Monday, January 31, 2005

Stock Market Looks Undervalued by 30%

Yesterday I ran across a graph at (good collection of data here) showing the historical valuation of the overall stock market for the period 1979-2005. The data compare the actual S&P 500 index with "fair value" defined as "12-month forward consensus expected earnings divided by 10-year US Treasury bond yield."

To summarize the data:

1979: Market was undervalued compared to fair value by about 30%;
1980: Market quickly caught up with fair value;
1981-1998: Market tended to track fair value within 10%;
1999-2000: Market rose while fair value fell, producing 30% overvaluation during the dot-com craze;
2001: Market fell, bringing it back in line with fair value;
2002: Fair value rose while market contiinued to slide, producing undervaluation of market by 30%;
2003-2004: Both market and fair value rose, maintaining 20% to 30% undervaluation.

By this simple measure of fair value, today the stock market is 30% undervalued compared to where it historically has traded.

Possible future scenarios are:

1. Analysts' estimated earnings will be revised downwards, bringing fair value down to market;
2. Interest rates will rise, pushing fair value down to market;
3. Market will rise to fair value line;
4. The market vs. fair value gap will continue.

Based on history and "mean reversion" thinking, #4 is unlikely, particularly in the long run. At this point in market history, I think it is a good educated bet that the stock market will converge to (and possibly shoot past) fair value over the next year or two. Unless interest rates rise dramatically (budget deficit and trade balance worries?) or estimated earnings get revised downward quickly (recessionary impact of rising oil prices?), the market should have a lot of room to rise. I am on board in anticipation of a healthy run upwards to fill the 30% undervaluation gap.

From an asset allocation point of view, I think it likely that the generous flow of money that has gone into chasing real estate over the past five years could slow, with some of the money finding its way back into the stock market. The recent revival of venture capital money (2003-2004) following the dot-com bust (2001-2002) is a sign that investor interest in equities is once again on the rise.

Saturday, January 29, 2005

Merits of Volatility in a Portfolio

Here's a simple explanation of how volatility can work in an investor's favor to generate higher portfolio returns.

Prices in financial markets tend to move geometrically, not arithmetically. Certainly, at the extremes a stock's fall is limited to 100% but it can rise an unlimited amount. The basic geometrical "one-to-one mapping" of up moves to down moves is:

Probability of movement up X%
= probability of movement down [1 - 1/(1 + X/100)] x 100%

If we buy two stocks and one rises while the other falls an equal geometric amount, we end up with the following two-stock portfolio returns:

1% up move + 0.99% down move gives very close to 0% average move;
10% up move + 9.1% down move gives 0.45% average UP move;
30% up move + 23% down move gives 3.5% average UP move;
50% up move + 33% down move gives 8.3% average UP move;
100% up move + 50% down move gives 25% average UP move;
200% up move + 67% down move gives 67% average UP move;
500% up move + 83% down move gives 208% average UP move;
1000% up move + 91% down move gives 455% average UP move;

Observe how volatility is an investor's friend. For example, it is better to buy two volatile stocks and see one rise 100% while the other falls 50%, producing an average portfolio return of 25%; than to buy two less volatile stocks, see one rise 10% and the other fall 9.1% and end up with an average portfolio return of a measly 0.45%. At the ten-bagger extreme, with one stock rising 1000% and the other falling 91%, the advantage of high volatility becomes strikingly clear--no one would complain about a portfolio return of 455%!

For this reason, I prefer to hold volatile stocks rather than less volatile ones, believing that over time the volatility will work in my favor on a portfolio basis.

Friday, January 28, 2005

The Long-Term Investor's Quintuple-Edged Sword

I list what I see as the main advantages of long-term investing:

1. Ride the Secular Trend: History tells us that capitalism favors equity investors over bondholders. Going long for the long haul puts capitalism's "wind behind your back."

2. Save on Fees: Long-term investing means less portfolio turnover, consequently lower fees. For example, a 1% (100 b.p.) per annum savings in fees over 30 years produces a very significant difference: $100 at 7% growth gives $761, while 8% growth results in $1006. That's a 32% advantage over 30 years.

3. Defer Taxes: Throw taxes into the mix and the difference widens: Continuing to work the above example, with 20% tax paid every year on 7% profits, $100 grows to $513 after-tax over 30 years; whereas if 20% tax is paid only once at the end of 30 years on the cumulative 8% annual profit compounded over 30 years, $100 would grow to $825 after-tax. That's a 61% advantage over 30 years, approximately half from fess saved and half from the time value of deferring taxes over the years. Bump the tax rate up to 30% and the advantage widens to 75%.

