Monday, 2 February 2015
Staying Rational in a Falling Market, using rational price or rational value approach
By Ellis Traub | September 16, 2008
Those "buy-and-watch" physician-investors have experienced one of the most unsettling periods in their investment lives. They've seen the value of investments soar to heights that would have cast a shadow on Icarus, and then plummet to depths that few of us have ever seen. These extraordinary bubbles and busts have tested the faith that many have in fundamental investment principles and likely caused some to abandon their discipline. Many who stayed the course are still questioning whether they should have been able to tell when the market was going to take its dive.
Of course, the best way to keep your mind at ease through times like these is perspective. Those who are thoroughly grounded in long-term thinking know that these kinds of events are transient and will eventually work out. Patience and vigilance are the only attributes an investor needs to get through them. A new approach is found in rational price or rational value, which pertains to a portfolio whose stocks have been priced at their rational prices.
There's no question that the most recent bubble was the product of what Federal Reserve Chairman Alan Greenspan termed "irrational exuberance."We now know that in the course of a year, the price of a stock can go up or down, departing as much as 50% from the average price. The distortion that applies to the price is also applicable to the price/earnings (P/E) ratio, which is a function of the price. Viewing the P/E ratio as merely a rate you pay for a dollar's worth of earnings makes perfect sense.
During the course of a 5-year cycle, the market's P/E ratio will typically make even greater departures from the norm. And several times during a century, excursions from the average can be extreme and either delightful or painful.
The significant thing for physician-investors to remember is this: If the price is truly driven by earnings in the long term, and successful methodology says that it is, then deviations in the P/E ratio, the "rate," must be caused by something other than earnings. If it weren't, the price and P/E ratio would always march in absolute lock step with the most recently reported earnings per share.
KNOW THE HUMAN FACTOR
What is that mysterious force that causes the price and P/E ratio to vary up and down, sometimes by huge amounts? It's nothing more than the collective perception or opinion about the effect that the daily host of media reports, stories, current events, earnings forecasts, speculation, etc, will have on the economy, the market, an industry, or a company. It's fear, greed, paranoia, and euphoria that uninformed or over-informed speculators act on. These change every minute; reported earnings do not.
How, then, should you compensate for these fleeting, disconcerting, and often misleading trends? We recognize that the daily, short-term fluctuations in the P/E ratio are not important when compared to earnings over the long term. This allows us to calculate a rational price for each of our stocks and a rational value for our holdings.
Simply stated, the rational price tells what the price of our stock would be if the public's decisions to buy or sell were governed by earnings and not by all the unpredictable factors. In effect, the rational price answers the question, "If the public really had it together, what would they be paying for my stocks?"
To calculate a price, use the "signature P/E ratio" and earning per share. The simplest way to do this is to multiply a company's 10-year average P/E ratio by the most recent trailing 12 months' earnings. Once you've calculated your rational prices, you can analyze your portfolio and calculate its rational value (ie, the sum of the products of the number of shares and their rational prices).
The benefit to be derived from this exercise is significant. It puts whatever irrationality Mr. Market might be currently laboring under into perspective and gives you a view of just how irrational he is at any time. It's a way to quantify just how right you are compared to the rest of the world, which goes a long way toward providing comfort when times are bad, and tempering euphoria when they're good. And, if nothing else, it may be just the encouragement a physician-investor needs to stay the course. That may be the best medicine of all.
Ellis Traub, author of Take Stock: A Roadmap to Profiting from Your First Walk Down Wall Street (Dearborn; 2000), is chairman of the Inve$tWare Corp (www.investware.com), manufacturers of stock analysis software. He welcomes questions or comments at 954-723-9910, ext 222, or firstname.lastname@example.org.- See more at: http://www.hcplive.com/publications/pmd/2003/53/2654#sthash.4g85ciyZ.dpuf