Friday, December 2, 2011

Rear-View Mirror Investing

"People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." - Warren Buffett in Fortune, December 2001

From this article in AAII Journal on the "Nifty Fifty":

"The Nifty Fifty were a group of premier growth stocks...that became institutional darlings in the early 1970s."

The article then added...

"The Nifty Fifty were often called one-decision stocks: buy and never sell. Because their prospects were so bright, many analysts claimed that the only direction they could go was up."

Ugh. Many of these were good businesses but price matters. Here's what to keep in mind you hear an extreme valuation being justified:

"...many investors did not seem to find 50, 80 or even 100 times earnings at all an unreasonable price to pay for the world's preeminent growth companies."

Forbes magazine later said this...

"What held the Nifty Fifty up? The same thing that held up tulip-bulb prices in long-ago Holland—popular delusions and the madness of crowds. The delusion was that these companies were so good it didn't matter what you paid for them..."

Forbes then pointed out the problem wasn't with the companies. Instead, the problem was...

"...the temporary insanity of institutional money managers—proving again that stupidity well-packaged can sound like wisdom. It was so easy to forget that probably no sizable company could possibly be worth over 50 times normal earnings."

These days, quite a few high quality large cap stocks are selling at price to earnings (P/E) in the mid-teens and even much lower that that. Of course, the P/E multiple can shrink further but it's not as if, at some point, the opposite can't also happen. The growth in intrinsic value and the expansion/contraction of P/E ratios frequently have little to do with one another.

At a time when the macro world seems to have only darkening skies ahead, many won't be considering that a high probability. If or when large caps will get expensive again* isn't knowable but, while it seems improbable now, at some point down the road they just may.

The multiple of earnings that investors are willing to pay tend to expand when the skies seem clear and predictably often contract when less so.

In the 2001 Fortune article, Buffett compares the 1920s to the 1940s and explains the "monumental hangover" the public was still suffering 20 years later:

"The country was then intrinsically far more valuable than it had been 20 years before; dividend yields were more than double the yield on bonds; and yet stock prices were at less than half their 1929 peak...But rather than seeing what was in plain sight in the late 1940s, investors were transfixed by the frightening market of the early 1930s..."

Buffett then said don't assume it's just the small investor who invests in the rear-view. He uses the early 1970s as an example:

"...this was Nifty Fifty time--pension managers, feeling great about the market, put more than 90% of their net cash flow into stocks, a record commitment at the time. And then, in a couple of years, the roof fell in and stocks got way cheaper. So what did the pension fund managers do? They quit buying because stocks got cheaper!" - Warren Buffett in Fortune, December 2001

When a good business is bought at a nice discount to value, there's little need for the macro world to improve or for P/E multiples to expand to make investor returns satisfactory.

Meaningful discounts to value are usually the most pronounced when the macro storm clouds seem to everywhere and getting worse.

Now, once a good business has been bought at a discount, it's certainly not a problem if the prices investors are willing to pay for a dollar of earnings happens to expand down the road.

Don't plan on it but consider that possible outcome a bonus if it happens.

The opposite, buying at the higher earnings multiples, doesn't work that way. You have to hope the high multiples remain high or sell and hope for attractive prices down the road. Being on the wrong end of a crunch in earnings multiples wouldn't be fun.

By comparison, buying when multiples are attractively low and learning to ride out the storms seems a much more doable game.

Inexpensive shares of blue chip businesses happen to be plentiful these days but it's probably not a good idea to assume they'll remain that way indefinitely.

Shares happen to be cheap for now and will be until they are not. Who knows if or when an era similar to the Nifty Fifty will return.

Adam

* Remarkably, and the AAII article reveals this, many of the Nifty Fifty did actually do very well over the long run despite the high P/E ratios. That doesn't mean it made sense on a risk-adjusted basis to pay up. The article has the luxury of looking at results after the fact. Investors don't have such a luxury. Since all investors have to invest going into an unknown and unknowable future, it's crucial to buy even the best businesses with a margin of safety.
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