Value investor drought

Pity the poor value investors.

Although they have excellent long term records, value investor results over the past couple of years have been poor relative to the market.

Consider Bill Miller at Legg Mason. After beating the S&P 500 for 15 years in a row, he has had a dreadful 2 1/2 years. His performance has been so bad his mutual fund investors are leaving in droves.

Does this mean value investing no longer works? Should investors pursue another methodology? If value investing hasn’t worked, what has?

The answer is momentum. If you simply invested in the things that were going up, you would have easily beaten the market. Invest in natural resources, such as oil or gold, after they went up and they’d just keep going up.

Is that a good way to invest now? Not normally, and probably not going forward.

You see, the market goes through periods when one thing works and others don’t. This rarely lasts because everyone jumps on the bandwagon until it’s full and no one else is left to jump on board. I think we’re close to that point now.

The last time momentum out-performed value investing was in the 1998-1999 period. After that, value investing clearly beat momentum investing for several years running.

Usually, when the market goes down, value investing handily out-performs. But in this down market, momentum has been winning. You have to go all the way back to the early 1990’s to find a similar situation. Guess what happened after that? That’s when Bill Miller’s record 15 years of out-performing the S&P 500 began.

Don’t pity the poor value investors–JOIN THEM. Every time value investing has performed poorly in the past has proven to be an excellent time to get on the value investing bandwagon. Right now, people are getting off, and that’s precisely why you should be getting on!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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The stock market is down, but is it cheap?

Caution: please remove sharp objects from arms reach before you read this!

The S&P 500 is almost in bear market territory, down just short of 20% since its most recent high.

This fact leads market commentators to question if the market is getting cheap.

My answer: looking at long term, historical evidence, the market is not cheap. In fact, it would have to drop another 23% from current levels or remain flat for 4 1/2 years before trading at historical, fair value.

Before you read my reasoning below, please keep in mind that you don’t have to invest in the market as a whole. In fact, there are times when it’s better to invest in active managers who are trying to beat the market (but make sure they really can beat the market). Because I believe we are in a secular bear market that started in 2000, I think this is one of those times.

I’m finding some of the best bargains I’ve seen in my 12 1/2 years of investing. I’m absolutely giddy about the great companies I’m finding at great prices. This evaluation does not, however, include the stock market as a whole.

Why do I think the market is expensive. In a word, history. Looking at the history of the S&P 500, you can clearly see that earnings per share grow at around 6% a year over the long term. A plot of S&P 500 earnings per share with a simple exponential fit is a wonderful thing to behold (send me an email if you want to see it). Every time earnings per share deviates from the long term average, it regresses to the mean. Every time.

Using such a plot, I can see what the average, forward price to earnings ratio has been since 1948 by simply dividing year end price by the one year forward estimate of earnings (using the 6% growth rate fit on historical S&P 500 earnings per share).

Since 1948, the forward price to normalized earnings ratio has been 14.85. Let’s keep things simple by rounding up to 15. That allows for the fact that price to earnings ratios have been creeping up over time.

Using my plot of normalized earnings per share for the S&P 500 of $65.70 (June 30, 2009 normalized earnings per share for the S&P 500) and an historic price to forward earnings of 15, I come up with a fair value for the S&P 500 of $985.50, or 23% below current levels ($1,280 at the time of this writing).

By my reasoning, the S&P 500 wouldn’t be at fair value unless: 1) it drops another 23% tomorrow or 2) remains at $1,280 for the next 4 1/2 years.

I don’t mean to scare anybody with my forecast, I’m simply showing that, in the long term, price follows earnings. And, if earnings grow at historic rates and the market is willing to pay in the future what it was in the past for those earnings, then the S&P 500 is anything but cheap right now.

I wouldn’t assume a lot better results if you’re invested in the market, or with a professional investor who is so diversified as to essentially be mimicking the market (a lot of them are, a whole lot).

Take heart, though. You don’t have to invest in the market. Look for stocks that are better quality and cheaper than the market and you’ll do just fine. Or, better yet, find a professional who can do it for you.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The returns you get on your money matter…A LOT!!!

Although I understand clearly the argument for low cost index funds, especially for more risk averse people, I want to briefly make the argument for going after above average returns.

Why? Because it can have a HUGE impact on your quality of life. Getting above average returns can greatly improve your safety and security both before and during retirement.

