Saturday, November 26, 2011

Stock Valuation in perspective......Part 2

Part 1 found here

Recently, in an interview on CNBC, the world's greatest value investor, Warren Buffett, said he was ready to buy stocks and the valuations are compelling. Last week Buffett took a US$10B stake in IBM[Here is a good explanation why he did it]. IBM has been around for more than 100 years and has been a blue chip company for the at least the last 40 years so Buffett would have tracked the valuation of the stock over a long period of several decades and only now he decides to buy the stock. You can actually do better than him because IBM stock has fallen a few % since his purchase. Buffett rarely buy tech companies - he owns a small stake in Microsoft. So why is he doing it now? Remember a few years ago when the tech bubble took the Nasdaq index upwards of 6000 in year 2000? The Nasdaq index today, 11 years later  is 2440. If you look at the tech bellwethers like Intel, Cisco, Dell they went from P/E ratios in the range of 30-60 to 7-10.  Dell today is a $14.22 stock that earns $1.94 per share. The market values the company at US$20B. It has net cash of $8B and annual free cash flow of $3.5B[Link to Dell financial statistics].

If you take the current financial statistics of many companies, you find that they are at their cheapest or close to their levels in history. All the speculative fluff in the dot.com era has completely disappeared and if companies like Dell simply maintain their current performance and do no worse, the stock price can double in 10 years because it would have so much cash in its bank account, it would be able to buy back every share at double the price.

Stock valuations are more striking if you look at what risk free (these days not so risk free) US treasuries are yielding and the current interest rate which is at their lowest in decades. Remember the main cause for the US tech bubble was the aggressive rate cuts by the Federal Reserve after the Asian crisis that drove money towards higher yielding assets such as stocks. So why hasn't the same happened?

An interesting study by Robert Shiller - the guy who coined the term "irrational exuberance", warned us about the tech bubble and housing bubble - shows why stocks may not be as cheap as what investors think. Looking at average earnings in the last 10 years, finds that stocks are actually expensive:

The reason why the average 10 year earnings for stocks are poor is because they include the year when we had the financial crisis. So basically you value stocks with the assumption that there will be an economic crisis within the next 10 years just like the last 10 years stocks, stocks are actually not cheap. If the next 10 years is as unstable as the last 10 years, stocks are not cheap.

However to make money investing, investors shouldn't be asking whether stocks are cheap or expensive but whether they will be going up or down.


So how useful is Shiller's work for making money in the next 5 years? If you look a Shillers' P/E ratio for stocks (see above), you will notice when it shows that stocks are really cheap and get to the bottom valuation of ShillerPE of 10, the stcok market is followed by rallies or stop falling.  If  valuations go above 30, stocks can go higher but a sharp correction or bear market tends to follow. One thing to note is the financial crisis did not the ShillerPE to below 10 - it stopped at around 13 in the bottom of 2009. That left many investors who were waiting for the market to go lower out of the subsequent rally.  Also if you look carefully at the chart, there is a period in the 60s when the market exceed today's ShillerPE of 20 and continued going up for a few years.

I believe the ShillerPE overstate the "expensiveness" of stocks for 2 reasons.

Stocks are not priced in isolation or in absolute terms. When you have money, you can keep it in the bank, but a piece of property for investment, buy some US treasuries or commodities or gold or just keep it in the bank. Because stocks are an investment option and it has to be valued relative to other investments.

This is the first time stock dividend yields pay more than US govt bonds in our lifetime. The reason being investors are extremely fearful of holding any assets with risk so they prefer US treasuries even though the yield is so low. In that sense stocks are cheap because it is unloved by investors...and not for unjustifiable reasons given we are in the midst of a very crisis.

Companies have huge cash hoards (the highest in history) and profitability is at record highs when stock prices are way off their hights.

