How Undervalued Are US Equities?

I started my online writing career with The Motley Fool back in the mid 90’s when they were an AOL darling. I not only learned about investment principles from the Dave and Tom Gardner, there were some professional editors who taught me how to write for general audiences. I’m much better off financially and professionally due to the investment and writing coaching.

I used to write about investing on this blog in the early days, but really only in relationship to investment decision making. It’s a good time to make some comments.

Times like this make longterm investors very happy, at least if you have investable cash. If you’re happy with companies you currently own, then these gyrations in markets and economies don’t really affect investment decision. But when the market is driven lower by news that has no predictive value, like a down grade in the US soveriegn credit rating, it can be time to invest.

In the well known book Stocks for the Long Run, there’s a neat analysis of the sources of variability in stock price. The largest effect is overall moves in the market itself. We’ve all seen days where the market moves up and down in concert. I compare it to currency fluctuation- the dollar has gained value relative to the entire universe of equities. Since equities are now moving down in the short-term, there is potential gain as they regress to the mean of steady upward increased value. Clearly, the time to initiate long term investment is now, in crisis, not at times of peak optimism.

The best longterm metric for valuing the universe of equities is to compare the cash they generate compared to lending money. The most common value used for US equities is the S&P500, the 500 largest US companies. The value for lending money is a bit more debatable, but 10 year treasury bonds are commonly used as a safe longterm indication of the cash generated by lending.

The earnings history for the S&P500 is available as an Excel download here (registration required). I’ll use the price to earnings ratio for the full year 2011 which is half historic and half estimates. I could use either 12 month historic data or 12 month projected data and the numbers will shift a bit.

The 2011 P/E is 12.68. I actually want the reciprocal which is the earnings in dollars for each dollar of stock of the index I own. That’s 1/12.68 or 0.079 earnings yield. Yields are always percentages, so we’ll call that a whopping 7.9% earnings yield. The yield on the 10 year treasury this morning is 2.39, [a near historic low][4].

So you get more than 3 times as much cash earnings today from equities than long term bonds an unusually undervalue signal for stocks. If you believe, as I do, that the value of companies will regress to the mean over the next few years, buy solid companies you understand.

My current portfolio? Apple (AAPL), Pacific Health Labs (PHLI), Barrick Gold (ABX), Walmart (WMT), and Williams Sonoma (WSM). And outside of my investment portfolio, my employer, PAREXEL International (PRXL).

Most Disingenuous

The Motley Fool: How I Lost $200,000:

When you lose hundreds of thousands of dollars, primarily because of your own stupidity, there isn’t much solace.

I was a contributor to the Motley Fool in the early days when they started on AOL. When they “professionalized” their staff, I stopped. I owe a lot to the Gardner brothers, both for what they taught me about investing and about life. But I became disenchanted with their approach during the tech bubble as it became more and more clear that valuations were out of whack. They had a great approach to evaluating businesses, but they consistently ignored value. It was the only way that one could participate in the hot market of the time- you had to ignore what you were paying in order to keep playing.Once I realized that the party was over, I sold most of my holdings and manage to preserve much of the gains I had from the period. Others, like Selena Maranjian who authored the article remained true believers and held on until the bottom. The Fool had to abandon their founding principles in the end because their real money portfolios which had outperformed the markets during the rise had returned to earth. Now they push community and most shocking to me in a way, is they now promote mutual funds. They send out emails trumpeting short term gains in selected stocks which I generally ignore.This article bugs me as Selena seems to be blaming herself for not putting value into the equation and selling during the bubble. I think it would be more honest for the Fool itself to come clean about its mistakes during it’s growth period. They lacked a sell discipline. It’s something every investor needs. Knowing when to sell is much harder than knowing when to buy. In general, one should sell when the reason for buying is no longer present. In a liquid market with relatively low transaction costs, every day that one holds an investment, it is as if one is buying it anew. At least if we ignore tax considerations which can create value in selling stocks held at a loss and penalties in stocks held at a profit.