I have written before about one of the most important changes I believe is needed in thinking about investing over the last few decades: Historical Stock Returns.
My belief is that there has been a fundamental change in the valuation of stocks. Long term data contains a problem in that we have generally realized that stocks are more valuable than realized 100 years ago. That means a higher based PE ration is reasonable and it distorts at what level stocks should be seen as very overpriced.
It also depresses expected long term returns, see my original post for details.
Since 2000, it’s become much more complicated. The rules have shifted. We used to say that this time is never different. I think what has happened from 2000 until today is a challenge to that. Since 1998, price-earnings ratios have averaged 60 percent higher than the prior 50 years, and profit margins have averaged 20 to 30 percent higher. That’s a powerful double whammy.
Diehard Ben Grahamites underestimated what earnings and stock prices would do. That began to be a drag after 1998.
I believe he is right. I believe in the value of paying attention to historical valuation and realizing markets often go to extremes. However, if you don’t account for a fundamental shift in valuation you see the market as overvalued too often.
So why have prices risen so high without a hint of euphoria — at least until very recently — or a perfect economy? My answer is that the discount rate structure has dropped by two percentage points. The yield on stocks is down by that amount and bonds too. The market has adjusted, reflecting low rates, low inflation and high profit margins.
Again I agree. Our political parties have aided big business in undermining market through monopolistic market control and that has been consistent (and increasing) for decades now. It makes stocks more valuable. They have moats due to their monopolistic position. And they extract economic rents from their customers (granted they put a large amount of those ill gotten gains into executives pockets but even so they gains are large enough to increase the value of the stocks).
On top of these strong forces we have the incredible interest rate conditions of the last decade. This is the one that is most worrisome for stock values in my opinion. It servers to boost stock prices (due to the poor returns for interest bearing investments). And I worry at some point this will change.
There is also likely at some point to be a political return to the value of capitalism and allowing free markets to benefit society. But for now we have strong entrenched political parties in the USA that have shown they will undermine market forces and provide monopolistic pricing power to large companies that provide cash to politicians and parties in order to have those parties undermine the capitalist market system.
I believe the stock market in the USA today may well be overvalued. I don’t think it is quite as simple as some of the measures (CAPE – cyclical adjusted PE ratio or market value to USA GDP) make it out to be though. As I have said for several years, I believe we are currently living through one of the more challenging investment climates (for long term investors seeking to minimize long term risk and make decent returns over the long term). I still think it is best just to stick with long term portfolio diversification strategies (though I would boost cash holdings and reduce bonds). And since I am normally light on bonds and high on stocks, for someone like me reducing stock holding for cash is also reasonable I believe (but even doing this I am more in stocks than most portfolio allocations would suggest).
As usual the 2016 Letter to Berkshire Hathaway shareholders by Warren Buffet provides great thoughts for investors.
American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle.
Warren is not a fan of market timing, for good reason. I do think he may be a bit overly-optimistic. It is not something innate about the geography of the USA that means whoever is within that area will prosper over the long term. Our actions as a society materially impact our long term success. Yes, we have done very well economically and we have many factors continuing to make that likely to continue. But it is not certain.
Those willing to challenge rosy projections serve a useful purpose. But investors must be careful not to lose out on gains. Timing the market is rarely successful. Even in the cases where people do reasonable well getting out of a highly priced market they often fail to get back into the market until after they lose money on the effort (they may save a bit on the downside but then don’t get back in until they missed more upside than they saved on the downside).
- understand all exposures that might cause a policy to incur losses;
- conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does;
- set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and
- (4) be willing to walk away if the appropriate premium can’t be obtained.
Many insurers pass the first three tests and flunk the fourth. They simply can’t turn their back on business that is being eagerly written by their competitors. That old line, “The other guy is doing it, so we must as well,” spells trouble in any business, but in none more so than insurance.
Must of Berkshire Hathaway’s success is due to what seem like fairly easy things to do. For example, what Warren discusses here. This reinforces a point that is often overlooked which is the management philosophy that has helped Berkshire Hathaway achieve their success. Every year Warren Buffett praises the senior managers at various Berkshire Hathaway companies for good reason.