In my opinion,  stocks are not as expensive as suggested by Shiller. However, they have not fully priced in the crisis in the worse case scenario. The outcome of the crisis is a complete unknown and much of the outcome depends on the actions leaders caught in the turmoil. Stocks are probably cheap enough to rally once there is some kind of stabilisation of the global economy. Where stocks will be in the coming months hinges on on whether the EU leaders would perfer a quick "kick the can down the road" approach or a more painful but more permanent fix or something in between. In the longer term, if stocks fall sharply from current levels, they are probably good bargains even if we go into a recession as long as the economic system is not too broken to recover in a few years. In the previous posting on stock valution[oart 1] I showed a valuation approach using book value - stocks become irrationally cheap when investors start selling below their book value....each time that happens stocks prices move up. Such below book value valuations tend to occur during a recessions and a rough estimate puts the STI at 2000 if our blue chips trade at book value.

25 comments:

Anonymous said...

Coys are holding cash. I think they may be waiting an opportune time buy back their stockst at rock bottom price and then issue place back shares again when mkt rallies.

Anonymous said...

I think the main reason USD is rising is that people are switching from the Euro to the safe haven. So i doubt the Euro would likely recover. Hence, buying short would be the best possible option now.

Anonymous said...

Warren Buffet is not God. Mind you his portfolio has been hammered. If you really want a safe, sustainable and sleepless night investments, then consider food.

Most of the clever money is going into this sector. The cleverer ones are even buying agriculture land and food processing plants.

Corn, soyabean, palm oil & kernels, cocoa, rice and sugar are all good.

I dont care... said...

If the trend indicates that food and its immediate partners such as agriculture lands, processing plants, will be in demand, how will these products reach the markets?

Via ship?, digital transfers?
Rail? air? or do we have to travel to Chiang Mai to pick our bags of thai fragrant rice?

How do we pay for these?
bank draft? newater? our assholes?
sell our daughters?

Will these companies that run these processing plants, land and commodities be listed on any stock markets?

How will these products be produced? by machines?

Who will make them? maintain them?

Who will train the people to operate these machines?

How will they be paid?.. ( if ever )
by cash?.. using thai baht? UD$$ bags of rice?

Would they need clothes and shoes and tooth paste and beer or coffee?

Would they have children?

Who will bring us to Chinag Mai to pick up our bags of rice?.. or maybe we have our tastebuds changed to eat pizza instead?.. so we buy Italian semolina flour?


The world will not collapse.
Eat drink & be merry.. wanton mee will still be available at your neighbourhood.

Discard the newspaper, switch off your app browser and do your work, which you are being paid.

Do not listen to MiTA..
Do not listen to Lim Swee Say
Do not listen to anal ysts
Do not listen to Jim Rodgers
Do not percieve that 3% growth is dismal
( its dismal to the PAP whose pay is linked to it .. they are just speaking out loud.. in fact we should celebrate any number below 5%)

Tell your family how much you love them, buy tickets to a concert and enjoy the entertainment

Buy a holiday for the family and enjoy the hotel.. forget about shopping malls.

Go to the airport and sit and watch people for 1 hour... you will be suprised what you see.

Anonymous said...

Food has to be a good investment in the long run, otherwise why would the Brotherhood suffer snakes and scorpions just to get into the action? We all know these are ruthless gamers who regularly invade other planets for raw materials, only now they are using many of they knowledge, networks and good will mined in gaming to apply to the real world. So far they seem to be doing very well. In some cases doubling and even tripling their investments. Are you telling us all, they are wrong? After all these are the same people who predicted market meltdowns when some senile idiot was talking about the golden age and once in a lifetime investments when they invested in dead dog companies like citi and ubs

Anonymous said...

IBM? Lol, maybe Warren Buffett haven't tried to buy their products.

Anonymous said...

euro may be low now but will go up soon just like usd.

Anonymous said...

Save as much cash as you can now. Stocks will be wonderful christmas presents next year, but not this year. Property will also make wonderful presents in 2-3 years.

Anonymous said...

"The world will not collapse.
Eat drink & be merry.. wanton mee will still be available at your neighbourhood."

