Market Commentary

Value Counts … Eventually

“…valuing the market has nothing to do with where it's going to go next week or next month or next year, a line of thought we never get into. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.”
Warren Buffet, Op-ed Piece in Forbes Magazine,
Nov 22, 1999

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
Warren Buffet, Op-Ed Piece in The New York times,
October 16, 2008

It would be hard to overlook when one of the world’s most successful investors makes an uncharacteristic move and comments on the outlook for the broad equity market. What is interesting is that the first quote above, delivered at a time when Buffet was warning about the excesses of the tech market in 1999, received a good measure of ridicule when it was delivered. In relation to the second quote, where markets continued to sell off heavily in the wake of several high profile Buffet investments, there has been some chatter about Buffet ‘losing his touch’. It is our belief that history will prove him right as it has in the past.

Given the magnitude of the declines over September and October, investors might be forgiven for not sharing Buffet’s positive view. Chart 1 shows the year to date returns for various global indices in local currency terms. Canada, down 29.4% since the start of the year, has fared somewhat better than most other markets, but is still on track for one of its worst showings.

Is there value?
Given the performance of the market so far, it is a fair question to test Buffet’s comments and ask, “Is there value in this market?” In our view, such an effort is likely to be subjective and fraught with some risk, not least because of the collective inability of the markets to foresee the risks posed by leverage in the financial system or to predict the extent and path with which the dominoes have fallen or could continue to fall.

That said, there are a few basic measures of value for the markets. One of them is the Price to Earnings (PE) ratio. This ratio simply measures the amount that the market is willing to pay for $1 in recurring earnings for a company, or for a market index. A PE ratio of 15x means that investors are willing to pay $15 now to receive $1 of current earnings.

The top panel in Chart 2 depicts the PE ratio for the S&P 500 and S&P/TSX since 1956 (based on trailing recurring earnings). Current levels are at their lows since the early 1990’s and the market low reached in mid October saw PE ratios fall to levels approximating the lows of the 1987 crash.

The chart shows that PE ratios have gone lower in the past, touching high single digits in the late 1970’s and early 1980’s (yellow shaded box). For perspective, however, we have added data for 10-year US Treasuries (middle) and inflation (bottom).

Equity markets are a discounting mechanism; they take future earnings and put a value on them today. This process is heavily influenced by interest rates and inflation. In a high interest rate, high inflation environment, today’s value of a stream of future earnings is much lower than the value of the same income stream in a low interest rate, low inflation environment. With the rapid rise and persistent high level of interest rates in the 1970’s and 1980’s, a very low PE multiple was warranted. Today, even though headline inflation spiked in the summer due to rising oil prices, most forecasters expect inflation to fall back to somewhere in the 2% range later in 2009, reflecting slower economic conditions and lower oil prices. Furthermore, periods of debt reduction and a troubled lending environment have generally been associated with deflationary risks. With interest rates roughly half of what they were in the late 1980’s and early 1990’s, the current market would strike many as being attractively valued from a bigger picture perspective, even more so at the lows experienced in mid-October.

Other Measures of Value
Other measures of value are Price to Book Value (P/BV) and Dividend Yield.

• P/BV – The book value of a stock is a rough approximation of what a company is worth after all of its assets and liabilities have been disposed of; in other words, the recovery value in the event of insolvency. As shown in Chart 3, the ratio of price to book value has reached lows unseen since the early 1990’s. Again, at the October 10 lows, P/BV fell to levels not seen since the trough of the 1987 crash. Moreover, RBC Capital Markets’ Quantiative Research team has calculated that at mid-October, roughly 30% of North American companies were trading at or below their break-up value.

• Dividend Yield – Dividend yields have also risen to levels not seen in 15 years as shown in Chart 4. It is also evident that dividend yields prior to 1990 were much higher; however this to some degree reflects the ways that corporations have chosen to spend their cash. In recent years, many corporations have chosen to buy back shares rather than pay dividends which, in a perfect world, allows investors to receive capital gains as opposed to dividend income, and own a larger proportion of the company and its future earnings.

• A more telling measure might be the yield based on the cash flows earned by a company after paying all of its expenses, known as free cash flow. Chart 5 shows that at mid-October, the free cash flow yield on large capitalization US stocks reached a level rarely seen in the post-war period. In our view, any opportunity to buy companies at valuations where they are able to generate cash flows of 8% (some of which might be paid in dividends, some reinvested, and possibly some used to repurchase stock or retire debt) is worth noting. (A real estate investor who could find an income property that generated an 8% cash yield after all expenses would happily borrow money at 6% or 7% to buy it, calculating that even if the price of the property declined by 1% or 2% each year over the life of the loan they would do no worse than break even, while if value or rents were to increase even modestly, return on the investment would be high).

What does this tell us?
Stock markets experienced extreme volatility over the month of October. While the S&P 500 and S&P TSX fell -34% and -30% respectively for the year to date as of October 31, they troughed at -43% and -38% mid month. At trough levels:

• The metrics mentioned above were at levels not seen since roughly the time of the 1987 crash, a time when interest rates were significantly higher.
• The overall decline in prices was approaching the largest drop witnessed in any bear market in the post war period.
• According to RBC Asset Management, the market was pricing in roughly a 35% decline in earnings, commensurate with the most severe recessions in the past 50 years (Chart 6).

