Showing posts with label extreme cheapness. Show all posts
Showing posts with label extreme cheapness. Show all posts

Friday 30 December 2011

Buffett's Ratio Says Stocks Are Getting Interesting

17 August 2011
The art of cheap.

One of the hardest things to grasp in investing is that when the present turns the darkest, the future becomes the brightest. Warren Buffett once captured this with a famous and oft-repeated quote: "I will tell you how to become rich: Be fearful when others are greedy, and greedy when others are fearful."
There's another, more specific Buffett rule that gets less attention. In 2001, Buffett wrote an article for Fortune magazine laying out a few investing truisms. In short, you want to buy stocks when the total market capitalization of all public companies looks cheap in relation to that country's gross national product (similar to gross domestic product, or GDP). He called this technique "probably the best single measure of where valuations stand at any given moment."
He even threw around some numbers. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."
Tallying up the total market value of all listed stocks isn't easy. Different analysts come up with different numbers. The most widely used method is the full capitalization version of the Wilshire 5000 index, which tracks the market cap of all U.S. companies "with readily available price data." Divide that index by gross national product, and you get Buffett's ratio.
Where are we today? After the market bloodbath of the past few weeks, the ratio of U.S. stocks to GNP recently hit 79% -- just below what I'd call Buffett's comfort zone.
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Source: Dow Jones, St. Louis Fed, author's calculations.
Understand what this does not mean:
  • It does not mean stocks are bound to go up in the short run. No metric can predict that.
  • It does not mean stocks won't fall further from here. A ratio becoming mildly attractive doesn't rule out the possibility of it becoming much more attractive. In fact, that's usually how it works. The history of bear markets is that of stocks becoming not just a little cheap, but obnoxiously cheap.
And importantly, other valuation metrics, such as the cyclically adjusted P/E ratio created by Yale professor Robert Shiller, still peg stocks as slightly overvalued.
But Buffett's metric means things start getting interesting. Forty years of data show there's a fairly strong correlation between Buffett's ratio and stock returns two years hence. At 79%, today's ratio is in a range that has historically set investors up for decent future returns:
U.S. Stocks as
% of GNP
Average Subsequent
2-Year Return
< 60%21%
60%-80%24%
80%-100%13%
> 100%(4%)
Source: Dow Jones, St. Louis Fed, author's calculations. Data since 1971.
There are no certainties. There are no promises. But investing gets interesting when the odds of success are in your favour. Buffett's ratio suggests those odds are now pretty good. If you were excited about stocks a month ago, you should be thrilled about them today. Indeed, many of us are. 
"The lower things go, the more I buy," Buffett said last week. How about you?


Saturday 20 March 2010

New Study Reveals World's Greatest Investment Strategy


New Study Reveals World's Greatest Investment Strategy

By Dan Ferris 

Thursday, February 18, 2010 



It's official: Buying the cheapest assets you can find is where you make the biggest, safest, easiest money as an investor. 

What made it "official" to me was a just-completed study by one of the greatest living investors. The investor is Jeremy Grantham. His firm Grantham, Mayo, Van Otterloo, manages over $100 billion. 


Grantham recently published the results of a 10-year forecast he made for the period from December 31, 1999, to December 31, 2009. In 1999, Grantham predicted the rank and return for 11 different asset classes. The actual rankings wound up correlating 93% with Grantham's forecast.The probability of equaling or besting such a performance is about one in 550,000. 


How did he do it? As he wrote in his latest investor letter, "We forecast [back in 1999] that the egregiously overpriced S&P would underperform cash and everything else – what should you expect starting at 33 times earnings? – and we assumed that emerging equities would do extremely well despite a 0.7 correlation with the S&P, because they were cheap." (Italics added.) 


Grantham's forecasting feat confirms a thesis I've believed in for a long time: If you wait for asset prices to reach extremes of valuation, you have an excellent chance of outperforming most investors. It's difficult to wait for these extremes to come around, but it's crucial to your success as an investor. 

Grantham's track record for spotting valuation extremes goes beyond a single 10-year period. He and his clients successfully avoided every bubble of the last two decades (Japan in the '80s, tech stocks in the '90s, financials and housing in the '00s). He was bearish at the top of the most recent bubble, in 2007, and super bullish at the bottom, in late 2008/early 2009. 

Again, Grantham's secret is being bullish on cheap, unpopular assets and avoiding expensive, popular assets. 

Today, Grantham says only the higher-quality large-cap stocks are attractive. I say the same and recommend World Dominator stocks like ExxonMobil, Microsoft, and Procter & Gamble. You can read more about this idea here and here


As for the broader market, Grantham says the S&P 500's fair value is around 850, 20% below its current level. 


Grantham expects seven years of "below-average GDP growth" and "more than our share of below-average profit margins and P/E ratios." Falling average price-to-earnings ratios are an important aspect of the sideways market I've been telling people about since November 2009. 

Grantham's lessons are powerful and easy to understand. Avoid what's expensive. Buy what's cheap. 

Stocks were incredibly popular in 1999, when Grantham made his prediction. They crashed three months later. Emerging markets were very cheap. They produced excellent returns. In both cases, extremes of valuation trumped all else.

If you're buying and selling businesses without knowing how to value them, and how to spot extremes of valuation in them, you can't possibly hope to make a dime in the stock market. If you fancy yourself a "trend follower," be careful you don't follow your beloved trend straight off a cliff. 
Grantham's forecasting success proves waiting for extremes of value to arrive makes long-term investing success much, much easier to achieve. 

And while I normally don't pay a bit of attention to predictions, it's great to see such a common sense forecast prove the case for value investing once again. 
Good investing, 


Dan Ferris 


http://www.dailywealth.com/427/New-Study-Reveals-World-s-Greatest-Investment-Strategy

Friday 23 October 2009

A rally from extreme cheapness to excellent value

So what happens next? If that was a rally from extreme cheapness, what does the market do when it is merely excellent value?

Overpriced = price at more than 120% of Intrinsic Value

Fair price = price at more than 80% but less than 120% of Intrinsic Value

Bargains = price at less than 80% of Intrinsic Value



Overpriced:

Extremely overpriced = more than 50% above intrinsic value
Overpriced = more than 20% above intrinsic value



Fair price:

Fair value = +/- 20% of intrinsic value



Bargains:

Good value = 20% lower than intrinsic value
Excellent value = 30% lower than intrinsic value
Extreme cheapness = 50% lower than intrinsic value