The world will not collapse. But a lot of lives are or will be (e.g protests, civil strifes, occupy wall street, etc) becos adjustments are very painful or too late for some or many (e.g too old or beginning of a new learning curve).

Beliefs & assumptions where past education / training were heavily invested & deployed are shattered when they have to make this painful transition.

Anonymous said...

"If you take the current financial statistics of many companies, you find that they are at their cheapest or close to their levels in history. All the speculative fluff in the dot.com era has completely disappeared and if companies like Dell simply maintain their current performance and do no worse, the stock price can double in 10 years because it would have so much cash in its bank account, it would be able to buy back every share at double the price."

10 years ? Provided they are still around (some may be). As long as their current fundamentals (does Olympus ring any bell) are maintained and not outcompeted and the cash remains intact and not flown out through some legal loopholes by some wise guys, your suggestion sounds pretty good.

But again, don't you think buy back should be done right now (did you say cheapest) when it is undervalued rather than in 10 years' time when it may be overvalued.

Online doctor said...

That will lead to a mottled in May to collect our bags of rice? .. or maybe we have changed our taste buds to eat pizza instead? .. so we bought Italian semolina flour?

Anonymous said...

Lucky, I don't think if the economy is on the way down, it is risky to buy at 2000 STI, on March 9,2009 the index was 1456.95 and if my memory serves me right in 1998 the index went down to 800? I will be more comfortable to buy between 800 to 1500 cause I think the mess we are in is no less than in 1998 and 2009?

Anonymous said...

Sembmarine 04 Oct $3.07 now $3.65
Sembcorp 04 Oct $3.32 now $4.01
SPH 04 Oct $3.71 now $3.85
KepCorp 04 Oct $7.10 now $8.91
CDL HTrust 04 Oct $1.38 now $1.52
StarHub 04 Oct $2.84 now $2.87

What has changed since 4Oct 2011?
Was there more bad news? or less of it?

If there was more bad news, why has the stock prices gone up instead of down?

If they have gone down, I dont see the numbers matching the words!

Something not right here... there are many interested parties adding fuel to the fire.

My view?.. stay out until prices drop below 4 Oct and drop another 30%.. only then will it be cheap.
Otherwise, I will take my chances at Marina Bay.

Amused said...

This is not your grandparents' stock market. It has become more like a casino lately. I would stay away until things blow up in Europe and China. Good luck! (...and you will need a lot of it.)

Anonymous said...

Anon 22:55

I guess another Mar 9,2009 or even at 1998 levels may be on the way soon.

So best to buy in between or preferably near 1998 levels.

Such chances happen once in a long time.

Anonymous said...

Many companies in the US do not last for more than 100 years. IBM has survived this but it will be even more difficult to grow and maintain such old big elephant in coming years. Remember elephant cannot dance properly. IBM may not be around in few ten years time.

The stock market ten golden rules are:
1. Buy low and sell high.
2. Buy only when no one is interested to enter the market.
3. Sell only when almost everyone is interested to buy.
4. Hold whenever 2 or 3 above is not happening.
5. Do not believe what the analysts say.
6. Do not study the fundamentals of the stock you are interested because it is a waste of time.
7. Buy some of the stock that big boy like Warren Buffet is buying.
8. Do not be greedy and know when to enter and exit the market.
9. Consider other investment as well.
10. Cash is the king at all time if you are not investing.

Observing the ten golden rules, you will be fine.

Lucky Tan said...

anon 20:43,

STI at 2000 now is roughly the same as STI at 1500 in March 2009.
Our blue chips have 3 years of earnings and accumulted cash since. Also there is inflation so $1 today is less than $1 in 2009. You price things relative to book value not absolute numbers.

Those waiting for STI to go back to asian crisis low during the fincnial crisis complete missed the opportunity.

Don't try to time things perfectly if you buy at compelling vailuations, things take care of themselves most of the time, Even if fate goes against you, the downside won't be that bad or as bad as others who rode the market all the way down.

