Investors beware: the warning light has begun to flash amber
Warren Buffett recently observed that markets can quickly turn from green to red, without pausing at yellow. It was a veiled warning that when valuations are at extremes – as they are today – it doesn’t take much to trigger something serious.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Laurent
:
Great article. I agree, markets are in a very interesting position. I have a Nikkei analogue that says there is a very good probability global stocks are quite close to embarking on another massive slide down. I don’t have them yet, but I’m getting ready for some Nikkei puts. Maybe in the next month or so. I could be wrong and stocks could have a massive bounce higher but as you said, with the massive dumb money coming into etfs, corp yields climbing (Especially see it in companies with terrible balance sheets like Tesla where Tesla bonds are selling off hard) and the Fed doing the QE unwind maybe the bear market has begun.
Roger That
:
April was a great month.
Roger Montgomery
:
Indeed. Flashing Amber ain’t red.
Julian Watt
:
Hi Roger
Thanks for the articles. They are valuable.
The Montgomery & Global funds seem to be holding about < 20% in cash. Is that because you believe the invested companies will ride out a fall or because you bought them cheap enough that they won't drop to a loss or do you have a stop loss in place to sell them if they drop too much. Also is there a percentage that you would recommend average investors hold in cash in order to take advantage of a correction?
Roger Montgomery
:
Hi Julian, thanks for your post. We cannot make a recommendation to you individually and I don’t know what an “average” investor is. Even if I knew with perfect accuracy that in 2019 there will be a 40% correction investors would respond in a variety of ways. Our cash reflects our process. The cash is the remainder of that process. If value emerges the cash will fall, and if volatility picks up the cash will go up. there are a number of companies that we think are both high quality and good value and so we are invested where we believe that to be the case on an absolute and/or relative basis. if that changes so will our cash weighting. To determine the right amount of cash for you, you have to develop and follow your own process. Sticking a wetted finger in the air to determine which way the wind is blowing is not a process for cash weighting that can be repeated consistently or successfully.
nathan stromer
:
“It was a veiled warning that when valuations are at extremes – as they are today – it doesn’t take much to trigger something serious.” Mr Buffet is clear that he does not think valuations are at extremes today.
Roger Montgomery
:
His cash balance might suggest otherwise. Prior to the GFC Buffett also appeared sanguine about markets but was hoarding then record levels of cash too.
nathan stromer
:
Berkshire’s cash balance has consistently been near “records” for the last decade. Post March 2009, it was deployed in quantities far less than was available. Indeed, Mr Buffett very recently observed that outright purchases of large business at control premiums is difficult at current pricing; but that smaller purchases at traded prices do not suffer from the same affliction. Predictions on prices are difficult. We know prices are relatively high, but predicting that they are “extreme”?
Roger Montgomery
:
A quick examination of each year’s annual report reveals the answer.
nathan stromer
:
Mr Buffets recently significantly added to Berkshire’s ownership of the world’s highest capitalized company, Apple Inc. Despite already being a huge holding at far lower prices. This behavior suggests either Mr Buffet thinks Apple stock is too cheap, or that cash is unattractive relative to additional stock purchases. Either way, it would support his statements that in general, pricing is not extreme. Of course, some pricing may well be extreme, and it may be high. The Montgomery view may be shown to be correct in hindsight; however Mr Buffets words and actions reasonable support an alternative view. Its probably wise to be as rational as possible.
Roger Montgomery
:
You will note we have always said the returns from shares will, in the long run be better than cash.
And don’t forget everyone can makes mistakes:
https://www.ft.com/content/27963a92-4a36-11e4-8de3-00144feab7de
https://www.cnbc.com/2017/12/15/warren-buffetts-failures-15-investing-mistakes-he-regrets.html
https://www.cnbc.com/2017/05/06/warren-buffett-admits-he-made-a-mistake-on-google.html
Jon E
:
I’m curious with so much money being dumped into tech stocks, how do you value a company like google or Facebook and arrive at it as fair value?