The fairly simple idea of hiring trustworthy, capable and ethical people and giving them freedom to manage for the long term seems too easy to provide an advantage. But it does. Warren Buffett is very careful to pick people that are more concerned with providing value to customers over the long term than promoting themselves and seeking massive short term rewards for themselves. This simple act of hiring people that are willing to put customers and shareholders before themselves allows your organizations to function in its long term best interest.
In so many other companies short term incentives destroy value (Warren’s point 4 above). This failure can extend to companies Warren is significantly invested in: such as the long term and deep seeded mismanagement at Wells Fargo due to very poor leadership at that company for years. But in general, Berkshire Hathaway is much better at avoiding these toxic behaviors driven by very poor executive leadership when compared to other companies.
The importance of Berkshire Hathaway focusing on the long term and not getting distracted by short term financial measures is vastly under-appreciated.
By focusing managers and CEOs on actually running the business Berkshire Hathaway again does well compared to their competitors. Far too many companies spend the time of executives on playing financial games to divert huge payments to themselves that they then try to claim are not really costs. This is enormously costly to investors and our economy.
Diversification and keeping down fees are the investing strategies that will help more investors than anything else.
The report, The Dwindling Taxable Share Of U.S. Corporate Stock, from the Brookings Institution Tax Policy Center includes some amazing data.
In 1965 foreign ownership of USA stocks totaled about 2%, in 1990 it had risen to 10% and by 2015 to 26%. That the foreign ownership is so high surprised me. Holdings in retirement accounts (defined benefit accounts, IRAs etc.) was under 10% in 1965, rose to over 30% in 1990 and to about 40% in 2015. The holdings in retirement accounts doesn’t really surprise me.
The combination of these factors (and a few others) has decreased the holding of USA stocks that are taxable in the USA from 84% in 1965 to 24% in 2015. From the report
As with much economic data it isn’t an easy matter to determine what values to use in order to get figures such as “foreign ownership.” Still this is very interesting data, and as the report suggests further research in this area would be useful.
Related: There is No Such Thing as “True Unemployment Rate” – The 20 Most Valuable Companies in the World – February 2016 (top 10 all based in the USA) – Why China’s Economic Data is Questionable – Data provides an imperfect proxy for reality (we often forget the proxy nature of data)
Alphabet (Google) writes how they purchased 3.2 million shares this quarter in their earnings release:
In Q1 2016, we repurchased 3.2 million shares of Alphabet Class C capital stock for an aggregate amount of $2.3 billion, of which $2.1 billion was paid during the quarter. The total remaining authorization for future repurchases is approximately $1.4 billion. The authorization has no expiration date.
And they tout non-GAAP earnings, while of course reporting the GAAP earnings as required. One of the things executives like about non-GAAP earnings is they pretend the stock they give away to themselves doesn’t have a cost to shareholders. When you call attention to spending over $2 billion in the quarter to buy back 3.2 million shares it seems silly to then claim that the stock you gave away shouldn’t be considered as an expense.
How can you pay over $2 billion just to get back the stock you gave away and also pretend that money is not really a cost? And on top of that you promote the buyback as evidence that the stock is really worth more than you paid (after all why would you pay more than it is worth). But when you give the stock away to yourself that shouldn’t be seen as a cost? It is amazing they can do this and think they are not doing anything wrong.
And where does Google stand compared to last year for outstanding shares? 689,498,000 last year compared to 699,311,000 now. So nearly 10,000,000 more shares outstanding, even after they bought back 3.2 million this quarter. In the previous quarter there where 697,025,000 shares outstanding. All these figures are weighted-average diluted share balances for the entire quarter.
Google CEO, Sundar Pichai, got a $100 million stock award in 2015 (before being promoted to CEO). After the promotion he will be taking an additional “$209 million in stock granted every other year (he has to stay at Google for four years after each grant to cash them out).” He was granted $335 million in stock in 2014 and $78 million in 2013. You can see how quickly the executives paying themselves this well (this is 1 executive, a highly ranked one but still just 1) can dilute stockholders positions even with multi billion dollar buybacks in a quarter.
