monday, October 1987, which boasts the highest ever single-day percentage fall (22.6%) on the Dow, hardly features. Current CAPE values, close to 30, also appear exaggerated when compared to current earnings.

Causes

There are several reasons for these anomalies, two of which relate to the use of a simple moving average to smooth earnings.

The simple moving average (SMA) is calculated as the sum of earnings for 10 periods which is then divided by the number of periods, 10 in our case. While the SMA does a reasonably good job of smoothing it has some unfortunate tendencies.

First, the SMA tends to “bark twice. If unusually high or low data is recorded, the SMA will rise or fall accordingly, as it should. But the SMA will also flag unusual activity, in the opposite direction, 10 years later when the unusual data is dropped from the average.

Second, the SMA is fairly unresponsive. If earnings rise rapidly, the SMA will lag a long way behind current values.

The third anomaly relates to the use of a moving average of earnings to reflect future earnings potential. Companies may incur losses at the low-point in the business cycle, especially in a severe down-turn like 1929 or 2008, but the impact on future earnings capacity is marginal.

Take a simplistic example, where earnings are $1 per year for 9 years but a loss of $5 is incurred in the following year.  When the business cycle recovers, potential earnings are likely to be $1, not $0.50 (the 10-year SMA).

Examples

All of these flaws are evident in the CAPE chart above.

Problem 1

Expect a fall in CAPE next quarter (Q1 2019) when losses from Q4 2008 are dropped from the SMA period.

Problem 2

Earnings multiples in the lead-up to Black Friday (1929) and the DotCom bubble (2000) are both overstated because of the lag in the SMA caused by rapidly rising earnings.

Problem 3

Potential earnings in 1936 are understated because of the sharp fall in earnings during the Great Depression, resulting in an overstated earnings multiple. The same situation occurs 2009-2018 when losses from 2008 inflate CAPE values.

Proposed Solution

I tried a number of different moving averages in order to avoid the above anomalies but all, to some extent, presented the same problems.

Eventually, I tried dropping the moving average altogether, instead using the highest previous four consecutive quarter’s earnings to reflect future earnings potential. I call this PEmax © (price over maximum historic earnings). PEmax matches normal historic price-earnings ratio (PE) most of the time, when earnings are growing, but eliminates the distortion caused by sharp falls in earnings near the bottom of the business cycle.

S&P 500 PEmax

PEmax overcomes distortions associated with the 1936 bear market rally, Black Monday in 1987 and our current situation in 2018.

Compare how the two perform on a single chart below.

S&P 500 PEmax compared to CAPE

The spikes on Black Friday and the Dotcom bubble are more muted on PEmax but still warn that stocks are over-priced relative to future earnings potential. The 1936 bear market rally is restored to its proper perspective. As is the 1987 Black Monday spike, by removing the distortion caused by declining earnings in the early 90s. The same happens after the Dotcom bubble. And again in 2009 -2018.

Potential Uses

The historic average (1900 – 2018) for PEmax is 12.79. For what it’s worth, standard deviation is 5.32 but this is not a normal distribution.

S&P 500 PEmax distribution

The median (middle) value is slightly below the mean, at 12.23.

Visual inspection of the data suggests that low values are skewed towards the first half of the 20th century. The average over the last 50 years (1969-2018) is 15.85 but, again, this may be distorted by the Dotcom era.

Based on visual inspection, we suggest using a PEmax of 15.0 as the watershed:

  • PEmax greater than 15.0 indicates that stocks are over-priced; while
  • PEmax below 15.0 presents buying opportunities.

Potential Weaknesses

PEmax has one potential weakness. If S&P 500 earnings are ever exaggerated by an unusual event, to a level that is unlikely to be repeated, potential earnings will be overstated and PEmax understated. Fortunately, that is likely to be a rare occurrence, where earnings for the entire index spike above actual earnings capacity.

Conclusion

PEmax ©, an earnings multiple based on the highest previous four consecutive quarter’s earnings, is a useful comparison of price to future earnings potential. It eliminates many of the distortions traditionally associated with price-earnings multiples, including CAPE. High PEmax values (above 15) suggest poor future performance, while low PEmax values (below 15) correspond with greater investment opportunity.

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Jesse Livermore: The Wall Street fool

“What beat me was not having brains enough to stick to my own game – that is, to play the market only when I was satisfied that precedents favored my play. There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time.”

~ Jesse Livermore in Reminiscences of a Stock Operator

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