Roger Montgomery
:
Just because money is being dumped into something doesn’t preclude it from being cheap. Value is not price.
When it comes to PE’s its worth reflecting on the following…
“It has every available quality except that of being useful”.
CS Lewis
Conventional Wisdom however suggests a company with a low price/earnings multiple can be considered a better value stock than a company with a high price/earnings multiple.
I wrote this some time ago…If you are an investor in the sharemarket, you have probably read the above statement in numerous articles written by well-intentioned journalists, in countless books by equally well-intentioned authors and in research published by professional analysts.
The statement is, however, misguided and misleading and those who make it may be displaying their ignorance rather than their insight.
In my first job as an analyst, fresh out of university, I also thought I was showing off my knowledge when I could recite the price/earnings (P/E) multiples of the companies I had “analysed”, those in whose shares I had invested, the aggregate P/E ratio of the broader market or the relative P/E ratios of companies within a sector or of overseas peers.
My initial acceptance of the P/E is easy to understand. My mentors, my supervisor and every newspaper article written about listed companies supported my use of the P/E ratio and indeed condoned it. The humble P/E multiple was thus elevated from a rule-of-thumb to a specialist tool for analysts.
Today, managing a more significant amount of money ‘ for clients, shareholders, friends and family ‘ I see the P/E as a rudimentary and clumsy guide for investors. More tellingly, I could not immediately tell you the P/E of any of the companies whose shares we own (sure, I could work it out quickly enough, but I don’t know off-hand).
Yet, as my interest in P/Es has declined, the readiness of commentators and stockbrokers to quote the P/E in all its forms remains unyielding and, more worryingly, unquestioning.
The P/E or price-to-earnings multiple, is simply the market price of a company’s share divided by the company’s earnings per share.
It is widely regarded as a measure of value, a way to determine whether a company’s shares are cheap ‘ as the following from the Australian Stock Exchange’s own website confirms: “In particular, value investors have long considered the price/earnings ratio (p/e ratio for short) a useful measure of the relative attractiveness of a company’s stock price.”
But despite its popularity, sharemarket investors should question any blind faith they have in the P/E multiple. Why? First, some of the world’s most successful investors say it is irrelevant; and second, we can use some basic arithmetic to demonstrate there is little use for it.
Berkshire Hathaway chairman Warren Buffett, possibly the world’s most successful investor, once said: “Irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one the investor should purchase.”
It is the section, “irrespective of whether the business carries a high price or low in relation to its current earnings” that is relevant to this discussion. Buffett is declaring that P/Es are virtually irrelevant in determining a great value-investing opportunity.
Think about this: Price is what you pay and value is what you get. Your job as an investor (as opposed to speculator) is to buy assets for less than what they are worth. If Benjamin Graham (Buffett’s mentor), was correct when he said, “in the short run the market is a voting machine, but in the long run it is a weighing machine” then, by acquiring businesses at below their long-term worth, the market will eventually recognise and reflect that worth.
We have seen this occur in Australia far too many times to disagree with Ben Graham and so have become avid proponents of the rational approach to value investing.
But the P/E has nothing to do with true value investing. It merely compares price to earnings, and price is not value.
As value investors, we are interested in the comparison between price and value, and only then can we identify whether a company’s shares are bargains or not.
There are two basic problems with P/E multiples:
The P/E figure is irrelevant in determining return to an investor.
Earnings per share and earnings growth are unimportant in determining both attractiveness and value.
Any chef knows that if you add chocolate chips, you don’t get a lemon meringue. It’s the same with valuation formulas. If price is an input, you don’t get value as an output. Conceptually that is easy to understand. A couple of tables should help cement it.
In my book Value.able I show a table that describes a company that generates a normalised rate of return on equity of 5% ‘ a mediocre retailer, for example, and retains all its earnings, paying no dividends.
