"If you are pretty sure that the market is too high, it is a better policy to keep your money in cash or Government bonds than it is to put it in bargain stocks. However, at other times - and that is most of the time, of course - the field of undervalued securities is profitable and suitable for analysts' activities." - Benjamin Graham, Current Problems in Security Analysis (1946-47), Lecture 7.
There is a lot of fear in the water lately about the movements in, and prospects for, the US stock market. In these challenging times we can gain some perspective from the investment classics.
All of Graham's writings are concerned with the opportunity cost inherent in our choice to invest in one asset to the necessary exclusion of others. As value adherents know, Graham developed the concept of the margin of safety to quantify that opportunity cost. Most of us have used the margin of safety to frame an investment decision about a specific business: if I believe that Harley-Davidson has an intrinsic value of $100 per share and it closed yesterday at $50, the margin of safety is 100% (ie: intrinsic value less price, divided by price).
However, Graham also used the concept of margin of safety in relation to the entire market. The following quote is from a Graham lecture in 1972, taken from the footnote on page 515 of the annotated Jason Zweig edition of The Intelligent Investor:
The margin of safety is the difference between the percentage earnings on the stock at the price you pay for it and the rate of interest on bonds...At the time the 1965 edition of The Intelligent Investor was written the typical stock was selling at 11 times earnings, giving about a 9% return as against 4% on bonds. In that case you had a margin of safety of over 100 per cent. Now [in 1972] there is no difference between the earnings rate on stocks and the interest rate on stocks [this should read "bonds"], and I say there is no margin of safety...you have a negative margin of safety on stocks...
In those sentences Graham reveals his formula for the margin of safety for the stock market as a whole. Using the 1965 data, the formula is the 9% earnings yield for stocks, less the 4% bond yield resulting in a 5% spread in favour of stocks. Dividing the 5% spread by the 4% bond yield returned a margin of safety for stocks in 1965 of 125% relative to bonds.
Using time series data for both the S&P 500 p/e ratio and the yield on US 10-year Treasury bonds, I have constructed the chart below using Graham's formula. The data are bounded by the first of the S&P earnings reports for December 1988 and run for each calendar quarter to the most recent S&P earnings estimate in March 2006 (click to enlarge):
The most obvious features of the chart are that, if you follow Graham's approach:
- the margin of safety for large cap stocks relative to 10-year US Treasuries has mostly been negative since 1988; and
- the period since 2003 (where the margin of safety has remained positive) is the best time to invest in US large caps in the past 18 years.
If the earnings of US large caps are not rapidly and invisibly declining as I write this, the declines in all major US equity indices since March must have only increased the margin of safety for stocks.
To conservatively estimate the current margin of safety (ie: at 1 June 2006), I have assumed zero growth in large cap earnings since the last S&P 500 p/e estimate at the end of March 2006. On the basis of that assumption and a 10-year Treasury bond yield of 5.1%, the current p/e ratio for the S&P 500 is approximately 17.1. To place this in context, the average p/e of the S&P 500 since 1935 is 15.7 and the average between 1996 and 2005 was 27.5.
Accordingly, despite the Fed's serial rate-tightening program, the current Graham margin of safety for large caps relative to 10-year Treasuries is at least 14%. For a company like Abercrombie & Fitch (NYSE:ANF), which has a trailing twelve month p/e of 15.2, the margin of safety is more like 30%. If you can find a large cap with sustainable earnings and a decent moat trading at a p/e of 10, the margin of safety is near enough to 100%. As Graham said, the field of undervalued securities is profitable and suitable for analysts' activities.