4. Face Less Competition: Financial markets and assets tend to be priced quite competitively, in the sense that when a pack of investors are all looking at buying the same stock or property, the pricing unually ends up being higher than I want to pay. Since the vast majority of institutional and individual investors are bunched up towards the short end with investing horizons of a year or less, those investors with longer term investing horizons have the advantage of facing less competition, which should translate into more attractive deals (viewed from a long-term perspective) both on the way in and on the way out.

5. Exploit Timing Advantages: In our short-term world, thinking long-term provides opportunities to buy stocks and properties cheaply when Mr. Market is pessimistic about future prospects, and to sell at dear prices when Mr. Market becomes irrationally exuberant. Fundamentals (sales, profit margins, earnings, cash flow, etc.) evolve as companies grow, while market prices fluctuate on the whims and emotions of the herd of investors. There are convergence-divergence opportunities in this interplay of long-term fundamentals with short-term price movements.

That sums up the five-fold "edge" that long-term investors have. Good value on the way in and high profit in the way out are available to patient investors with a long-term view who are willing to "think different" (Apple's one-time marketing slogan) from the pack.

Wednesday, January 26, 2005

Persistent Earnings, Cyclical Returns (III)

Using earnings and returns for the 30 DJIA companies over the past 10 years, I have crunched a few more numbers. Instead of boring you with the detail, I will just summarize the results:

1. Higher earnings reliability is correlated with higher returns (r-squared = 0.24): Companies generating more reliable earnings provide higher returns over a long period of time;
2. Earnings reliability shows some persistence (slope = 0.09, r-squared = 0.08): Companies with consistent earnings tend to continue to provide consistent earnings;
3. Returns, however, do not show persistence; in fact, returns tend to be a reverse indicator! (slope = -0.24, r-squared = 0.18): Companies providing the highest investment returns in 1996-1999 showed among the lowest investment returns during 2000-2003;
4. Consequently, earnings reliability, by itself, is not a good indicator of future returns (r-squared = 0.04): If an investor had bought the companies with the highest 1996-1999 earnings reliability at the beginning of 2000, he would actually have been worse off during 2000-2003 than an investor buying companies with lower earnings reliability.

In brief: While earnings may persist, returns do not. Why not? Because there are cycles of investor optimism, when the market (Benjamin Graham's "Mr. Market" is a good analogy here) drives prices and valuation ratios (P/S, P/E, P/CF, etc.) up in anticiption of growth acceleration--only to be followed by investor pessimism, when prices plummet and companies "get shot behind the barn," as it were, for missing earnings by a few pennies or projecting slower earnings growth. This is what happened during 2001-2002, when the stock prices of fundamentally sound companies (like Home Depot and GE) with high earnings reliability fell sharply.

The message here is that investors overreact, both on the way up and on the way down, even though earnings over the longer run may be fairly steady and predictable. Stated another way, we can say that investors tend to make buy-sell decisions based on short time horizons, providing buying and selling opportunities for investors with a longer-term mindset.

Prescription: Buy companies with consistently rising earnings that have become undervalued by the market. Sell these when they become overvalued (which can typically take years). Repeat this exercise with a portfolio of stocks (or real estate properties).

Sounds easy enough, right?

Tuesday, January 25, 2005

Earnings Reliability and Total Returns (II)

Does higher earnings reliability lead to higher returns? For evidence to begin to answer this question, I went back to the Dow earnings data and generated a scatter plot against total returns over the same period of time, 1995-2004. Unfortunately, I don't know how to upload graphs to this blog; so, a simple numerical table will have to suffice:

Tables show:
Dow component: Earnings reliability vs. total return (annual)

Companies with HIGHEST earnings reliability:
Home Depot (HD): 2.39 vs. 18%
General Electric (GE): 2.38 vs. 17%
Wal-Mart (WMT): 2.23 vs. 21%

Companies with LOWEST earnings reliability:
Boeing (BA): -0.27 vs. 4%
Honeywell (HON): -0.31 vs. 6%
Hewlett-Packard (HPQ): -0.47 vs. 8%

Among the remaining 24 Dow components:

