8/3/2019 Stocks Look Pricey

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Title:

Stocks Look Pricey

Word Count:

1025

Summary:

The first quarter of 2006 is over. Now is a good time to reflect on stock prices and the opportunities they

present.

Bargains are scarce. Equities are expensive. In recent weeks, Ive heard several fund managers say

valuations are still attractive. I dont agree. Generally speaking, valuations are unattractive. Returns on

equity are higher than historical levels. A market-wide return on equity of 15% is unsustainable. Price-to-

earnings ratios may not fully reflect how expe...

Keywords:

value investing blog, value investing podcast, value investi

Article Body:

The first quarter of 2006 is over. Now is a good time to reflect on stock prices and the opportunities they

present.

Bargains are scarce. Equities are expensive. In recent weeks, Ive heard several fund managers say

valuations are still attractive. I dont agree. Generally speaking, valuations are unattractive. Returns on

equity are higher than historical levels. A market-wide return on equity of 15% is unsustainable. Price-to-

earnings ratios may not fully reflect how expensive stocks are. Price-to-book ratios are more alarming.

There are two additional concerns. Most discussions of the relative attractiveness of equities focus on the

S&P 500 and forward earnings. The S&P 500 is not the most representative index. It may not be the bestindex to consider when looking at market-wide valuations.

Forward earnings are (necessarily) estimates. Where current returns on equity are unsustainable, projected

earnings that use similar returns on equity may overstate the earnings power of equities in general. This can

occur even where the estimates appear reasonable given current earnings. If you start with unsustainable

base earnings, you are likely to overestimate future earnings even if you truly believe you are assuming very

modest earnings growth.

Assets in general are pricey. Value investors have few places to turn if they continue to insist upon a true

margin of safety.

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Bonds are unattractive. Long-term inflation risks make U.S. treasury, corporate, and municipal bonds a

fools bet. There is little to gain and much to lose. The know-nothing investor who buys a top-quality bond

today and holds it for decades may very well find his purchasing power diminished.

There may be some select opportunities in foreign equities. But, these are difficult to evaluate. Foreign

government obligations are also difficult to evaluate, but that isnt much of a problem for value investors,

because most foreign government debt is priced to perfection. Youll have to be willing to take a lot of

uncompensated risks if you want to own such bonds.

Of course, there are exceptions to every rule. There may be a few bonds out there that are attractive. There

certainly are a few attractive stocks out there. But, even those stocks that look very attractive relative to their

peers dont look nearly as attractive when compared to past bargains.

Value investors face a difficult choice. They can assume stock prices will return to historical levels, and hold

cash until the correction comes. Or, they can accept the reality they currently face.

There is no logical reason stock prices must necessarily return to historical levels. During the twentieth

century, real after-tax returns in diversified groups of common stocks were very high relative to other

investment opportunities. There have been various reasons given for why this occurred. Many have said

these returns were possible, because of the higher risks involved in holding equities. Over the long-term,

risks were somewhat higher than todays investors seem to remember, but they were hardly severe enough

to justify the kind of performance spreads that existed during much of the twentieth century.

True, if you bought at inopportune times, it was possible to remain in a fairly deep hole for a fairly long

time. But, if you gave no real consideration to the timing of your purchases or the prospects of the

underlying enterprises, you did better than many bondholders who chose their investments with the utmost

care.

This is a disconcerting problem. It may be that most investors are overly sensitive to the risk of an

immediate paper loss in nominal terms, and therefore overlook the much greater risk of a gradual loss ofpurchasing power. Issuing fixed dollar obligations may be the best bet for any business or government that

seeks to swindle investors.

For the sake of the common stockholders, I hope many of the best businesses continue to issue such

obligations when money is cheap. Corporate debt gets a bad name, because it tends to be overused by those

who dont need it and shouldnt want it (and, of course, by those businesses that do need it but won't survive

even if they get it). The businesses that would benefit the most from the use of debt usually appear to have

more cash than they could ever need. But, its best to think ahead. For truly high quality businesses, the cost

of capital will fluctuate far more wildly than the likely returns on capital.

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If, during the last hundred years, stocks really were far cheaper than they should have been, is there any

reason to believe stock prices will return to past levels? The past is often a pretty good predictor of the

future but, not always. Its difficult to say whether, over the next few decades, valuations will, on average,

be higher or lower than they are today. However, it isnt all that difficult to say whether, at some point over

the next few decades, valuations will be higher or lower than they are today. The answer to that question is

almost certainly yes. They will be higher and they will be lower. Maybe for a few years or a few months.

Maybe for a full decade. I dont know.

What I do know is that value investors will have opportunities to make investments with a true margin of

safety. But, should they wait?

Thats the most difficult question. Today, I am not finding opportunities that look particularly attractive

when compared to the best opportunities of past years. But, I am still able to find a few (in fact, a very few)

situations where the expected annual rate of return is greater than 15%.

That will be more than enough to beat the market. It will also likely be enough to provide a material increase

in after-tax purchasing power. Thats not guaranteed, but it hardly seems holding cash would offer the better

odds in this regard.

So, is an expected annual rate of return of 15% good enough? Is it reasonable to bet on the good opportunity

that is currently available instead of waiting for the great opportunity that may yet become available?

Ill leave that for you to decide.

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