Where are we in the market?

I don't participate in the macro forecasting game and since I don't like looking foolish don't usually make comments about it- there's just too many variables: elections; central bank interventions; untraceably complex sharing of risk between companies and among countries; currencies; moody dictators; sunspots; etc. Naturally, then, here are my comments on this subject. The purpose is to maybe lay out a helpful backdrop from a fundamental perspective of the overall market that we're operating within.

Except for things like art and baseball cards, investment value is usually tied to earning ability. Even though there are plenty of investment approaches that ignore this fact, this remains fundamentally true of a stock. Not just a single stock, but the entire stock market as a whole. It's been well said that price is what you pay and value is what you get, and although the two can grow apart for extended periods, with price wandering off, over time price comes back to value.

We'll use after-tax earnings as the proxy for value and price is self explanatory. Price, as measured by the overall market's P/E ratio, is not startling high, but isn't cheap. This is generally the measure that is watched for bubble indications. Most often it's rising prices that is the concern. However, the distance between value and price can widen not only due to price increases but also due to earning decreases.

In the aggregate market, both price and value are mean reverting- human nature pretty much guarantees this. At the combined market level, corporate after tax profits (CATP) have a long term (since 1929) mean level of about 6% of GDP with a "band of normalcy" falling between 4.5% to 6.5%. In the last 5 years they have been at or near record highs, surpassing 11% in 2013. Both competition and regulation will eventually see that these recede back into their normal range. Since 1920 there has been an average of 7.5 years between trough and peak of the CATP as a percentage of GDP. Our current high CATP as a percentage of GDP happens to be right about 7.5 years since the last trough. Earnings, which is the fundamental basis for price, look to have some headwinds which may already have begun being felt.

The other fundamentally important factor I'll mention is also one that obeys the law of mean reversion: interest rates. This has clearly been the boy falsely yelling "wolf" for a number of years now. Rates have been expected by many, including myself, to increase long before now. I have little idea when they will meaningfully rise but eventually they will. Interest rates affect different types of businesses differently but have one overarching and uniform affect on the market as a whole- they form the basis for discounting future earnings. The higher the rate the lower the value of future income must be, of course.

The position of having record low rates and record high CATP as a percentage of GDP is an undesirable situation for the overall stock market and some of the market's unsatisfactory results are most definitely a result. This is the bigger picture, the stage that thousands of publicly traded "actors" perform on. We're more concerned about those individual performances than the background so let's move briefly on to the more important topic of individual companies and keep with the theme of understanding investment consequences in conjunction with fundamental aspects.

The appreciation return received from an investment in a publicly traded business can be expected to equal its return on equity (ROE) times its earnings retention rate, provided that its price-to-book ratio and number of shares remain constant. If the ratio that future investors are willing to pay for a company's equity, its P/B ratio, moves above (below) what was originally paid by the current investor, this movement will increase (decrease) the return that could otherwise be expected based on the company's ROE.

The ideal situation, then, is finding companies with high sustainable growth rates (ROE x retention) and below justifiable P/B ratios. The high ROE should indicate the quality of the business and its competitive advantage (why I say "should" is highlighted in a moment). The P/B ratio represents its popularity, and therefore the price you'd have to pay to own that business (remembering that a fantastic business can be a terrible investment based on the price paid (and vice versa)). The caveat is that just identifying currently high ROE is not enough. Further, even a business with a track record of high ROE, while definitely better than just one or two years of high returns, is still insufficient to pass judgment on the quality of an enterprise. There remains the need to understand the business and why that business can achieve and maintain a high return on its equity.

High returns on investment are sought by all businesses, and it's this widespread pursuit that typically brings above expected returns back in line with normal expected returns in an industry. A company realizing high ROE entices competitors into their market. This increased competition will result in reduced margins and returns on capital... unless a company possesses a competitive shelter of some sort that protects it from competition and allows it to continue earning above normal returns. Having some insight into what allows a business to achieve better than expected returns, given that there are market forces constantly trying to take them away, is important to not making bad investments.

A good example of this was a company named Strayer Education, a for-profit, post-secondary education company. An analysis by Morningstar around 2010 cited its very attractive ROE (above 95%) and, moreover, its historical record of high ROE, commenting that this represented a wide "moat". That wasn't an illogical conclusion. However, the question of "why can they achieve such great returns on equity?" may have exposed some problems. You might have first looked to see if they were a low cost producer and if this enabled them to offer great tuition rates. The answer here was no. In fact, generally for-profit education is substantially more expensive than non-profit tuition. This understanding could have led to asking: "if they charge so much more, is the quality of education significantly better?" This would have been hard to measure but the answer here was also no based on the default rates of loans taken out by their students. This starts to look troublesome: they charge more, provide less, yet are earning very high returns. This digging could have led to the conclusion that they were able to earn such high returns only because, although their customer were the students, the payer of tuition was primarily the government (they were dependent on federal student aid). This disconnect between payer and consumer and a sleepy government led to abuses and a high ROE that was completely unsustainable.

The quantitative (observing a high ROE and the current price being paid for that return) is easy. The qualitative (understanding why a company earns what they do and how sustainable it likely is), however, is both critical and much more difficult. In this way the whole market behaves like its pieces- there's plenty of noise but long term results stem from fundamental aspects and the useful thing is understanding what those are and how they might look in the future.

In summary, the larger forces described above- those of fundamental value- will ultimately direct the overall market and they will ebb and flow. It looks like we are in the ebb stage.

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