Companies with HIGHEST total returns:
Citigroup (C): 0.70 vs. 23%
United Technol. (UTX): 0.53 vs. 22%
Microsoft (MSFT): 0.76 vs. 20%

Companies with LOWEST total returns:
General Motors (GM): 0.23 vs. 3%
Coca-Cola (KO): 0.28 vs. 3%
Merck (MRK): 1.11 vs. 3%


1. Companies with the highest earnings reliability (HD, GE, WMT) produced among the highest total returns (average = 19%) over the past 10 years. By comparison, companies with the lowest earnings reliability (BA, HON, HPQ) had considerably lower total returns (average = 6%);

2. The remaining 24 companies, which sit in the central "cloud" of the scatter plot, also show the same correlation: Companies with the highest returns (C, UTX, MSFT) had, on average, higher earnings reliability than companies with the lowest returns (GM, KO, MRK).

The full scatter plot of all 30 Dow components has an r-squared coefficient of 0.24, giving us some confidence that, as expected, higher earnings reliability is generally correlated with higher total returns.

Conclusion: To the extent that companies with consistent earnings in the past continue to post consistent earnings in the future, we should give serious consideration to companies with high earnings reliability as we search for higher returns.

Sunday, January 23, 2005

Importance of Earnings Reliability (I)

As an investor, I seek high returns but also have a strong preference for predictability of investment outcome. In the long run, a company's stock price tends to rise or fall with earnings (or, perhaps better: free cash flow; similarly, real estate prices are strongly correlated to the household earnings power of neighborhoods--but these are topics for another time). The ability to determine where earnings will be in a few years naturally impacts the certainty with which we can predict our investment performance.

So, just how predictable are earnings? Earnings predictability depends on many factors: the industry a company is in, balance sheet leverage, how the company is managed, etc. To establish a reference point, last night I took a look at the earnings (EPS) growth of the 30 current members of the DJIA over the past 10 years. Based on historical EPS figures during the period 1995-2003 (including 2004 results where available), I calculated the compounded (geometric average) annual EPS growth for each Dow component. Using year-on-year percentage changes in EPS, I also calculated an "earnings reliability" measure defined as follows:

Earnings reliability = (Average change in EPS)/(Std. dev. of EPS changes)

(This measure is similar to a Sharpe ratio--the higher the ratio, the more predictable (or less volatile) the earnings are.)

The table below shows how the component companies in the Dow stack up (top 15, in order of decreasing earnings reliability). I also list analysts' average 5-year growth estimates and the forward PE (current price/next year's earnings estimates) for each company.

Company: EPS-Reliability/ Hist.-Growth/ 5y-Growth-Est./ Fwd.-PE

Home Depot: 2.39 24% 13% 16
GE: 2.38 12% 9% 20
Wal-Mart: 2.23 16% 14% 19
Johnson & Johnson: 1.24 13% 11% 18
Merck: 1.11 10% 3% 12
Microsoft: 0.76 20% 11% 18
Citigroup: 0.70 19% 11% 11
Procter & Gamble: 0.69 12% 10% 19
AIG: 0.67 14% 12% 13
IBM: 0.60 12% 9% 17
Altria: 0.54 10% 8% 12
United Technol.: 0.53 16% 10% 16
Intel: 0.50 7% 13% 16
3M: 0.49 10% 10% 20
American Express: 0.42 11% 11% 17

(Data from and

To take a peek at the numbers behind the earnings reliabiity measure, here's how a few of the EPS (in $) time series for 1995 to 2003 look:

Home Depot: 0.34, 0.43, 0.52, 0.71, 1.00, 1.10, 1.29, 1.56, 1.88
Citigroup: 0.87, 1.36, 1.27, 1.22, 2.15, 2.62, 2.75, 2.59, 3.42
DuPont: 2.77, 3.18, 2.08, 1.43, 0.19, 2.19, 4.15, 1.84, 0.99
Boeing: 0.58, 1.60, -0.18, 1.15, 2.49, 2.44, 3.41, 2.87, 0.89

Home Depot's earnings have been rising so steadily over the past 10 years that analysts' estimates for 2004 (2.26) and 2005 (2.56) are easy to believe. At the other extreme, Boeing's earnings are so volatile that it is more likely that analyst's estimates for 2004 (2.57) and 2005 (2.58) could be off the mark, increasing the likelihood of a negative earnings surprise.