Assuming the shares are purchased and sold at the same P/E, the internal rate of return (IRR) to the shareholder will be equal to the company’s rate of return on equity, in this case 5%. Given this rate of return on equity is lower than can be obtained elsewhere, it appears rational that the company should not retain its earnings but pay them out. The P/E multiple of 10, however, is silent on these issues.
Another table, shows a company that also has $1 of equity, generates a 5% return on equity, but management is rational in the face of inferior returns on equity and pays all its earnings out as a dividend. As a result there is no growth in the earnings. Regardless of the fact that the company has no growth in earnings, the shareholder now achieves a higher return (an IRR of 10%), buying and then selling five years later at the same P/E.
Comparing the rates of return from the two examples, it is evident that for every dollar the company retains in the first example, 50¢ of shareholders’ wealth will be destroyed.
You will notice that the investor’s rate of return, as expressed by the IRR, is higher when a company with a low return on equity pays all its earnings out as a dividend. This is rational behaviour on the part of management who “think like owners”. They wouldn’t invest their bonus payments and other incentives at 5%, given the risk of running a business, so they shouldn’t invest the funds of the owners/shareholders at the same rate.
Uninhibited earnings should only be retained when there is a good possibility (use history as a guide) that capital retained will produce incremental earnings at a rate that is equal to or higher than returns produced by alternative investment options.
The above examples assist in the understanding of the misguided trust placed in the P/E as a measure of “value”. Both companies had a P/E ratio of 10, both generated a return on $1 of equity of 5%, so in the first year both could be purchased at the same price. But the second company produced a return to investors that was double that from the first company. So what use is the P/E of 10, or of 12 or 13 or any other number for that matter?
Over the years, a never-ending stream of commentators has attempted to encapsulate a definition of “value investing”. Many refer to the P/E, suggesting that low prices compared to earnings are an indication of whether “good value” is being presented.
For example, one Fund manager suggested: “market P/Es are reasonable. The prospective P/E for the S&P/ASX300 is around 13, which represents good value.”
Such conclusions are erroneous because absolute value cannot be determined this way. As we have just demonstrated, it’s not the P/E that determines whether a share investment represents good “value”, it is the rate of return on equity of the underlying business, the rate of distribution versus retention and the investor’s desired rate of return that will establish whether a share is overvalued or undervalued for that investor.
A rational alternative
Because price is what you pay and value is what you get, the only way to estimate a rational price is to adopt a valuation model where no input is derived from price.
For the value investor, the best thing to do is forget about the P/E multiple. It’s rudimentary, clumsy and, worst of all, over-rated.
Rather, it is the “business owner” approach to investing in the stockmarket that is precisely what Benjamin Graham and later, Warren Buffett, espoused and have been advocating for decades. It’s what is detailed in Value.able It’s the only way to value a company. Beware of irrational, illogical and flawed imitations.
Chris
:
Here’s another sign, Roger.
http://www.adelaidenow.com.au/business/sa-business-journal/spotify-hits-high-notes-on-us-listing/news-story/e4ab31826bd5734d9d7bd10dd54b2e74
SPOTIFY picked up more fans on Wall Street on Tuesday as investors gave the unprofitable company a warm welcome in its stock market debut. After several hours of anticipation, Spotify’s shares traded as high as US$169 on the New York Stock Exchange before falling back slightly.
The stock market’s rousing reception left Spotify with a market value of about US$28 billion, according to FactSet (by comparison, Apple’s nearly 3-year-old music streaming service has 38 million subscribers).
“The similarities here, we believe, are much greater than the differences,” an analyst wrote in a recent research note assessing the parallels between Spotify and Netflix.
Unlike Netflix, Spotify still isn’t profitable, having lost more than 2.4 billion euros (US$3 billion) since it started more than a decade ago. Spotify has also made it clear that it intends to remain focused on adding more subscribers instead of making money for now.