You don’t hear companies promoting how much dilution they are imposing on shareholders in order to provide windfalls for executives. I wonder why? No I don’t. I do wonder why reporters promote the buybacks and ignore the fact that the dilution is so extreme that it even overwhelms billions of dollars in buybacks.
Alphabet reported $6.02 a share in earnings and $7.50 a share in non-GAAP “earnings” for the latest quarter.
As I have said before I believe Google’s ability to extract enormous profit from their search dominance (as well as YouTube and adwords) makes it a very compelling long term investment. It would be better if the executives were not allowed to take such huge slices from the cash flow Google generates. But it is able to sustain those raids on stockholder equity and still be a good investment and appears likely to be able to continue to do so. Though I think they would be better off reducing the amount executives take going forward.
|2||Alphabet (GOOGL)||USA||$496 billion|
|4||Exxon Mobil||USA||$341 billion|
|5||Berkshire Hathaway||USA||$329 billion|
|8||Johnson & Johnson||USA||$296 billion|
|10||Wells Fargo||USA||$245 billion|
Apple lost $131 billion in market cap since my October post. Alphabet (Google) lost just $1 billion in market cap, and for a short time moved past Apple into the top stop. Facebook achieved a rare increase during this period, gaining $16 billion and moving up 1 spot on the list. All the top 10 most valuable companies are based in the USA once again.
The next ten most valuable companies:
|13||China Mobile||China||$219 billion|
|15||JPMorgan Chase||USA||$214 billion|
|16||Procter & Gamble||USA||$211 billion|
|18||Industrial & Commercial Bank of China||China||$206 billion*|
|20||Petro China||China||$191 billion|
Market capitalization shown are of the close of business February 26th, as shown on Google Finance.
The 11th to 20th most valuable companies includes 4 USA companies, 3 Chinese companies and 3 Swiss companies. Toyota fell from 20th to 25th and was replaced in the top 20 by Verizon, which resulted in the USA gaining 1 company and costing Japan their only company in the top 20. Pfizer also dropped out and was replaced by Walmart.
The total value of the top 20 decreased by $189 billion since my October post: from $6.054 trillion to $5.865 trillion. Since my October 2014 post of the 20 most valuable companies in the world the total value of the top 20 companies has risen from $5.722 trillion to $5.865 trillion, an increase of $143 billion. The companies making up the top 20 has changed in each period.
A few other companies of interest (based on their market capitalization):
Since April of 2005, the portfolio Marketocracy calculated annualized rate or return is 7.1% (the S&P 500 annualized return for the period is 6.9%). Marketocracy subtracts the equivalent of 2% of assets annually to simulate management fees – as though the portfolio were a mutual fund. Without that fee, the return beats the S&P 500 annual return by about 220 basis points annually (9.1% to 6.9%).
Since the last update, I have added Gilead to the portfolio. I also dropped PetroChina and Templeton Dragon fund (as I had mentioned I would do).
The current stocks, in order of return:
|Stock||Current Return||% of sleep well portfolio now||% of the portfolio if I were buying today|
|Amazon – AMZN||736%||12%||9%|
|Google – GOOG||400%*||21%||15%|
|Danaher – DHR||129%||8%||8%|
|Apple – AAPL||85%||17%||17%|
|Toyota – TM||50%||8%||10%|
|Intel – INTC||46%||7%||8%|
|Pfizer – PFE||21%||6%||6%|
|Cisco – CSCO||14%||3%||3%|
|Abbvie – ABBV||1%||6%||8%|
|Gilead – GILD||-6%||6%||8%|
The current marketocracy results can be seen on the Sleep Well marketocracy portfolio page.
I make some adjustments to the stock holdings over time (selling of buying a bit of the stocks depending on large price movements – this rebalances and also lets me sell a bit if I think things are getting highly priced. So I have sold some Amazon and Google as they have increased greatly (and I have added to ABBV and GILD at nice prices). These purchases and sales are fairly small (resulting in an annual turnover rate under 2%).
I would consider selling Cicso. I also would like to find a good natural resource stock or two if I can find good stocks. I do feel the portfolio is too concentrated in technology and medical stocks so I am would choose a stock with a different focus if it were close to as good as an alternative focused on technology or health care, but I will also buy great companies at good prices even if that results in a less diverse portfolio.