I do not claim to be able to predict future stock prices with the kind of certainty that is needed to win short-term in the game of investing but, based on the past, I can make an educated guess about where earnings of companies with high earnings reliability will be in the future and, thus, how I believe stock prices will follow. Considering growth prospects and the reliability of this earnings growth, I prefer to own Home Depot at a PE of 16 and 5-yr. growth estimate of 13% (PEG of 1.25), rather than Boeing at a PE of 19 and 5-yr. growth estimate of 9% (PEG of 2.11). For companies with a history of solid earnings growth and high earnings reliability, I can be confident that higher future earnings will drive the stock price predictably higher over the years ahead.

(Disclosure: I have been long Home Depot for some time and continue to be impressed by the ongoing earnings growth of this stable retailer with a very conservative (D/E = 0.09) balance sheet. Earnings growth appears to have slowed to the mid-teens as the company has matured and seen competition from Lowe's; however, "big box" efficiencies brought to the fragmented home improvement sector and international expansion opportunities should provide catalysts for growth for years to come.)

Friday, January 21, 2005

Investment Idea: Sina

Following the close today, I read a comment that for the first time since 1977, the Dow, S&P 500 and Nasdaq have all traded down for each of the first three weeks in January. Year-to-date stats are: Dow -4%, S&P500 -4%, and the more volatile Nasdaq -7%. If this downward movement defines a trend for the year, we should brace ourselves for some tough months ahead. However, situations like this one also present opportunities to do a little "shopping." By the miracles of investor over-reaction and short-term profit-taking or loss-cutting (as the case may be), there often are companies whose shares become available at irresistably cheap levels.

One such company I have been eyeing for some time is Sina (SINA), the leading Chinese Internet portal. (Disclosure: I'm long and considering buying more shares.) A long list of positives attract me to this company:

* Long-term economic growth of China: 9% annual GDP growth may be slowing to 7%, but China is still the fastest growing economy in the world and has many years of growth ahead as it transitions from a managed to a market economy;
* Chinese Internet usage: Projections are that in 2005 or 2006, China will have more Internet users than any other country, and that will be when penetration is still only 15% or so;
* Market leader: Sina is the most popular Chinese Internet portal among the field including Sohu, NetEase and Tom Online. As market leader, Sina is favored by major players (note recent deals with Yahoo for auctions, NCsoft for games, Microsoft for Outlook SMS) seeking a partner in China;
* Summer Olympics: Over the next three years, the upcoming 2008 Summer Olympics will attract more attention to China, and Sina should benefit from more advertising revenue and growth as a result;
* Currency revaluation: The U.S., Japanese and other governments have been pressuring China to remove the peg of the RMB (currently said to the undervalued by 40%) to the dollar. While revaluation may be unlikely to occur this year and could wreak havoc on the Chinese economy when it does occur, profits from operations in China will see a windfall gain from appreciation of the RMB when translated into dollars;
* Low PEG: Analysts' estimates show 5-year projected earnings growth of 37% annually for Sina (vs. 11% for the S&P 500). Currently trading at a forward PE of 17 ($25.57 close, $1.47 Dec-2005 earnings estimate), Sina's PEG ratio is less than 0.5!;
* Upside: Analysts' average 1-year target price is $37, which would give about 50% upside if realized.

What's the downside? Well, anything is possible--maybe an earnings miss, increased competition and pricing pressure, loss of market leadership, a significant and protracted economic slowdown, tighter government controls, more insider selling, accounting problems. . . . Yet, given the robust growth and momentum of Sina's business and management's track record of positive earnings surprises in each of the past four quarters, it seems unlikely that a disaster in near. I gauge downside as being around last summer's low of $20 (PE of 13) and upside as high as $50 (PE of 35). From the current trading level of $25, this gives an attractive upside-downside ratio of 5:1.

While profit is never guaranteed in equity investing, at current price levels I am willing to make an educated bet on the long-term growth, profitability and success of Sina. A safe way to play is to check our investment thesis against the upcoming 2004Q4 earnings release (should be around Feb. 1), before loading up the truck, as they say.

Capitalism and Long-Term Investing

Suppose you were given a chunk of money, say, a million dollars, to work with a round figure. How would you invest it in today's world? Stocks or bonds or real estate? Bank CDs or cash? How about gold and oil? U.S. or international markets--Europe, Japan, China, Korea, Australia? There certainly is no shortage of choices.

