Investment Postcards from Cape Town

It is stating the obvious that an investor’s total return is made up of the price rise/decline plus the dividend payment. But how does one get a handle on the expected quantum of the price movement?

I am writing this from Veysonnaz, an Alpine village in Switzerland, where I am enjoying a few days of fresh mountain air. Although I planned on taking it easy with my family, I thought it might be worthwhile to consult with the mysterious gnomes while in this haven of global finance. 

The simple answer to the returns question, the gnomes tell me, is to focus on the two components of the returns calculation, namely the expected change in the price-earnings ratio of a company or stock market index and the expected growth in earnings of that company or index. (For the sake of simplicity, dividends, the third component of the returns computation, are not taken into account in this article.)

For those not well versed with the world of finance, let’s briefly review some basics. A price-earnings multiple of 10 times simply means that investors are willing to pay a price of $10 for every $1 of annual company earnings per share. However, if the price-earnings ratio increases to 15 without there being a change in company earnings, it means that investors are now willing to pay $15 for company earnings of $1. This represents a stock price rise of 50%.

If the company earnings of $1 increases to $1,25 without there being a change in the price-earnings ratio, it means that investors will now pay $12.50 for company earnings of $1.25. This represents a 25% rise in the price.

But company earnings and price-earnings ratios seldom change independently from each other. If the two examples above occur simultaneously, in other words the price-earnings ratio changes from 10 to 15 (i.e. a stock price rises from $10 to $15) and company earnings change from $1 to $1.25 (which would result in an additional price increase of 25%), the stock price will change from $10 to $18.75, which represents an increase of 87.5%.

So much for investment theory.

The earnings of the S&P 500 Index’s underlying companies have increased by 14% during the past 12 months compared with a historical average of 8.2% per annum since 1955. The current price-earnings ratio is 18.0 compared with the historical average of 17.2.

In order to get a feel for what these numbers mean, let’s consider the Plexus Valuation Calculator. The diagram is an easy way of determining the expected returns on the S&P 500 Index for different combinations of growth in company earnings and price-earnings ratios.

The diagram shows that if the price-earnings multiple remains unchanged and companies manage to maintain the same level of earnings growth achieved over the past 12 months, investors in the basket of S&P 500 shares can expect a return of 14% on their investment over the next year.

However, should the S&P 500 companies’ earnings be lower over the next year, say 10%, and the price-earnings ratio remains unchanged at 18.0, investors could expect a return of 10% on their investment over the next year.

But what happens when the price-earnings ratio falls to the historical average of 17.2 (still assuming 10% earnings growth)? This will result in a meagre return of only 5% over the next year. Furthermore, any combination of a price-earnings ratio of less than 17.2 and company earnings growth of less than 5% could result in a negative return over the next year.

Investors must bear in mind that companies are not all of the same quality and that any decrease in company earnings will not be the same for all the companies. There will no doubt be companies that will experience a larger decrease in earnings and there might even be some whose earnings could still increase. The same applies to the changes in price-earnings ratios.

Playing around with various combinations of earnings growth and price-earnings ratios makes for interesting reading. But, more so, it also makes it hard for me to find compelling value when considering the US stock market as a whole. The current market environment reminds me of the saying that “in these days the focus should be on the return OF capital rather than the return ON capital”. The gnomes concur.

While some sorry hedge fund tales abound, the following provides an entertaining “top ten” list of hedge fund manager quotes (some perhaps apocryphal), courtesy of Hermes, a London-based fund manager.

10. “If we don’t charge 2 and 20, no one will take us seriously.”

9. “We are 75% cash because we cannot find sufficient investments.”

8. “We charge 3 and 30 because that is the only way we can keep assets
     under several billion.”

7. “We don’t invest in crowded shorts.”

6. “I haven’t shorted before, but I do have my CFA.”

5. “Managed futures are a better investment than hedge funds because
     hedge funds are a zero-sum game.”

4. “What’s a Master Trust?”

3. “Your Head of Equity doesn’t understand our hedge fund strategy.”

2. “Basically, I look at the trading screens all day and go with my gut.”

1. “He will be with you in a minute sir, he’s still meeting with his architect.”

Which one are you?

In the true ancient fashion of King Arthur’s Knights of the Round Table, we have also gathered men of the highest order, not of chivalry but of investment expertise, at our virtual Round Table. In a world first, and a coup of note, four of the investment industry’s leading lights have gathered to debate and map out the direction of global financial markets.

The investment warriors occupying a special place at our Round Table are:

Knight Martin Barnes, managing editor of BCA Research,one of the world’s leading independent providers of global investment research. Martin was raised in Scotland, but relocated to Canada in 1987.

Knight David Fuller, a career analyst, writer, lecturer and investor/trader. He is a director of Stockcube Research where he is Global Strategist and the producer of the daily Fullermoney investment commentary. David was born in New York, but has been living in London since 1969.

Knight John Mauldin, president of Millennium Wave Investments and the author of the Thoughts from the Frontline e-letter and two New York Times best-selling books, namely Bull’s Eye Investing and Just One Thing. John lives in Dallas, Texas.

Knight Barry Ritholtz, the founder of Ritholtz Research and Analytics, author of The Big Picture financial blog and the Apprenticed Investor column and a weekly guest on Kudlow & Company. Barry lives on Long Island, New York.

I have assumed the King’s role in this cast, or more specifically that of moderator of the discussion.

The scene has been set, the wine has been poured and our warriors are ready to do battle.

Prieur: Gentlemen, let’s commence our discussion with a bird’s-eye view of economic growth. Firstly, where are we in the US economic cycle? Martin would you like to set the ball rolling?

Martin: Certainly. The economy is only part-way through a long expansion that began in 2001, after the briefest and mildest recession on record. The economy has been growing below trend since the second quarter of 2006, and this seems likely to persist through the end of this year, reflecting ongoing woes in housing and some retraction in consumer spending. There are no indications of recession any time soon.

David: The US economic cycle is going through a predictable slowdown, largely because of the sub-prime problems, exacerbated by rising long-term interest rates. I maintain that this is no more than a mid-term lull, not least due to the overall strength of the global economy, led by Asia.

The next slowdown period for the US may be in 2009 and 2010, if the Fed and a new administration in the White House decide to clean the Augean stables during the first two years of the US presidential cycle, as is sometimes the case. Also, money-supply figures indicate that inflationary pressures will increase, albeit erratically.

Barry: Based on historical comparisons, we are somewhat late in the cycle. But I hasten to add that prior cycles have not seen this much liquidity in terms of ultra-low rates and printed money. So it makes it difficult comparing apples with apples.

It’s also worth noting that we are only four years from the post-crash bottom. The effects of that collapse are still being felt.

The significance of the housing boom to the US economic expansion from 2001 to 2006 cannot be overstated. The full fallout from that unwinding, in both the sub-prime bust and the impact on consumer spending, is yet to be seen.

John: It seems that the discussion is progressing from relatively upbeat to my rather bearish stance. I still think we will see more of the current slowdown and perhaps a recession, primarily due to the slowdown in housing. As an example of the problem, the Los Angeles Times reports that the most recent UCLA Anderson Forecast for California suggests that the housing market there may not return to “normal” until mid-2009, and job losses in real estate finance and housing will depress hiring through the middle of 2008, lifting the unemployment rate in the Golden State to 5.5%. That certainly corresponds to at least a mild localized California recession. And I think that scenario will play out to a greater or lesser degree throughout the country.

That said, the rest of the economy is doing well, so I think that we will see a continued slowdown or mild recession for this year and then, coming out of that, the US economy should start doing well again. (more…)

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