Portfolio Management
Investors' gut feeling


The hard truth

Everyone would like some easy rule to follow to get rich. Well, such a simple rule does not exist. Even if it existed, it probably would not make you that rich. Suppose you have $10,000 and you are an investment prodigy who gets a 20% return every single year. Assuming you pay no taxes on the revenues generated and you do not divest your money, how much will you get 30 years from now? Answer is: you will "just" get a little shy of $2.4 million. Obviously, that is a lot of money. First, remember that in real life, you get taxed and inflation is going to make a dent in your bounty. Second, think about it, what are your actual chances of becoming one of the best tennis player or chess player in the world?

Warren Buffet started by investing $10,000 and was able to deliver the sort of returns mentioned above. As you know, Buffet is not a millionnaire but a billionnaire. The trick is that most of his fortune does not come from capital gains. The bulk of it initially came from commissions people were happy to pay for his investment services. Later, he improved his technique and used insurance float. This is equivalent to borrowing money at negative interest rate providing the insurance company does a neat underwriting work. Also Buffet, like Bill Gates benefited from a kind of capital most of us simply do not have: social capital (read family power and expertise). It informs you of opportunities and shields you from legal harm.

Let us review several of these simple rules investors rely on.

The historical approach

Many investors believe that the best investing strategy in the stock market consists in buying and holding a stock for a very long time. Behind this belief, lies a fact: for over a century, a shareholder with an investing time horizon long enough (more than 20 years) always made money. Over the long run, stocks appeared to bear as little risk as bonds or even treasury bills, only to offer a much higher return.

“Past performance is no guarantee of future results”. Does this sound familiar? Nonetheless, some investors still draw invalid conclusions from the past. To begin with, this rule does not apply to all investors. For example, if you are retired, would you feel comfortable to wait 20+ years to cash in your investments? For this type of investor, investing in equity may be a risky bet.

Moreover, sometimes stock prices are so high (remember the “New Economy” era?) that prospective returns become mediocre whatever the time horizon. That was assuming the rule holds. While the rule worked so far, no one can infer from it that it will in the future – or even in present times.

Consider this sobering fact: of the forty or so stock markets that existed in the world during the last century, only a few brought decent returns. These were the US, Canadian, Swedish and Swiss stock markets. Most others delivered poor returns once you deducted inflation, a significant part were interrupted for long periods of time, a few have been discontinued.

Academics would also mention the Efficient Market Hypothesis, a fundamental tenet of modern finance. According to the hypothesis, all information available to the public about them is appropriately reflected in their prices. Stock prices adjust only when the market acknowledges new information which modifies investors’ expectations. Assuming the Efficient Market Hypothesis is correct, only new information would influence market prices.

Therefore, share prices would reflect the true value of a company. Using any valuation criterion or indicator would be pointless since the market is a better judge of value. Economists infer from the Efficient Market Hypothesis that it is impossible to predict stock prices. There is evidence it is indeed the case in the short term. However, over the long run, the Efficient Market Hypothesis has proved wrong so far. Ben Graham school of thought, including Warren Buffet is testimony of EMH failure.

Here goes an economist’s joke. An economist comes across a $100 bill in the street. After a while, he decides the bill is not real. If this bill were real, someone else would have picked it up before!

Nonetheless, EMH should not be overlooked too quickly. As Warren Buffet commented: “Amazingly, [Efficient Market Theory] was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

Market indicators

Let us now turn to indicators. If the stock market is not always correctly priced, maybe some indicators can help. They could actually tell us when to buy and when to sell, or even what to trade. Most of these indicators have been around for a long time and use the same sound principle. A security may be overvalued or undervalued. When this happens, the indicator value slides away from its “normal value”. The “normal value” is generally a historical average of the indicator.

Dividend yield

One of the oldest indicators is the dividend yield. This is the ratio of paid dividend in the year per current share price. This is a very useful indicator. It allows investors to compare stock returns (that is, excluding capital gains) with other financial assets.

A low dividend yield seems to indicate an overvalued market. This was the case in 1999 when the dividend yield was close to 2% while the historical average had been around 5,5%. However, it is difficult to assign a reference value for the dividend yield other than the historical average. The dividend yield has systematically been below its historical average in the past 60 years.

The trouble with the dividend yield is that it hard to interpret. Any dividend yield level could be consistent with stock market correctly priced. On the one hand, it only accounts for a portion of income generated for shareholders. A larger and larger share of shareholders’ income comes from capital gains. Also, companies repurchase shares as a tax-efficient way to remunerate shareholders.

Additionally, low dividend yields do not necessarily mean that the stock market is overpriced. If retained profits increase, this means that the company is investing more. If the proceeds are put to a more profitable use than what is available to the individual investor, then the shareholder benefits from it.