Let's begin with a thumbnail sketch of the global politico-economic landscape. Following World War II, we lived in a bipolar world, with capitalism (U.S., Europe, Japan, Australia) pitted against communism (U.S.S.R., East Germany, North Korea, China). The U.S. and U.S.S.R. engaged in a Cold War arms race, expending a sizeable amount of GDP to build and stockpile nuclear weapons and support their large militaries. Well, this Cold War antipathy and paranoia was obviously very wasteful and, ultimately, the less efficient economies crumbled: China began to open her doors in 1978, and today shows promise of becoming the world's next economic leader by the end of the 21st century. The Berlin Wall fell in 1989, dramatically reunifying East and West Germany and helping to set the stage for economic cooperation in Europe and, among other things, the creation of the Euro in 1999. In 1991, the U.S.S.R.'s economy fatally imploded from internal weakness. Today, here we are in 2005, with North Korea struggling to maintain her economy, while (South) Korea flourishes by comparison.

The outcome over the past half century is crystal clear: Capitalism has outrun communism as an economic system. The trend for the next half century is also clear: We will likely see continued growth of the world's capitalistic economy, an environment in which private enterprise, for-profit corporations and entrepreneurs bring home all the kudos.

As investors, we are participants in this capitalistic system. For guidance on what to invest in, we simply need to ask: Who wins in capitalism? The nature of capitalism is that risk-takers profit, meaning that, on the whole, equities tends to outperform bonds. The world's multi-billionaires--Gates, Buffett, the Waltons, Ellison and others--are living examples of higher returns from equities. The historical long-run behavior of the financial markets, both in the U.S. and internatially, is well-documented in Triumph of the Optimists (2002), by Dimson, et al. The message is that over the past hundred years in all countries with available data (U.S., Canada, U.K., Ireland, France, Germany, Switzerland, Italy, Spain, Denmark, Belgium, Netherlands, Sweden, Japan, Australia, South Africa), equities have outperformed bonds. Representative examples of long-run (1900 to 2001) inflation-adjusted annualized returns are:

Country: Equities vs. Bonds

Australia: 7.5% vs. 1.1%
U.S.: 6.5% vs. 1.6%
U.K.: 5.6% vs. 1.3%
Japan: 4.3% vs. -1.5%
France: 3.6% vs. -1.0%
Germany: 3.3% vs. -2.2%
Italy: 2.3% vs. -2.1%

For verification and my own edification, I have also downloaded total return data on the U.S. market from and observed that, since as far back as the data go (late 1800s), there has never been a 30-year window when stocks (S&P 500) have failed to outperform both bonds (10-year Treasury) and cash (T-bills). This long-run outperformance of equities held true even for an equity investment beginning in 1929, just prior to the stock market crash and Great Depression of the 1930s. Looking ahead, I suspect that even for unfortunately timed equity investments begun in Japan at the end of 1989 before the collapse of the Japanese stock and real estate bubble, or in the U.S. in 2000 just before the bursting of the U.S. technology and Internet stock bubble, the familiar pattern will again hold true: Well ahead of their respective 30-year horizons--2020 in Japan and 2030 in the U.S.--the Nikkei 225 and Nasdaq stock averages will rise from ashes and equities will once again trounce bonds and cash.

Capitalism is a well-stocked train running along a well-built track, subject to delays (e.g., periods like 2000 to 2002 with lots of pain and suffering in the stock market) but unlikely to derail during the lifespan of anyone reading this blog. Aside from those wishing to make a habit of testing their powers of clairvoyance and trying to time the markets, anyone level-headed, informed, intelligent investor seeking high long-run returns should dedicate all or most of their available investment capital to equities. In our capitalistic world, the preponderance of evidence indicates that equities (both stocks and real estate) will continue to outperform other asset classes in the long run. Simply put, equity investing is the name of the game!

Thursday, January 20, 2005

Why an Investment Blog?

I started writing about investing a few years ago, off and on, just whenever a good idea came to mind. Sometimes I penned my thoughts by hand into the hardcopy spiralbound notebooks that I have been keeping for the past few decades. On other occasions, generally whenever I felt I had something more important to say, I would tap away on a keyboard and save my Word files for posterity--though never quite knowing when I or someone else might, if ever, take another look at what I had written. Then along came blogging. Hmmm, what a convenient way to organize, store and share my thoughts. To all of you who happen to become readers: Welcome! Let's together make this a most pleasant voyage into the wacky, wild and wonderful world of investing!