GADR: All Stocks, All The Time? (3/3)
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Why Revisit Graham and Doddsville?
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Berney: I believe that, due in large measure to this medium of
communication [computer networks], cycles that took months and
years in the past to complete are now being completed in weeks.
Just my humble observation.
Reynolds: Berney, you have identified the very core of the case
for revisiting Graham and Doddsville in the first place. The way
I understand the quote from Graham at the top of every issue of
GADR (see above), the laws of supply and demand do not change,
but the political and economic conditions in which these laws
operate do change. Note that Graham begins the quote that you
cited with the premise: "Since common stocks, even of investment
grade, are subject to recurrent and wide fluctuations in their
prices ..." In my view, that premise no longer applies to the
same degree that it once did -- at least not for those stocks
that Graham would consider "investment grade". Market swings
(and those of the overall economy) have been less frequent, of
shallower amplitude, and of shorter duration in the post-World
War II era than those of the eras preceding it.
Whether it's called the "New Era", the "Information Age", or the
"3rd Era of Value Investing", the point is that the widespread
availability of information and the speed with which labor and
capital markets respond to this information are at an all time
high. Therefore, the Market has never been more efficient.
Indeed, the Market had already become so efficient in the latter
years of Graham's life (the mid-1970's) that he began to wonder
aloud whether it was still possible to outperform the Market
averages. Buffett was disappointed and concerned by Graham's
late-life misgivings. As things turned out, the apprentice wound
up outperforming the master. But, he did not do so by slavishly
following Graham's techniques developed in the 1920's and 1930's.
Instead, Buffett developed techniques of his own for identifying
undervaluation.
Buffett Couldn't Wait
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There's an anecdote I've shared before that I think is worth
repeating. Back in the 1950's, around the time that Graham
retired and Buffett went out on his own, the DJIA finally
exceeded 381, the level it had first achieved shortly before the
1929 Crash. As the Dow approached and then rapidly surpassed
381, concern was so widespread about the possibility of another
Crash that Congress held hearings, at which Graham spoke as an
honored guest. Under the circumstances, Graham suggested to
Buffett that he wait for the next significant decline before
investing his clients' funds in the stock market. Buffett has
subsequently quipped, "I would still be waiting."
Historically, there had been an inverse correlation between the
dividends on stocks and the interest on bonds, i.e., as the one
rose, the other declined. On this basis, Graham had calculated
that stocks in the mid-1950's were greatly overpriced. But,
whether it's called "pricing", "valuation", "Contrarianism",
"bargain-hunting", or "whatever", the bottom line is that the
mid-1950's were the wrong time to be sitting in cash
waiting for a major decline in the Dow.
9200 is No Bargain
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I concede that the Market is unsustainably expensive. There are
many fundamental factors that would justify sending out a message
entitled "SELL EVERYTHING" (as one timing guru famously did when
the Dow was around 5800). Even after some recent
back-tracking, the S&P 500 is selling at a stratospheric 32 times
trailing earnings. The broad Market's P/E can be justified on a
fundamental basis only if earnings are temporarily at depressed
levels, or if the future is guaranteed to be all but perfect.
Obviously, neither is the case. The S&P 500's 1998 earnings are
flat, if not negative, relative to 1997 -- a growth rate of zero.
As to the coming year, I do not foresee a U.S. recession in
1999. But, with half the world already in recession, I don't
foresee 1999 as the kind of banner year required to justify the
current P/E of 32.
The Real Issue
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The issue I'm addressing, though, is not whether the Market is
overvalued. Obviously, it is overvalued. Rather, the
issue is: What should the intelligent investor do about
it? Specifically, are the valuation parameters that would take
us out of the Market at this time certain to provide a clear
signal as to when (or at what price) it is time to buy again? Do
we know -- with the same level of confidence that long-term
dollar-cost-averaging affords -- that Mr. Market will
eventually offer us that price?
Further, do we know that we will actually reenter the market, if
and when that price level is attained? Or will the more
negative news that would no doubt accompany a depressed price
level cause us to recalculate a lower reentry point -- keeping
us out of the Market that much longer?
