Share Sleuth's Notepad: Taming fear and greed
Discover what to do in a correction, witness systematic earnings manipulation, learn how the Washington Post avoided a pension crisis, and marvel at how one investor tamed fear and greed.
Field Guide to Stock Market Corrections
Joshua Brown’s Field Guide to Stock Market Corrections prompts a smile, and some reflection. In Brown’s schema, a correction is a nerve-wracking fall of 10% or more, as opposed to a refreshing dip of 5-10%, and a bear market panic of 20% or more. Brown puts corrections in their place. They’re frequent, they’re temporary, and very, very occasionally they develop into crashes. For those with time horizons over five years, the best thing to do is buy those high quality shares you missed out on when the market was rising and “grit one’s teeth and do very little”.
The market would have to fall more than 20% to bring some of the high quality shares on the Watchlist into my price range, but the list of good companies at less attractive prices is there so I can add them to the Share Sleuth portfolio, should the opportunity arise.
“Good friends” Robert Shiller and Jeremy Siegel, both US academics, have long been warring about the Cyclically Adjusted Price Earnings ratio (CAPE).
Benjamin Graham used long-term PE ratios, a share’s price divided by a company's earnings averaged over up to ten years, as a means to eliminate the obvious objection to the standard PE ratio, that last year’s earnings might be exceptional. Shiller applied the technique to the US stockmarket in general, and many investors, use variant long-term PEs to take the temperature of the market.
They’re at it again, or at least Siegel is. He says CAPE, which currently indicates the market is considerably overvalued, fails to take account of accounting changes that caused companies to make huge write-offs and artificially depressed profits in 2000. Since 2000 reported earnings have diverged markedly from another measure of profit recorded in the US national income accounts (NIPA earnings), whereas before they moved in line.
It’s a technical argument, that need not worry bottom-up investors much, except for an alternative explanation for the volatility of reported profits since 2000, this time from Andrew Smithers, who runs a UK consultancy. Smithers says companies are manipulating earnings much more than they were, because earnings drive share prices, and executives award themselves bonuses for rising share prices.
It’s not so much the fact of this manipulation, which is well known, but the extent of it that catches the eye. Smithers also compares reported earnings to NIPA earnings and discovers:
From 1955 to 2000, the 10-year volatility measures and the standard deviations over the previous return are the same for both series. Since 2000, published profits have been 4.5 times more volatile than NIPA profits. Companies now want to show that profits are appalling when they are bad and very good when they are merely good.
That should worry any investor that uses earnings as the denominator in any calculation. The minority of CAPE aficionados can rest easier though, since the manipulation swings both ways, it may not have the impact Siegel claims.
Lessons from pension fund management
Anyone who remembers Warren Buffett’s comparison of derivatives to weapons of financial mass destruction in advance of the subprime mortgage crisis will not be surprised the celebrated investor predicted trouble for companies funding defined benefit pension schemes decades before the pension funding crisis was recognised.
A memo from Buffett to the owner of the Washington Post sent in 1975 advised her to be wary of making relatively painless current promises with the potential to grow into an enormous bill the company would not be able to pay. It also warned her that growing a pension fund through conventional investment management would not be sufficient, because, as a group conventional fund managers do not add value, and it’s not possible to distinguish individuals that do by skill, and are therefore likely to continue adding value, from those that are just lucky (for more on this, see last week’s note).
Instead he proposed a “mildly unconventional plan”, to set up a pension division that would invest in undervalued companies:
Specifically, it probably is possible to invest the $12 million in our pension fund in a dozen businesses (maybe more...) with current intrinsic value (measured by private-owner valuations and transactions) attributable to our investment of, say, $20 million and current earnings of at least $1.5 million. The portion of such earnings paid out to us is clearly is worth 100 cents on the dollar, and a reasonable batting average by the managements of companies in which we invest should result in the portion reinvested having similar value. If this is the case, such a “pension division” operation will produce better returns than bond investment at current rates.
In other words, Buffett would target companies with an average earnings yield no lower than 7.5% (1.5/20) on the assumption that in general they would be able to maintain profitability and their earning power.
It must be emphasized that measurement of this program would have to be based on the progress in our share of earnings and assets of the constituent companies - not short term market movements.
The Washington Post adopted the plan. The pension fund is in surplus.
Taming fear and greed
You’ll laugh, you’ll cry, you’ll shake your head in bemusement. Wexboy’s two part series on fear and greed exhorts you to “Learn Some Bloody Voodoo”. I wouldn’t, but if you’ve seen this, you’ll know I “Worship the Spreadsheet”. Wexboy:
I want you to create a friggin’ majestic portfolio report that’s so complex & removed from reality, it will hypnotize you into believing it’s purely an interesting academic exercise. It’s Monopoly money, at best… Ironically, the less you care about money, and profits & losses, the more abstract the notion of fear & greed will become – you’ll become far more rational & effective in your investment decision-making.
On the blog this week:
The engineering consultancy has grown through recession by providing a good service at low cost. But it’s also been relying on Australia for most of its profit. The economy is slowing there.
DS Smith has wowed investors with a strategy to focus on packaging consumer goods in recycled paper and a deal that has made it the second biggest manufacturer in Europe.
Publishing Technology has developed end-to-end software for digital publishers. A series of impressive deals suggest it may be capturing a significant share of a new market but risks remain...
About the author
Richard is companies editor of Interactive Investor and a columnist at Money Observer magazine. A keen private investor through his Self Invested Personal Pension, he manages two virtual portfolios. The Share Sleuth portfolio is a hand-picked collection of mostly small-cap value shares, while the Nifty Thrifty is a mechanical portfolio designed to pick large, successful companies at cheap prices.
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