Monday, June 20, 2011

Stocks Cheapest in 26 Years

At least that's what this Bloomberg article suggests.

Bloomberg: Stocks Cheapest in 26 Years as S&P Falls, Profit Rises

Valuations do seem not at all expensive for some stocks. The Dow Industrials, for example, at this time offer a number of examples of stocks selling near or even below 10 times earnings.

Obviously, the earnings expectations could prove to be optimistic. We could be heading into a soft patch (or worse) that ultimately make those earnings look more than a bit inflated.

Still, with the earnings yields (inverse pricing to earnings) in the 8% to 10% range, valuations do seem reasonable even if earnings growth turns out to be modest. Some of these franchises -- though, of course, not all -- even have somewhat better than modest earnings growth prospects. The better ones produce lots of excess cash that'll be available for distribution to shareholders. What does get reinvested can produce attractive returns that also ultimately benefit shareholders. In fact, just a little bit of growth on top of an 8% to 10% earnings yield (as long as earnings are of the high quality variety and capital allocation is sound) quickly becomes above market returns.

Will capital will be allocated reasonably well? Do current earnings roughly reflect normalized free cash flow (i.e. not at a cyclical peak and not needed to maintain business competitiveness)?

That's what'll matter in the long run.

The key thing is that earnings are 1) free to be distributed to shareholders and/or 2) can be used for incremental investments that ultimately produce high returns for long-term shareholders. Some businesses need to use just about all their earnings (or what seems like earnings) to remain competitive. Many airlines and some automakers come to mind. Those companies only have earnings in an accounting sense but less so in an economic sense. Here's how Charlie Munger looks at it:

"There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, 'There's all of my profit.' We hate that kind of business."

Speculators can try to jump in and out the second kind of businesses if they want.

Most investors, it would seem, have better things to do with their money.

The risk of poor near term price action after buying shares of even the very best business "too early" is very real. Yet missing the chance to benefit from potential favorable long run economics of a franchise can be just as costly (errors of omission).

Warren Buffett has pointed out how costly errors of omission can be:

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in."

Investing well is not about successfully buying at the lows. That's effectively impossible and, in fact, the attempt to do so creates its own problems. Investing is about buying something understandable at a discount (to intrinsic value). In fact, attempting to time things perfectly might result in missing the chance to buy something at a sensible price.
(Near-term price action is inherently BOTH directions. When the focus is on judging how price compares to value and long-term effects, the price action tends to end up mattering much less than some seem to think.)

The key question is the sustainability of each franchise. It's about whether the long run economics are likely to remain in tact. The focus should always be, at least for long-term owners, on price paid relative to a conservative estimate of value. In fact, if the price drops further it sometimes can create an opportunity.
(By offering the chance to buy shares of a good business at a discount via incremental purchases, buybacks, and dividend reinvestments.)

10-year Treasuries yielding less than 3% seem, by comparison, very unattractive.

Those 10-year Treasuries probably feel safer to some investors in the short run but that doesn't mean they are actually safer when all risks are considered.


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