Macro Investing 2: Valuation
October 2, 2006
Valuation is a long and complex topic, but you have to start somewhere. I suppose anyone who dabbles in stocks, even a little bit, is aware that something like an 8x trailing price/earnings ratio is low, and 20x is high. 25x is definitely high, and above that is high danger territory. For individual companies, the picture is more complex. It is certainly possible to have a 4x trailing earnings stock that is maybe too expensive (like homebuilder stocks today), and a 25x trailing earnings stock that is arguably a bargain based on its growth profile. On the broad scale of a diversified stock index, however, these oddities average out.
We won’t go into the various methods for valuation here, although I would refer to our earlier piece on real estate valuation for an example of how this sort of thing is done. The point is, you should have some awareness of whether assets are cheap or dear. When assets are cheap, there is a chance they will gain higher valuations, while their intrinsic values (such as profits) will also increase. This double-whammy effect can lead to rapid increases in market prices. If you buy an asset at a high valuation, then there is a fair chance that valuations will fall, so that the speculator will not make any money even if fundamental values slowly improve. Worse yet, if fundamental values decline (due to recession or other economic disaster), you find values and valuations plummeting together, leading to dramatic declines in market prices.
Thus, valuation is one of the greatest defining variables of investment returns. Real estate investors have a nice saying: you make your money when you buy, not when you sell. In other words, you buy an asset at a price at which you can’t lose. If you think about making your money when you buy, things will usually turn out well. The goal then is to make the most money possible when buying, or in other words buying the best assets you can find for the best prices you can find. If you are willing to hold an asset for a long time, i.e. your strategy does not rely on a greater fool, then you are probably in good shape. This does not mean ignorant “buy and hold” investing, in which stubbornness and indecision replaces research and due diligence. It means that you understand why your asset is worth owning, no matter what the market price is.
However, valuation has very little value in market timing. A cheap market can get cheaper. An expensive market can get more expensive. Both can continue in that fashion for years at a stretch. To understand when to get into a market, you have to use your macro tools to identify a period in which the macro picture is changing. For example, I believe that the housing bust in the US will have considerable repercussions beyond the housing industry, and thus negatively affect virtually all businesses in the country. If asset prices were low, this might not be that important. There was a major consumer slump in Korea recently, but stocks went up anyway, in part because they were so cheap to begin with. However, from today’s high valuations, I see considerable risk in US equities, and believe that we are at or near a turning point for them. But even if I am wrong about US equities turning down, the fact that they are so highly valued means that I won’t be missing much upside by not being in that market. If I am wrong, then stocks might go up around 6% per year. Which is sure a whole lot better than getting 5.25% in cash. Or not.
One reason I am harping on valuation here is the not-so-long-ago tech bubble, which truly was a bubble of the most disgusting proportions. For whatever reason, many “macro” guys choose to remain stone ignorant when it comes to valuing individual companies. They saw a booming economy, and apparently “the market” was confirming their rosy forecast. Stock fundamentalists were saying that Cisco at 100x earnings was gaagaa — not to mention the legions of companies, many with multi-billion-dollar market caps, whose chief virtue was that they didn’t make money at all! (In those days, making a profit was a sign of foot-dragging conservatism.) Thus, if you choose to understand macro investing, please ALSO understand how to read and analyze financial statements. Even if you find that you are a subaverage stock-picker, and end up sticking with index investing instead, this knowledge will give you a much better idea of which indexes to be involved in, and when.
To take another example, I would stay away from equities in India at this time. Fundamentally they are doing great, and all your macro tools may indicate more good things ahead, but at 25x earnings they are priced to do great. It seems that every emerging market has a time when it gets to 25x earnings. Even the Philippines was 25x earnings back in 1995 or 1996. Typically, it doesn’t stay there very long. Today you can buy companies in the Philippines — good ones — for 6x earnings. Maybe they will go to 25x in the future.
That’s all for now. It’s fun to talk about the investing process instead of the heavy macro stuff from time to time.