The Price-Earnings Ratio (PER)

This is probably the most widely used indicator today. It is defined as the ratio of market value over profits. Historically, the price earning ratio averages at around 13. A higher value tends to be symptomatic of an overvalued market. Like the dividend yield it is subject to certain flaws. For example, since it is based on profit and this number is generally an estimate.

Economically, the PER criterion seem to make more sense than the dividend yield. Still, in 1932, PER was 24 while the stock market had been clearly undervalued.

The seasonally adjusted Price-Earning Ratio (PER)

The Price-Earnings Ratio, being based on profits, is sensitive to economic cycles. To smooth out this effect somewhat, economists came up with a seasonally adjusted PER. This indicator seems better at forecasting future returns. But it has several drawbacks: it relies on future profit estimates and there are many ways to carry out the seasonality adjustment.

Yield ratios and yield differences

These are exotic criteria without any theoretical justification which are frequently used by professionals of the profession. The general idea goes like this. You try to compare the dividend yield with other yields offered by various asset classes. When the ratio or difference goes beyond or below a certain threshold, you declare that the stock is overpriced (respectively underpriced). The underlying assumption is that interest rates and dividend yield are related. They might usually have a 2:1 ratio or a 1% difference. While there is actually a relationship between stock market prices and interest rates, it is a complex one.

The naïve approach using dividends

Here is another way to look at financial markets. Maybe it is not always worth investing in it. Maybe one should take some preliminary steps to analyze potential returns. This would involve studying the possible future pattern of profits and dividends.

The trouble with this method is that one would have to know the profits say for 10, 20, or 30 years, in advance. In practice, however, security analysts only project – that is with reasonable confidence - profit numbers for the following two years. Beyond, profits are deemed to grow at a certain rate, sometimes set at the same level as the rest of the Economy.

Dividends are derived from Profits using a “payout ratio”. This is literally the ratio of dividend over profit. Once future dividends are estimated, the investor can calculate the theoretical return of the stock. (This is done by discounting the future cash flow of dividends, each dividend being discounted at the interest rate appropriate for its maturity. Hence, next year dividend would be discounted at 1 year interest rate, dividend in year 2 would be discounted at the 2-year interest rate etc.. this is related to the Net Asset Value concept)

The trouble with this method is that one would have to know the profits for 10, 20, or 30 years, in advance. In practice, however, security analysts only project – that is with reasonable confidence - profit numbers for the following two years. Besides that, profits are deemed to grow at a certain rate, sometimes set at the same level as the rest of the Economy.

There is a well-known property in finance which states that a 1% increase in the growth rate of dividends raises by 1% the return of the share. One common mistake is to assume that dividends will increase at the same rate as the Economy. Hence, 1% of added economic growth would result in a 1% increase in 1% share price.

This argument was actually used during the dotcom frenzy to justify insane company valuations. Smart consultants went about chanting that The US economy was now growing at 4% annually instead of 3% prior to that... Nowadays, we would be happy to get just the old 3%.

What is wrong in the argument? It is not easy to spot but the argument actually contradicts one rock solid postulate in Economy: No free lunch. An increased growth does not come from nowhere: for example, people would need to do more babies or work more, new energy resources would have to be found. But demographic trends are hard to change and energy alternatives are scarce.

In general, growth comes from productivity gains. Productivity gains are achieved by investments made by companies. When a company invests more, it means that it is using a larger part of its profits to do so, whereby reducing the dividend paid. Therefore a 1% increase in economic growth cannot result in an increase of the dividend growth of 1%.

Dividends and intangibles

To complete the previous idea, one could study the profit dynamics over time and calculate the dividends knowing the future investment needs of the company to sustain a chosen profit trajectory.

The return of a stock has two components: dividends and capital gains. So far, we have only discussed dividends, implicitly assuming that the share was held forever. In real life, the stock is sold at some point in time - preferably as far away in the future as possible so as to minimize transaction costs and headaches. This means that in addition to dividends you will need to come up with stock prices projections at 10, 20 or 30 years into the future. One way to do this would be to determine the "long term" proportion of intangibles over book value using Tobin's q.

4 Factors affecting the share price

A share is not a financial asset like the others. It is an expectation of future dividends but also a share of a business. Then, when for one reason or another, the intrinsic value increases, the shareholder wealth is augmented. In total, there are four factors that contribute to the change in share value:

In principle, factors 1, 3 and 4 are reflected in the share price. However, the second factor is trickier. The change in intrinsic value has two main causes.

The second aspect is generally not as well known as the first. The inflation rate applicable to machinery and real estate is actually lower than that of the consumer index. That is to say, return on capital is not correctly evaluated.

No free lunch

The hard truth is that everything comes with work. You have to do your research to understand a company’s business, estimate its value, evaluate the ability and honesty of its management, and project that into the future. Then, when you come up with your selection of a few securities you like, you may want to ask yourself about the allocation between them. Bet On Views might help you at this stage.