I don’t try and sell significant portions of the portfolio and have a large cash balance to time the market. I will, however, sell some of the individual positions if I think the price is very high (or to rebalance the portfolio a bit).
The market has gone down a fair amount recently and may go down more. It may be in that downdraft I will find a nice candidate to add at an attractive price.
If you wonder why the Apple return isn’t higher, I debated adding it at the outset but decided against it. So I only started adding Apple in 2010 and added to that position over the next several years.
* Marketocracy seems to have messed up the returns for Google (probably due to the split); this is sad as their purpose for me is to calculate returns, but my guess is between 350-450%
|4||Exxon Mobil||USA||$342 billion|
|5||Berkshire Hathaway||USA||$340 billion|
|9||Wells Fargo||USA||$282 billion|
|10||Johnson & Johnson||USA||$281 billion|
Google and Amazon were star performers in the last 4 months with Google up $127 billion and Amazon increasing $96 billion moving Amazon from outside the top 20 into 8th place. Facebook increased in value by $64 billion and moved from the 18th largest market cap to 7th. The China market declined quite rapidly since June and the largest Chinese companies saw significant drops in market cap.
Industrial & Commercial Bank of China and China Mobile dropped from the top 10 (replaced by Facebook and Amazon). That results in USA companies holding the top 10 spots (the next 5 are either Chinese or Swiss).
The next ten most valuable companies:
|11||Industrial & Commercial Bank of China||China||$250 billion*|
|12||China Mobile||China||$247 billion|
|14||Petro China||China||$241 billion|
|16||JPMorgan Chase||USA||$241 billion|
|17||Hoffmann-La Roche||Switzerland||$231 billion|
|20||Procter & Gamble||USA||$210 billion|
Market capitalization shown are of the close of business October 30th, as shown on Google Finance.
The 11th to 20th most valuable companies includes 3 Chinese companies, 3 USA companies, 3 Swiss companies and 1 Japanese company. Alibaba, Tencent, China Construction Bank and Walmart dropped out of the top 20 (replaced by Amazon, Pfizer, Proctor & Gamble and Toyota). Alibaba remained above $200 in market cap making it the only company worth more than 200 billion that missed the cut. In the top 20 the USA gained 2 spots, China lost 3 and Japan gained 1.
The total value of the top 20 has barely changed since my June post on the top 20 most valuable companies in the world: from $6.046 trillion to $6.054 trillion. Since my October 2014 post of the 20 most valuable companies in the world the total value of the top 20 companies has risen from $5.722 trillion to $6.054 trillion, an increase of $332 billion. Several companies have been replaced in the last year to create the current top 20 list.
A few other companies of interest (based on their market capitalization):
The 10 publicly traded companies with the largest market capitalizations. Since October of last year the top 20 list has seen quite a bit of profit for stockholders (mainly in Apple and Chinese companies).
|4||Exxon Mobil||USA||$352 billion|
|5||Berkshire Hathaway||USA||$346 billion|
|6||China Mobile||China||$340 billion*|
|7||Industrial & Commercial Bank of China||China||$306 billion**|
|8||Wells Fargo||USA||$292 billion|
|10||Johnson & Johnson||USA||$273 billion|
Apple’s market cap is up $115 billion since the last list was created in October of 2014. That increase is more than 50% of the value of the 14th most valuable company in the world (in October 2014).
China Mobile increased $100 billion and moved into 6th place. Industrial and Commercial Bank of China (ICBC) increased $78 billion to move into 7th place.
Exxon Mobil lost over $50 billion (oil prices collapsed as OPEC decided to stop attempting to hold back supply in order to maximize the price of oil). Alibaba (the only non-USA company in the last list) and Walmart dropped out of the top 10.
The total value of the top 20 increased from $5.722 trillion to $6.046 trillion, an increase of $324 billion. Several companies have been replaced in the new top 20 list.
The next ten most valuable companies:
|11||JPMorgan Chase||USA||$250 billion|
|12||China Construction Bank||China||$250 billion**|
|13||Novartis (NVS)||Switzerland||$246 billion|
|14||Petro China||China||$237 billion|
|19||Hoffmann-La Roche (ROG.VX)||Switzerland||$231 billion|
Market capitalization shown are of the close of business last Friday, as shown on Yahoo Finance.
