Last Updated May 25, 2012
I’m a big fan of CAPE (cyclically adjusted price earnings) and Tobin’s Q as tools for understanding expected future risk and returns from a stock market. After reading Wall Street Revalued: Imperfect Markets and Inept Central Bankers, I’m an even bigger fan.
The logic is simple. Market valuations must be tied in some way to earnings (the discounted cash flow that I hear so much about from earnings based investors). Earnings for an entire market, over the long term, are somewhat predictable using past earnings. These earnings are generated by assets and so market values are tied in some way to assets. CAPE seeks to value markets using earnings and Tobin’s Q does it with asssets (or net assets to be more precise).
More important than valuing markets is the idea that higher valuations give lower expected returns for greater downside risk, while lower valuations give greater expected returns for lower downside risk. Smithers uses a ‘hindsight’ value, the average returns over 1-30 years from any given point in history, to give some indicator as to what the returns were from that time. This is overlaid with CAPE and Tobin’s Q, both of which would have provided investors with a pretty good guide to their expected future returns.
I invest some of my money passively, using a FTSE 100 ETF and a UK Bond ETF. These valuation metrics have given me plenty of food for thought with regard to asset allocation. Typically, using MPT (Modern Portfolio Theory – see The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk for a great explanation of this sort of investing) style asset allocation you’d allocate say 40% of you money to bonds and the rest to stocks, the idea being that stock outperform over the long term so you put more money in there. Then each year you rebalance back to 40/60, e.g. if the stock market went down you might sell bonds to buy stocks which is good now that they’re cheaper. However, MPT doesn’t really talk much about ‘cheap’ or ‘expensive’. It’s more interested in risk (standard deviation) and returns and correlation between asset classes. This is all well and good and very sensible but I like to know the value of what I’m investing in since I believe that markets and assets can be valued.
So without going into too much detail here I use a function to decide my bond allocation for me based on the value of the market using CAPE, or CAPE10 as I call it which instead of using the last 10 years real earnings in the P/E ratio it uses the average of the last 10 years 10 year real average earnings. I then work out the long term average and see where the market currently is in relation to that long term average. The lower the CAPE10 value the more I allocate to stocks, the higher the value the more I allocate to bonds.
The same kind of thinking can be applied to individual companies, and that’s basically how I do my value investing.
In a perfectly competitive market a company must be worth its net assets, or at least cannot be worth much more or much less for long. If a company is earning so much that it is worth more than its assets then competitors would enter the market, replicating the successful company in order to achieve the same high earnings. This added competition would decrease earnings and the company’s value. If a company is earning so little that it is worth less than its assets then the owner would either sell the company in order to put his capital to work more effectively; fix the company so that its earnings improved and therefore its value; or if the particular market sector was affected by poor earnings a competitor may sell out thus reducing competition and increasing earnings and therefore the value of the company.
Of course in the real world it doesn’t work out like this given the time and effort and cost involved in both setting up, changing, or closing down a business. But, on average, over the long haul, perhaps company valuations do mean revert to some typical multiple of their net assets. Buying low price to book companies allows you to ride the mean reversion wave back to fair value. On average, over the long term, of course.