Common Sense on Mutual Funds

Fairly Valued at 100 Times Earnings?

Indeed, in the waning days of the twentieth century, observers who believed that the market was in fact undervalued were making a strong case. In an article on the editorial page of the Wall Street Journal in March 1998, James K. Glassman and Kevin A. Hassett of the American Enterprise Institute accentuated the positive. A four-column banner headline asked: “Are Stocks Overvalued?” The answer followed immediately: “Not a Chance.” The writers suggested that stocks (then trading at 25 times earnings) could safely double in price—to 50 times earnings. “We are not so foolish as to predict the short-term course of stocks, but we are not reluctant to state that, based on modest assumptions about interest rates and profit levels, current P/E levels give us no great concern—nor would levels as much as twice as high.”

Their analysis depended primarily on two assumptions. The first was that stocks deserve no risk premium over bonds. Citing research by Wharton Professor Jeremy Siegel indicating that real long-term stock returns are less volatile than those from bonds or bills, Glassman and Hassett argued that the historical risk premium of 3.5 percent that stocks commanded over bonds could disappear altogether. As the risk premium declines, stock prices rise.

Their second assumption was that cash flows to the stock investor would, over the long term, grow at roughly the same rate as the economy. When both assumptions are plugged into a rudimentary mathematical model, the result implies that there is almost no price-earnings ratio at which stocks would be overpriced. In their article, the authors report: “We find the P/E that would equalize the present value of the cash flow from stocks and bonds is about 100. By this measure, the stock market is undervalued by a factor of about four,” indicating that the stock market, then priced at roughly 25 times earnings, could quadruple. That analysis would seem to be the strong form of the bullish case.

Glassman-Hassett, Siegel, and Occam

Whichever case prevails, these forecasters are all working in an Occam - like way, relying principally on the long-term fundamentals of dividend yields and earnings growth to make their evaluations. Glassman and Hassett, in their thesis, added a second, deceptively simple variation. With the stroke of a pen, they eliminate what has been an almost infinitely variable risk premium in favor of a single unvarying standard: a zero premium. Would that investing were that easy! By postulating that stocks have room to rise until expected stock returns equal bond returns, they eliminate the role of speculation. At that point, of course, stocks would be valued to provide future returns equal to the current yield of the U.S. Treasury bond. It’s as simple as that.

The Glassman-Hassett argument notwithstanding, I am not willing to concede that stocks deserve no risk premium, nor even the slim premium that would be required based on current fundamental investment values of stocks and bonds. Simple logic says that, over time, a final outcome that is predictable on a straight-line basis (compound interest on a zero-coupon Treasury bond, for example) is more attractive than the same final outcome that is subject to wide fluctuations before the end point (i.e., a stock portfolio with a guaranteed long - term return). Nonetheless, it is possible that we are indeed at the dawn of a new economic era in which stock risk is muted, stock return is more certain, and the risk premium is accordingly more modest.

Rightly or wrongly, many institutional investors seem to be even more strongly concerned about the course of future stock returns than I am. Jeremy Grantham, founding partner of institutional investing powerhouse Grantham, Mayo and Van Otterlo, looks for nominal stock returns of about 3 percent during the coming decade, well below the range of 5 to 8 percent that my analysis, based on good fundamentals and some diminution of the price-earnings ratio, suggests. Gary Brinson, head of investment policy for some $1 trillion of assets managed by international banking giant Swiss Bank Corp., is only slightly more optimistic. He looks for future returns on U.S. stocks in the 7 percent range in nominal terms. His version of Occam’s razor is based on, as he puts it, “Simple math. The dividend yield is 1.5 percent. Real growth has historically been 2.8 percent. Let’s be heroic and say it’ll be 3.5 percent going forward . . . which gets me to 5 percent. Add inflation of 2 percent, and there’s my 7 percent. In the long run, stock prices have to track underlying fundamentals.”²

Historic Parallels?

One final thought: There are some remarkable historic parallels between today’s investment thinking and the investment thinking that prevailed in 1929. The 1929 mood was well captured by Graham and Dodd in their original (1934) edition of Security Analysis—perhaps the most powerful financial textbook of the century. In Chapter XXVII, the authors examined in retrospect the causes of the 1929-1933 market crash. Consider these excerpts (italics added):

The New-Era Theory

During the latter stage of the bull market culminating in 1929, the public acquired a completely different attitude towards the investment merits of common stocks. The new theory may be summed up in the sentence: “The value of a common stock depends entirely upon what it will earn in the future.” Hence, the dividend rate and the asset value were entirely devoid of importance. This complete revolution in the philosophy of common-stock investment took place virtually without realization by the stock-buying public.