Taken together, these points would support the notion that equity prices at the very least provide a reasonable balance of risk and reward for the longer term investor. The key unknown is the path of the markets near term; we would not rule out a retest of recent lows as deteriorating economic numbers and earnings forecasts remind investors of the risks still faced by the market. Moreover, the slowing global economy and ongoing overhang from the liquidity and banking crisis could lead to a fairly tepid recovery for some time. In short, value counts, but not always right away.

What Can Investors Do?
There is always a strong tendency amongst investors to wish they had resorted to tactical asset allocation in bear markets, hopefully holding only cash when markets were declining, and switching to all stocks when the bottom has passed. In our experience, this is rarely done successfully, and risks compounding the negative performance by failing to be there for the eventual rise in the markets until it is much too late. A study by Dalbar Inc. notes that many mutual fund investors underperform the funds they own because they tend to buy heavily as the market approaches the top and sentiment is most positive, and sell near the bottom when sentiment is at its worst (Dalbar Inc, 2008 Quantitative Analysis of Investor Behavior). Moreover, history has shown us that markets often turn long before a bottom registers in employment, corporate earnings, and consumer and business sentiment and the upturn can often be swift.

Reacquanting One’s Self with Long Term Investment Plans
Putting aside the temptation to time the markets via tactical asset allocation, the fundamental driver of the investment process is the investor’s long-term strategic asset allocation. The decision over what proportion of a portfolio to invest in stocks and bonds is a personal one based on the desire for growth versus safety and the investor’s time horizon.

In the 83 years since 1925, US stocks have recorded a total of 24 negative annual returns. Of these, eight recorded losses between 10% and 25%, and another three losses exceeded 25%. Yet over the long term, investors have benefited from owning stocks in their portfolio. Whether investors chose to turn the equity dial a little or a lot, occasional setbacks – sometimes big ones, are not unexpected and are not easily avoidable. The biggest mistake an investor can make once his or her long-term strategy has been set, is to deviate or change strategy at critical junctures. This not only means avoiding the temptation to go to all cash when markets are already down, but also to continue to implement the long term strategy on an on-going basis.

More specifically, we would note that in most cases, loss years have been followed by a positive equity performance the following year. This raises the importance of rebalancing. Consider a portfolio that started out as 50% equities and 50% bonds at the start of the year is now in the range of 39% equities and 61% bonds (due to the decline in equities). The bonds have done their job in blunting the downside of the equity market and even rising somewhat in value, however should stocks begin to rise, the investor would now be underweight stocks and would underperform his or her strategic asset allocation. Naturally, committing more funds to equities at a time when markets have fallen 30-40% is emotionally very difficult. Such a reallocation need not happen all at once, and can be accomplished in a number of ways.

One such way is the reinvestment of dividends and coupons into the stock market. Much is often made of the fact that there have been occasions where equity returns were flat for an extended period of time, such as in the 1970’s. As shown in Chart 7, investors buying stocks in 1973 would have had to wait until May 1980 before stocks would once again return to the price at which they purchased them (blue line). However, had the investor reinvested his or her dividends (red line), the value of the portfolio would have troughed slightly earlier and, as dividends were reinvested in a rising market, the value of the portfolio would have risen at an accelerated rate, returning to its original value in May of 1976, and growing by another 40% by May of 1980.

Being Smart Within the Equity Portfolio
There are many things an investor could do within their equity portfolio. Investment themes for the current environment include:

• Look for companies that are leaders in their field in industries which are defensive in nature; i.e. those that make money in good times and bad. Makers of consumer staple goods and companies in the health care come to mind. Most of the opportunities lie in firms outside of Canada.
• Look for large capitalization companies that are leaders in their field and can capitalize on the failure of weaker competitors to increase market share and enter the eventual recovery on a stronger footing. Companies are in the business of adapting to changing environments and those with a strong vision, a unique product, or strong execution abilities will also see their share prices suffer in a bear market, but are more likely to survive and prosper when the downturn has passed.
• Avoid or at least be very careful of those companies with heavy near-term refinancing needs given the difficulty most corporations are currently having accessing the capital markets on favorable terms.
• Look for companies that pay consistent and growing dividends. The ability to steadily grow dividends while simultaneously growing the business is a sign of strong management. The discipline imposed by a regular dividend payment reduces the likelihood that management will divert resources to poorly thought out projects or other inappropriate uses. As demonstrated in Chart 7 above, just reinvesting dividends is an important part of growing a portfolio. However, assembling a portfolio that features growing dividends is likely to increase that gap, as demonstrated by Chart 8 which illustrates the performance of stocks with a strong history of growing their dividends. Note, given the market selloff, there have been no safe areas to hide, nonetheless, the “dividend growers” still managed to outperform.

• Diversify holdings amongst a large number of positions (20 or more, depending on size of the portfolio) in a wide range of industries and geographies.
• Finally, given that so many stocks have fallen in value, there may be a tax planning opportunity with tax-loss selling strategies, where capital losses can be used to recoup taxes paid on capital gains in the past, or put aside to offset potential gains in the future.

In summary, we find it hard to argue with the Warren Buffet assertion that stocks are well valued for investors with multiple-year horizons. We believe that current valuations provide a fair trade-off between potential upside and risks, despite the fact that the catalyst for realizing that upside remains unknown, and there is the potential for both a period of volatility ahead of us, and a potentially tepid recovery for some time thereafter.

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