I would be very surprised if the Market does not fall
significantly, say 10% or 15%, from current levels. But, that
would still leave the Dow overpriced by historical standards. At
Dow 7000, a drop of 24%, the Dow's P/E would be a shade under 19
-- still at the high end of the historical range. At Dow 6000, a
decline of 33%, the Dow's P/E would be 16 -- still no bargain.
To get back to the historical P/E norm of 15, the Dow has to fall
to 5550.
And, there are those who point out that today's earnings are
significantly inflated by past write-offs of current costs,
off-income-statement options payments to corporate executives,
etc. So let's shave the published earnings data by 10%. This
gets the Dow down to 5000, to support a P/E of 15. But that
still leaves no margin of safety. To have a 30% margin of
safety, relative to historical P/E's, would require the Dow to
decline to 3500. This represents a decline of around 62% from
the Dow's recent close of 9202.
A 62% Market decline would be one of the greatest Market declines
of the past 2 centuries, and by far the greatest of the
post-World War II period. Yet, there would still be a case to be
made that the Market would be overvalued at 3500. For there
would no doubt be a concomitant deterioration of economic
fundamentals accompanying a 62% decline in the Dow. Therefore, a
greater "equity risk premium" would have to be assigned to stocks
in relation to bonds.
As can be seen, there is no end to this game -- no absolute point at
which one can say without any lingering doubts: Now the
Market is truly undervalued. I recall that when the Dow actually
was at 3500, the Bears were already roaring at the top of their
lungs. Indeed, there were plausible-sounding Bears, like WSW's
Monte Gordon, when the Dow was approaching 2000!
Yet, there is no guarantee that the Dow will ever see
7000 again, much less 3500. The Market could oscillate
between 7100 and 10,000 for the next 10 years -- a not
dissimilar pattern to that of the 1970's. At what point does an
advisor say, "Sorry, I was wrong to advise waiting for the Dow
to fall to 3500 (or 5000 or 7000, etc.) -- it's time to get back
into stocks, even though the Dow's P/E is still overvalued."
Who would still be listening?
Wayne: I don't believe an investor should ever be looking at the
aggregate Market level to determine whether or not to invest,
unless he/she is buying the whole Market, e.g., an Index fund.
What investors should do is buy individual stocks that meet a
definition of "Value" that offers greater expected returns than
alternative investments, with an appropriate Margin of
Safety.
Conversely, they should sell those investments that are not
priced to return an adequate rate of return. The cash level the
investor will hold is a result of these actions, and is
determined by the individual investor's ability to find
alternative stock investments that offer Margin of Safety after
any sale. In an extremely high Market, it is possible that no
stock alternative can be found that meets the definition of a
"good value". In this situation, the investor should accumulate
cash.
That is what I am doing and that is what Buffett is doing.
Reynolds: And, you are doing it very well. What I am trying to
do, though, is in some small way provide the average investor
with "practical counsel", as Graham called it in his subtitle to
The Intelligent Investor. As a practical matter, I do not
believe that the average investor has the time to duplicate the
efforts of investors like yourself and Buffett. And, I think it
is unrealistic to believe that Mr. Market can be beaten unless an
investor is willing to make a commitment of time and effort at
least as great as that required for any part-time job. After
all, Mr. Market is working at his job 24/7.
Yet, how many individual investors have the time to do the
research necessary to arrive at the independent conclusion that,
as you put it, "no stock alternative can be found that meets the
definition of a 'good value'"? Automatically
dollar-cost-averaging, though, requires no such commitment of
time. I believe that Graham would concur on the significance of
this last point.
Tempus Pecunia Est
---------------------------
The issue of how much to discount the time expended, or saved, by
choosing an active investment strategy instead of a passive one
reminds me of my favorite story about Buffett. Graham's original
choice to assist him in writing the last edition of The
Intelligent Investor was Adam Smith, then already a
bestselling author. However, the task eventually fell to
Buffett, who was hardly known outside of business circles at the
time.