The current top 10 includes 8 USA companies and 2 Chinese companies. The 11th to 20th most valuable companies includes 4 Chinese companies, 3 Swiss companies and 3 USA companies. Facebook (after increasing $21 billion), China Construction Bank (increasing $68 billion – it is hard for me to be sure what the value is, I am not sure I am reading the statements correctly but this is my best guess) and Tencent moved into the top 20; which dropped Procter & Gamble, Royal Dutch Shell and Chevron from the top 20.
A few other companies of interest (based on their market capitalization):
I was recently interviewed on equities.com, read the full interview – Financial Blogger Profile: John Hunter. Some quotes from the interview:
John Hunter: I look for good individual investments, but I also weigh my guesses about long term macroeconomic conditions in making investment commitments. I think there is much more risk to the drastic measures central banks have been making for the past few years than the market is factoring in. I think the poor job regulating risk in the financial system is also very risky at the macroeconomic level.
I don’t have any real idea of what the chance of massive economic failure is, but I am much more worried today than I have been. Pretty much, my worry has remained the same over the last few years. We did avoid an immediate meltdown, though we still had plenty of economic pain. Yet, in my opinion, the risk has remained very high for the last few years, but people seem to think central banks can continue this extraordinary behavior without consequences; I see a great deal of risk in the economy.
Three macro-economic factors make healthcare an appealing investment. First, the aging population should provide a booming market. Second, the huge increase in rich people globally that can afford very expensive medicine again provides an ever-growing market. Third, the broken healthcare system in the USA results in exceedingly high-priced medical care in a very large and rich market.
I also close out the interview with some tips I have shared on this blog over the years
John Hunter: I can’t pick one, but I can pick a few short pieces of advice:
- Save 15%, or more, of your income and invest it wisely. If you want to buy more, then earn more, or save extra until you can pay for it with the extra savings.
- Minimize costs on investments, use Vanguard or similar low fee funds. Buying individual stocks reduces even the costs of Vanguard. There are tradeoffs to diversity of your portfolio when buying individual stocks.
- Pay attention to the overall risk of the portfolio, and even beyond that, your entire financial picture. For example, in the USA we have extra healthcare expense risk that is outside our portfolio risk, but is part of our entire financial picture. Building your portfolio with extra-portfolio risks in mind is wise. Don’t get fooled into thinking about the risks of investments taken individually, even though that is what you will continually be bombarded with.
I think those that find this blog worthwhile will also enjoy the interview so I hope you read the full interview.
One thing for investors consulting historical data to remember is we may have had fundamental changes in stock valuations over the decades (and I suspect they have). Just to over simplify the idea if lets say the market valued the average stock at a PE of 11 and everyone found stocks a wonderful investment. And so more and more people buy stocks and with everyone finding stocks wonderful they keep buying and after awhile the market is valuing the average stock at a PE of 14.
Within the market there is tons of variation those things of course are not nearly that simple, but the idea I think holds. Well if you look back at historical data the returns will include the adjustment of going from a PE of 11 to a PE of 14. Now maybe the new few decades would adjust from PE of 14 to PE of 17 but maybe not. At some point that fundamental re-adjustment will stop.
And therefore future returns would be expected to be lower than historically due to this one factor. Now maybe other factors will increase returns to compensate but if not the historical returns may well provide an overly optimistic view.
And if there is a short term bubble that lets say pushes the PR to 16 while the “fair” long term value is 14, then there will be a negative impact on the returns going forward bringing the PE from 16 to 14. That isn’t necessarily a drop (though it could be) in stock prices, it could just be very slow increases as earning growth slowly pushes PE back to 14.
Another thing to consider is another long term macro-economic factor may also be giving long term historical returns an extra boost. The type of economic growth from the end of World War I to 1973 (just to pick a specific time, there was a big economic slowdown after OPEC drastically increased the price of oil). While that period includes the great depression and World War II, which massively distorts figures, from the end of WW I through the 1960s Europe and the USA went through an amazing amount of economic growth.