Roger Montgomery
:
Not much longer now…
Joe
:
It is interesting to see how the same set of data can be interpreted so differently by investors.
I suppose that is stating the obvious & is what makes investing profitable for some & not others.
On a slightly different note, Roger, I notice that, over the last few years, you have recruited in your team some serious maths talent. To that end, are you employing them & considering changing your strategy from “purely” value investing to one which incorporates “momentum” since there have been several studies which have shown that momentum investing can yield significant returns over the long term. With the advent of AI & the team’s expertise surely that is one area that the Montgomery team & its funds can improve on their ROI, instead of holding so much cash?
Regards,
Joe
Roger Montgomery
:
Thanks Joe. We do have the right answer and will implement according to our process.
Kelvin Ng
:
Hi Roger, I disagree. I think that equity markets are close to a major buying opportunity. Unlike previous bear markets, this time the bubble is in the credit markets and particularly sovereign bonds. In the past in bear markets asset allocators went to bonds for safety. This time if they do that they’ll get massacred. It will become apparent that the safety trade is to equities, and that’s where the big money will park.
The good thing about your funds is that even if the above thesis is wrong your holdings are always backstopped by conservative valuations.
Kelvin
Chris
:
With the greatest of respect Kelvin, I think it’s far too early to make that call. Although many of us are eagerly waiting for the opportunity, I don’t personally believe it’s here yet based on my own valuations for the US and Australian stockmarkets.
A “major buying opportunity” would only show itself when there is metaphorical “blood in the streets”, and even then, just buying anything is not the right move.
A couple of rattles does not make a market crash, but you’ll know it when you see it because there will be things that are marked down for a good reason and there will be those that are guilty by association only. How long the sale goes for though, that’s anyone’s guess.
Kelvin Ng
:
Hi Chris, I don’t think you understand what I meant. What I’m saying is that because of capital flows from bonds into equities, the most likely scenario is that equity markets will turn into a genuine bubble (a la Jeremy Grantham – S&P 500 around 3,500). Bond are in a genuine bubble already. And although I agree equities are expensive, they are not in bubble territory. And I’m saying the best strategy for playing this scenario is to invest in conservative value funds like yours, so that:
1.) if my scenario doesn’t play out your holdings would always be backed by conservative valuations and substantial cash levels; and
2.) if my scenario plays out then even though investors won’t fully participate in the stock market bubble they will still participate.
A bet both ways I guess.
Hope that helps.
Kelvin
Roger Montgomery
:
“they are not in bubble territory”; Generally we require hindsight to know
andrew ronan
:
Crazy thing is he could be right, but only because there is only one thing left that the fed can do and that’s buy equities through ETFs as the Japanese central bank has been doing for years now and reportedly owns over %30 of ETFs in Japan. I’ve been calling for a crash in the sp 500 for over a year now but since Janet Yellen said there will never be another financial crisis in our life time, I’ve begun trying to translate that comment of extreme insight and over confidence, and I can only assume she means to say we will do what it takes as good old Mario has said in the EU. In other words Print Print Print and Buy Buy Buy all the things or the whole house of cards will crumble. What else can they do ?
Kelvin Ng
:
By the way Chris and Roger, I really like your caution. That’s one of the reasons I invest in your funds.
Kelvin
andrew ronan
:
I can’t emagine that equities will rise if people sell bonds to buy them, because if bond yields rise much more than they have already due to being sold off, many more people will dump equities due to the fact that corporate debt is so high not to mention consumer debt, and if the costs of servicing those record debt levels rise even a little bit, it will have dramatic effects on consumer spending and corporate profits, hardly a tail wind for equities. All of which proves Alan Greenspans ingenious observation that we have two bubbles that are stocks and bonds, just don’t mention realestate, collectables, crypto currencies, etc etc. Well done Al, I just hope our kids and grandkids can live with the consequences of your experiments.