Fast forward to a few years ago. Smith had become the host and
producer of his first Public Television series, and Buffett had
recently surpassed Sam Walton to become the richest man in
America. In the midst of a television interview that had been
otherwise unexceptional, Smith threw a change-up that was high
and inside, by asking Buffett when a stock should be sold.
This was more than an innocent question. Buffett is widely known
for his buy-and-hold-forever policy toward his "permanent"
holdings like Coke, Gillette, and American Express. But, the
whole premise of Value Investing is contained in the passage
Berney quoted from THE INTELLIGENT INVESTOR, above:
"By pricing we mean the endeavor to buy stocks when they are
quoted below their fair value and to sell them when they rise
above such value."
Therefore, there must be times when a security is overvalued, or
at least fairly valued, and hence a candidate for sale. It
would be absurd to suggest that securities could be
permanently "undervalued". Obviously it would be the
valuation model that was mistaken, if it were never confirmed by
the security's Market price. (However [there is always a
"however" in investing], it could be the case that the amount of
a security's overvaluation might never exceed the taxes that
sale of the security by a particular investor might incur.)
Buffett had been the very picture of the
Billionaire-at-ease-with-himself, until Smith asked him this
question. Suddenly, Buffett looked like a human contortionist as
he twisted and turned in his seat. The best he could manage was
to mutter something along the lines of: We like buyin'em more
than sellin'em.
Buffett Turns The Table
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Near the end of the interview, Smith lobbed up a powder puff
question. He asked Buffett what advice he would give to someone
seeking to duplicate his investment achievements. I don't like
to criticize the way another man makes his living, but I have no
doubt that if, say, Albert Einstein and Leonard Bernstein were
still alive, they would be pestered with similar inanities by the
likes of Charlie Rose, Barbara Walters, et al. In the event,
Buffett replied in a completely matter-of-fact tone: Learn
everything you can about every publicly traded security.
Smith's voice broke like Bart Simpson's as he exclaimed: "But,
that's over 27,000 securities!" Buffett shot back with a cool
bordering on the curt: "Start with the A's."
In other words, as a practical matter, few have the time to do
justice to Graham and Buffett's methods, bestselling books to the
contrary notwithstanding. Buffett has modestly said that his
results required neither great intellect, nor great business
acumen. To my knowledge, he has never said they did not require
a great deal of time. Nor did Graham. By contrast,
automatically dollar-cost-averaging into an Index fund, once
established, requires no time at all. And, as they say, time is
money.
Summary
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What all of this illustrates is the power of combining two
easy-to-understand-and-apply investing criteria:
dollar-cost-averaging with leading companies in important
industries. As noted above, Graham would never have recommended
an all-stock portfolio (nor, for that matter, an all-bond
portfolio) to the average investor. So, he certainly would not
have recommended a one-stock portfolio! And, he did not
recommend beginning a program of dollar-cost-averaging at lofty
price levels, because of his concerns about investor psychology.
Yet, even in the extreme examples provided by IBM in 1987 and
Wal-Mart in 1992 of one-stock portfolios, with purchases begun
just prior to steep and prolonged price declines, by
dollar-cost-averaging in leading companies in important
industries, an investor is very likely to obtain far better
results that all but a fraction of other investors, professional
or otherwise.
It is no problem to find a list of leading companies in important
industries. Dow Jones & Company and Standard & Poor's have
already done it for you, by publishing the DJIA and the S&P 500,
respectively. The former is comprised of 30 leading companies in
important industries, the latter is a broader list representing
500 such companies. Since the S&P 500's establishment in 1926,
the two Indexes have produced almost identical results, when
viewed over the long haul. There are several no-load, low
management-fee mutual funds for both of these Indexes.
Graham and Buffett have demonstrated that by "pricing", gifted
individuals like themselves can outperform Indexing over the long
term. However, I am skeptical that the average investor is
likely to do better by "pricing" than he or she would do by
dollar-cost-averaging into an Index fund.