A new conception was given central importance—that of trend of earnings. The past was important only in so far as it showed the direction in which the future could be expected to move. Along with this idea there emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based upon research showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past. The combination of these two ideas supplied the “investment theory” upon which the 1927-1929 stock market proceeded. The theory ran as follows:

1. The value of a common stock depends on future earnings.

2. Good common stocks will prove sound and profitable investments.

3. Good common stocks are those with rising past earnings.

These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses which could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether it was a desirable purchase.

“New-era investment,” as practiced by the representative investment trusts, was almost identical with speculation—buying stocks instead of bonds, emphasizing enhancement of principal instead of income, and stressing the changes of the future instead of the facts of the past. New-era investment was simply old-style speculation confined to common stocks with a satisfactory trend of earnings. The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis.

An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy “good” stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic. Countless people asked themselves, “Why work for a living when a fortune can be made in Wall Street without working?”The ensuing migration from business into the financial district resembled the famous gold rush to the Klondike, with the not unimportant difference that there really was gold in the Klondike.

Investment trusts were formed for the purpose of giving the untrained public the benefit of expert administration of its funds—a plausible idea. The earliest trusts laid considerable emphasis upon time-tried principles of successful investment. But these traditional principles disappeared from investment-trust technique. The investment process consisted merely of buying shares of prominent companies with a rising trend of earnings—a select list of highly popular and exceedingly expensive issues, appropriately known as the “blue chips”—regardless of price.

Investment trusts actually boasted that their portfolios consisted exclusively of the most popular and highest priced common stocks. With but slight exaggeration, it might be asserted that under this convenient technique of investment, the affairs of a 10-million-dollar investment trust could be administered by the intelligence, the training, and the actual labors of a single thirty-dollar-a-week clerk. The man in the street, having been urged to entrust his funds to the superior skill of investment experts—for substantial compensation—was soon reassuringly told that the trusts would be careful to buy nothing except what the man in the street was buying himself.

In the new-era bull market, the “rational” basis was the record of long-term improvement shown by diversified common-stock holdings . . . as exemplified by a book entitled Common Stocks as Long-Term Investments, by Edgar Lawrence Smith, published in 1924, in which common stocks were shown to have a tendency to increase in value with the years, for the simple reason that they earned more than they paid out in dividends, and thus the reinvested earnings added to their worth. [But there was] a radical fallacy involved in the new-era application of this historical fact.

The attractiveness of common stocks for the long pull thus lay essentially in the fact that they earned more than the bond-interest rate upon their cost, for example, a stock earning $10 and selling at $100. But as soon as the price was advanced to a much higher price in relation to earnings, this advantage disappeared, and with it disappeared the entire theoretical basis for investment purchases of common stocks. When investors paid $200

per share for a stock earning $10, they were buying an earning power no greater than the bond-interest rate, without the extra protection. Hence in using the past performances of common stocks as the reason for paying prices 20 to 40 times their earnings, the new-era exponents were starting with a sound premise and twisting it into a woefully unsound conclusion.³

If the 1929 investment environment described by Graham and Dodd sounds like today’s to you (except that, in today’s market, $200 buys less than $8 of earnings), I’ m not surprised. Consider the similarity of the ideas expressed by Edgar Lawrence Smith in his 1924 book and by Professor Jeremy Siegel in his 1998 book. Consider today’s similar price-earnings ratios. Consider the seemingly parallel roles of the investment trusts of that era and the mutual funds of this era. Consider even whether the 1929 focus on portfolios, consisting of the most popular and highest-priced blue chips in an investment trust “administered by . . . a single . . . clerk,” isn’t a parallel to today’s popularity of index funds modeled on the Standard & Poor’s 500 Stock Index, heavily weighted as it is by growth stocks with enormous market valuations.

But things change. Today’s interesting historic parallels with the late 1920s may produce similar destructive consequences to those of that earlier era—or they may not. Nonetheless, better to know about the past than to remain ignorant of the lessons it may hold.

An interesting postscript: Chapter XXVII of the original edition of Security Analysis is conspicuous by its absence from the current edition. According to Raymond DeVoe of Legg, Mason & Company (“The Strange Case of the Missing Chapter”⁴), it was gradually abbreviated in subsequent editions, then omitted entirely in the most recent editions. That may be the most ominous sign of all.