Last Updated January 29, 2013
I’m sure you don’t need me to tell you what mood the market’s in. Borderline panic is probably as good a description as any. I may not like the panic, but as a value investor I do like the bargains it throws up and one such bargain may well be the FTSE 100 itself.
If I flick across to Google Finance the FTSE 100 stands at 5,036. If I were a technical trader then I’d probably say we might find some support at 5,000, but not much. If I were a TV news anchor with red braces then I might say “the FTSE 100 closed just above 5,000 today, which is where the index stood in 1998”. Since I’m a value investor who lives in Graham and Doddsville I prefer to start by looking at the ratio between that 5,036 level and the FTSE 100’s earning over the last 10 years.
PE10, friend of the long term investor
One of the many tools bestowed upon the investment profession by Ben Graham was PE10, or the current price over the average earnings of the last 10 years. There isn’t anything magic about looking at 10 year earnings averages (in fact 30 years may be better), but it sure is a step in the right direction compared to looking at the current PE.
Graham felt that for ‘leading enterprises’ the last 10 year’s earnings may be a reasonable estimate of the next 10 year’s earnings. With many large, established companies their earnings do fluctuate around a certain level or magnitude, and so using the past to estimate the future is not as whacky as it might sound.
The same idea can be applied to the market as a whole since the FTSE 100 is effectively a collection of ‘leading enterprises’. In fact I’ve written before about various approaches to valuing the market as a whole and even included a mathematical function for calculating stock and bond allocations.
If you want some empirical evidence then the excellent “Valuing Wall Street” and “Wall Street Re-valued” by Andrew Smithers provide a solid grounding in this area.
Put simply, the earnings of the FTSE 100 are relatively stable over longer periods. As the years tick by the 10 year average increases (most of the time) at a fairly predictable rate. In turn, the market level hovers around some average multiple of that 10 year earnings average. The market is typically between 15 and 20 times the 10 year earnings, but it can go below 10 times or even up to 30 or more.
The wonder of mean reversion produces a startling result:
The cheaper you can buy the market relative to its historic earnings the better your future returns are likely to be.
History is a good teacher
I hated history in school but I can’t ignore the lessons it provides to investors. Although generated from a simplified set of data, the graph below should give you an idea of what I’m talking about.
That’s a pretty boring chart. Over the longer term the earnings of the FTSE 100 have drifted upwards in a very unexciting manner. So far the credit crunch and Greek Crisis have managed to make a very small dip in PE10 as seen in 2010, which has subsequently bounced back in 2011.
In 2000 when everyone was very happy and thought that the future would look like Buck Rogers, investors were paying about 30 times the previous 10 year earnings average. With hindsight we know how that turned out.
In 2009 when it was the end of the world (according to the experts) you could buy the FTSE 100 at only 11 times the average earnings. So in 2009 each pound you put in the FTSE 100 was earning about 3 times as much as in 2000. Not only that but the downside risks where much smaller too.
I’m guessing that 2009 will turn out to have been a better time to invest than 2000.
Alas, things are not always that happy
If you want data going back much further then Robert Shiller has just about all anyone would want (on the US at least). Looking at over a century of data shows that the chart above paints a somewhat overly cheery picture. Things are not always that smooth and you can see with the US data below that the 10 year and even the 30 year averages can trend downward for decades at a time (through much of the 1920’s, 30’s and 40’s and to a lesser extent, the 1980’s).
However, that doesn’t change the fact that no one knows what the future earnings will be. It also doesn’t change the fact that buying shares – or the market – cheap relative to historic earnings has been a good strategy for over 100 years.
The future is not the past
Since investing is about future earnings and not those from the past, the assumption here is that the future will look like the past because in the past the future turned out to look like the past (more or less). This assumption springs from Occam’s razor, i.e. “we should tend towards simpler theories until we can trade some simplicity for increased explanatory power”.
There are thousands of theories about how the economy and corporate earnings are going to pan out over the next few years. Unfortunately these theories are generally devised by experts and experts have a fantastic track record of being rubbish at forecasting. Their theories and opinions have little if any explanatory power in hindsight, beyond what you’d expect by luck.
James Montier tends to write good pieces about how economist and the like can’t forecast ‘for toffee’ (for example, see this article from his blog). How many of them spotted this recession/depression? Pretty close to zero bar any perma-bears who don’t count as they are effectively the broken clock that was right twice a day.
In my opinion the simplest model is to say that the future earnings will grow as they have in the past, on average. Therefore if you can buy the index cheaply relative to past earnings then you are likely buying it cheaply relative to future earnings, and that’s what real investing is about at the end of the day.
Stocks – Overweight or underweight?
In Market Mayhem Or Golden Opportunity?, I said that at 5,129 the market was priced below its historic average PE10 and therefore the long term returns were likely to be at or above average. My estimate of the FTSE 100 PE10 is about 18, although I expect this to drop over time towards the US average of 16.
Either way, the current PE10 is around 12 which is definitely cheap.
My wife is none too keen on the whole stock picking game and so we run her pension as an index tracking stocks/bonds portfolio. The asset allocation policy follows the one I outlined in A Value Based Allocation Strategy.
At the current level our target allocation for stocks (for which we use a FTSE 100 index tracker) is 90% rather than the default target of 66%. I would go to 100% stocks if the market were to fall to half its long run average, i.e. 9 times the 10 year earnings, which we’d reach if the FTSE dropped to 3,900.
I guess for most investors 90% would scare the pants off them given the current Greek Crisis and in many ways that’s the point.
By following a fixed process I’m able to decide, in advance and without pressure, what I should do. Then, as long as I’m brave enough to stick to the plan and override any short term fears I may have, I can be greedy when others are fearful, as the saying goes.