Advice
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First, decide (or re-decide) whether you are more comfortable
being a "conservative" or an "enterprising" investor. Graham's
definition of the conservative investor is "one interested
chiefly in safety of principal and freedom from bother". The
"enterprising" investor is one who seeks to outperform Mr. Market
at his own game.
GADR's advice remains what it has been all along: Be a
conservative investor and dollar-cost-average into an S&P 500 or
DJIA Index fund. In the long run, you are all but assured of
beating 90% or more of all the professional money managers on
Wall Street, or anywhere else. Simple.
As we have cautioned every year, Indexing will not be as
profitable over the long term as it has been in the recent past.
Nevertheless, all historical evidence suggests that 20 or more
years of dollar-cost-averaging into an Index fund will not only
outperform every other asset class (bonds, real estate, cash,
etc.), it will also outperform all but a small fraction of
portfolios, of whatever description, that have been actively
managed by professionals.
Those investors who feel that Indexing is not "interesting"
enough can find plenty of interesting times ahead by
dollar-cost-averaging into GADR's Model Dow Value Portfolio
components: AT&T, Boeing, GM and IBM.
In GADR's opinion, this portfolio is still undervalued, and thus
suitable for the enterprising investor. Furthermore: 1) there
is virtually no possibility of any of these 4 companies going
bankrupt, and 2) this concentrated portfolio of leading
companies in important industries does not require a lot of
ongoing monitoring, notwithstanding the interesting times ahead.
The long-term rise in global demand for transportation and
information technology will serve this portfolio well -- with or
without monitoring. Thus, it pretty neatly fits Graham's
requirements for the conservative investor: safety of principal
and freedom from bother. As such, it is something of a hybrid
-- a portfolio for "conservative enterprising" investors.
Graham's choice of the term "enterprising" was not accidental.
Trying to outperform Mr. Market should be viewed as any other
business enterprise would be: Patience and endurance are
required. There will inevitably be missteps along the way. The
influence of luck, good and bad, will not be negligible. And, in
the end, no amount of effort, however intelligent, can guarantee
success. That's what "risk" means.
Graham believed, and GADR concurs, that the enterprising
investor's odds of success or failure will correlate with the
amount of time spent at this endeavor. Those enterprising
investors who do not have this time are advised to employ
someone who does.
In this regard, the world's greatest money manager may be
employed by anyone who has the $2,140 to purchase a share of
Berkshire Hathaway, Class B, based upon Wednesday's closing
price. It is noteworthy that Buffett works for what is no doubt
the world's lowest management fee, on a percentage basis.
Dividing Buffett's $100,000 salary by Berkshire's $75 billion
market capitalization implies that his unparalleled asset
management skills cost shareholders about .0000013% annually --
surely a bargain if there ever were one.
Furthermore, short-term re-adjustments in Index fund portfolios
may have created a buying opportunity in this unique company.
For details, see Wayne's posting at:
Message 6924897 .
Personally, I don't see how Berkshire could be undervalued if
Buffett himself does not think it is undervalued. But, don't let
my excessive literalism interfere with your chance to have
Buffett manage your assets.
Those enterprising investors who seek more excitement still would
be well served to construct a portfolio from among the picks of
Axel and Berney (see:
web.idirect.com and
Message 6514887 ). All
of their selections are leading companies in important
industries.
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Subject 19528
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Graham and Doddsville Revisited
Editor: Reynolds Russell, Registered Investment Advisor
web.idirect.com
Web Site Development/Design: ariana <brla@earthlink.net>
Consultants: Axel Gunderson, Wayne Crimi, Bernard F. O'Rourke,
Allen Wolovsky
In addition to editing GADR, Reynolds Russell offers investment
advisory services. His goal is to provide clients with total
returns in excess of those produced by the S&P 500.
His investment strategy applies the principles of Value Investing
established by Benjamin Graham to the circumstances of today's
economy and securities markets.
For further information, reply via e-mail to: gadr@nyct.net
*********
"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham)
(C) Reynolds Russell 1998. |