Lucky Tan said...
This comment has been removed by the author.
Lucky Tan said...

anon 22:55,

Markets have 10% swings every 2-3 weeks. But how much is the ODW, S&P today relatve to start of the year? roughly 3%!

I was looking at these massive swings since Aug 2011 in stock market, they are unprecedented. The European situation has generally been deteriorating. So the market should have been going down not swinging up and down so wildly. There are also very aggressive moves in the bond market.

The wild swings are cause probebly by aggressive shorter term trading. Very long term investors will step in once prices are low enough even Buffett has not gone all out to buy and has hoarded large amounts of cash.

Because these are short term trades they can reverse on a dime and move 6% higher say in 4 days...just because some leader in Europe say they will conside XYZ tp rescue the banks and so on.

Right now the crisis is spreading steadily to the core. The situation is actually worse than in 4 Oct. However, the US economic number also indicate the US economy is weathering this whole thing much better than anyone expected - remember the US economy is largely domestic and consumer driven.

This is the first time I'm seeing this kind of swings and it is led by what is happening on Wall Street. These are generally the result of very aggressive short term traders and possibly high frequency trading. They amplify moves in the short term overshoot then correct themselves to overshoot in the opposite direction.

So using the stock market to assess if things are getting better or worse is not a good idea. These routine 10% "rapid" swings has very little to do with the economy or the crisis. When short term speculators gain the upper hand on others by shorting the market they wull just look for bad news to coordinate their selling effort. Merkel repeat what she said a few days ago and they speculators come in to push the market down 2%. Conversely, when the market rises sharply in a short span of 2 weeks, it should not be intepreted that things are fine.

We see very unusual things like the S&P index falling 9(?) days in a row.

I don't have time to check out but quite sure these moves can be exploited by the very nimble to make money. After swinging sharply in one direction, the probability of such moves reversing increases as short term traders cannot keep building positions in one direction and they will have to reverse course. If you're smart, you wouldn't be cowed by a sharp move down or enticed by a sharp move up.

Anonymous said...

"So using the stock market to assess if things are getting better or worse is not a good idea."
Lucky Tan

So in Singapore, is using income inequality, MRT very crowded, HDB flats very expensive, too many FTs here etc etc to assess if things are getting better or worse good ideas?

A better idea would be whether, no matter what, PAP still has at least 90% seats in Parliament, right?

Anonymous said...

NO NEED TO BE SCARED OF FREAK ELECTION RESULTS

40% votes for Opposition = 6 seats in Parliament.

So, 80% votes for Opposition = 12 seats in Parliament.
PAP will still retain parliamentary majority.

Just vote your conscience in GE 2016

Anonymous said...

"Stocks are not priced in isolation or in absolute terms. When you have money, you can keep it in the bank, but a piece of property for investment, buy some US treasuries or commodities or gold or just keep it in the bank. Because stocks are an investment option and it has to be valued relative to other investments."

That is why whatever ratio or model (e.g be it Shiller or Black Scholes) will always fail to capture this relativieness. But all these ratios & models impress a lot because of its deliberate complexity.

Once you fix the essence behind the theoretical construct of your ratio and model, people will quickly master and game it rendering your initial assumptions obsolete and invalid (e.g schrödinger's cat paradox).

Besides, 'other investments' could be as mundane as spending on your next holiday or trying your luck in your next trip to casino.

Anonymous said...

Having GRCs is a good idea in Singapore so that PAP can win at least 90% seats in elections.

So what has this got to do with stocks or stock valuation?

Now imagine if the opposition had won 93% seats instead of PAP. What you think will happen to the stock market the next trading day?

So can you see the importance of GRC?

Anonymous said...

Just wondering what has the stock market got to do with the struggle for livelihood in Sin?

Is it to guide the rich to be richer and the poor to better living???

Singapore Man Of Leisure said...

Lucky,

Your financial postings are interesting and thought provoking!

I had a paradigm shift reading this:

"to make money investing, investors shouldn't be asking whether stocks are cheap or expensive but whether they will be going up or down."

Thanks!
Jared Seah