Let me give you some a examples to clearly illustrate my point.

Suppose Bob starts saving at 30, retires at 65 and dies at 95. Also, suppose he saves $100 a month from the time he’s 30 until he reaches 65. Finally, suppose he gets 7% returns from age 30 to 95. How much will Bob have to live on? Around $13,400 a year from the time he’s 65 until he dies at 95.

Now, suppose Fred does the exact same thing as Bob, except he gets 8% returns from 30 to 95–only 1% better than Bob! Fred will have around $18,400 a year to live on from the time he’s 65 until he dies at 95. That’s 37% more a year to live on!

Using slightly different savings inputs, that’s the difference between having $50,000 a year in retirement versus having $68,500 a year! That’s HUGE!!!

You can plug any numbers you want to in the scenario above, and you’ll get the same general answer. Getting better returns–even mere 1% better returns–can hugely raise your standard of living in retirement, thus giving you more peace of mind, safety and security.

More provocatively, let’s suppose you don’t know when you’re going to die–most people don’t! How long will your money last when your retire?

Let’s use the same numbers above, except let’s assume both Bob and Fred don’t know when they are going to die, so they spend $17,500 a year. How long will their money last if Bob gets 7% returns and Fred gets 8% returns? Bob’s money will last 17 years–he’ll run out of money at age 82. Fred’s money will last 38 years–he’ll have money until 103 years old!

Can you imagine running out of money at 82 versus having enough to last to 103? That’s a huge change in safety and security!

My point here is not that everyone should try to get above average returns. My point is that getting above average returns may REALLY be worth it if you have the tolerance and ability to go after above average returns.

I’ve been beating the market, after fees, by around 3.5% a year for the past 12 years (past results are no guarantee of future performance). Want to guess what my retirement projections look like? Want to guess how much peace of mind I have?

If you have the right temperament and the right financial situation to go after above average returns, it can have a huge impact on your current and future lifestyle. In my opinion, it’s well worth going after.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Concentration versus diversification

The academics will tell you to diversify, and they will probably tell you that there’s no such thing as too much diversification.

I beg to differ.

It all depends on your objective. If your objective is to match market performance, which, by the way, will beat 80-90% of individual and profession investors, then by all means diversify to your heart’s content.

In diversifying, make sure you have all asset classes, including stocks, bonds, real estate, commodities, etc. And, make sure you have subclasses within in those asset classes, like small and large stocks, foreign and domestic stocks, etc. Finally, make sure you keep your costs as low as possible.

But, if you want to out-perform the market, you have to concentrate your investments.

By definition, investing in all the stocks in the S&P 500 will, after fees, never significantly beat a low priced S&P 500 index fund. That seems obvious.

The only way to out-perform the index is to invest heavily in a few stocks that you believe can out-perform the index. Once again, that’s definitional.

It makes intuitive sense, too. Is it even possible to keep track–really understand and accurately assess the value–of 500 stocks? Not in this world.

It doesn’t seem reasonable to expect your 21st, 51st, 101st, or 501st idea to be as good as your top 5, 10 or 20, either.

It makes as much sense empirically as it does intuitively.

The folks who out-perform the market–really out-perform after fees by a worthwhile margin–are always concentrated on less than 50 or, more likely than not, 20 stocks.

And, they probably size their positions to correspond to the return and probability characteristics of the investments they make. By that, I mean they buy more of the stocks they believe have a high probability of getting outstanding returns and buy less of the stocks they believe have a lower probability of achieving merely good returns.

If you don’t believe me, look at Warren Buffett, or Bob Rodriguez, or Wally Weitz, or Bruce Berkowitz, or Glenn Greenberg.

Warren Buffet recently said that if he were managing $50 – $200 million right now, he’d have 80% in the top 5 stocks and 25% positions in the top few. If you aren’t as good as Warren Buffet, you probably don’t want to be that concentrated, but you get the idea.

Do you have to have conviction to invest this way? You betcha!! And nothing hones your investing focus like putting a lot of your money into a few stocks.

I’ve been investing this way for over 12 years now, and I’ve been quite happy with the results. I’ve beaten the market by a significant margin (past results are no guarantee of future performance), and this has allowed me to grow my net worth quite quickly.

If you want to match the market, diversify broadly and do it with the lowest fees possible.

But, if you want to beat the market, you should concentrate.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.