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Summary

  • It’s impossible to forecast the stock market in the short run.
  • The earnings of the individual company drive long-term returns.
  • Retired investors should be concerned with the stocks they own, not the market.
  • The P/E Ratio is a relative metric, and therefore, useless when viewed in a vacuum.
  • The broad stock market has little to do with the performance of individual stocks.

Introduction

Most stock markets are trading at all-time highs and therefore stimulating a lot of worry and angst. This concerns me because I believe it is causing a lot of investors to avoid making sound investment decisions based on a fear of unknowns. Furthermore, I don't believe it is possible to forecast what the stock markets might or might not do in the short run. But more importantly, I don't believe it's necessary or even rational to try.

In my opinion, individual investors, especially those depending on their investments to fund their retirements, should not be concerning themselves with vague notions of how the stock market might behave in the short run. The only investors that should be concerned about the broad stock market are those whose investment portfolios are comprised solely of broad market index funds. But for those investors with portfolios that are comprised of individual companies (common stocks), their primary concern should be with and about the specific companies they own.

My reasoning is simple and straightforward. It is not the stock market that will drive an individual's future returns. Instead, each individual's returns will be functionally related to and directly proportionate to the business success of the specific companies they hold. On the other hand, this previous statement is only true under two important conditions.

First and foremost, results will only be correlated to business success when purchases are made at sound valuation. Second, results will only be correlated to business success over the long run. My definition of the long run is over at least one business cycle (3 to 5 years) or longer. In the shorter run, stock prices can move up or down without valid reason. But since earnings drive market price in the long run, rational investors have to own a business (stock) long enough for earnings growth to create true intrinsic value.

Therefore, the primary intent of this article is to provide clear evidence that it truly is a market of stocks and not a stock market. But even more importantly, my intent is to provide supporting evidence that prudent investors need not concern themselves with trying to forecast something that cannot be forecast anyway. I believe that estimates about the future success of an individual business can be accomplished with a great deal more accuracy than trying to forecast the future results of a basket of stocks containing hundreds of individual companies.

As I often do, I will summarize this introduction by sharing appropriate words of wisdom from the venerable Warren Buffett:

"If we find a company we like, the level of the market will not really impact our decisions. We will decide company by company. We spend essentially no time thinking about macroeconomic factors. In other words, if somebody handed us a prediction by the most revered intellectual on the subject, with figures for unemployment or interest rates, or whatever it might be for the next two years, we would not pay any attention to it. We simply try to focus on businesses that we think we understand and where we like the price and management."

Ascertaining Future Returns One Company at a Time

One of the most important tools for the serious investor is the Price-to-Earnings Ratio (P/E Ratio). It is, however, one of the most misunderstood and misused tools. Learning how to use it properly and understanding its significance can significantly increase returns and lower risk. Perhaps the most important thing to realize when using P/E Ratios as an investment tool is that the P/E Ratio by itself is virtually worthless. The P/E Ratio's true value is as a barometer or tool used to measure important investment principles relative to each other. Unfortunately, most investors fail to realize this and therefore often miss the long-term benefits it offers.

The P/E Ratio, when used properly, assists the investor in the rational evaluation of the realistic probabilities of achieving a long-term rate of return and the amount of risk taken to get there. In short, the P/E Ratio when understood and utilized properly helps you ascertain, within a reasonable degree of accuracy, the future returns that a given common stock might offer. However, this is only true when it is evaluated in relation to the growth potential of the specific company in question. With that said, the following common definitions of the P/E Ratio are offered to add insight into its value and usefulness.

The P/E Ratio - 3 Common Definitions:

The P/E Ratio can be defined in several ways, with each definition adding insight to its significance. The simplest definition is simply the price of the common stock divided by its earnings per share. This is a basic mathematical definition expressed as follows: PRICE/Earnings = P/E Ratio.

A second commonly used definition is: The P/E Ratio is the price you pay to buy $1.00 worth of a company's earnings or profits. For example, if a company's stock has a P/E Ratio of 10, then you must pay $10 for every dollar's worth of that company's current earnings or profits you buy. If its P/E Ratio is 20, then you pay $20 for every dollar's worth of that company's current earnings or profits you are purchasing, and so on.

It is important to note, however, that a higher P/E Ratio does not necessarily mean that the company has a higher valuation or that it is more expensive than a company with a lower PE Ratio. This fact is not understood by many investors and is the key reason that the P/E Ratio has little value by itself or if looked at in a vacuum. It is theoretically possible, depending on each company's future business prospects, that a company with a P/E Ratio of 2 can be significantly more expensive than a company with a P/E Ratio of 40. (This important principle will be developed more fully later in this article.)

A third definition would be: How many years in advance you are paying for this year's earnings. For example, if a company has a P/E Ratio of 20, then you are paying 20 times this year's earnings. If the P/E Ratio is 10, you are paying 10 times this year's earnings, and so on. This definition illustrates a simple premise of what an operating business is truly worth.

Common sense would dictate that no rational individual would sell their profitable business for only one times current earnings (P/E Ratio of 1). Therefore, both public and private companies alike will rationally command a multiple of current earnings. As I will soon illustrate, the specific and appropriate multiple will be a function of the buyer and/or seller's expectations for the company's future earnings growth rate potential.

P/E Ratios Are Not As Important As Growth

In order to illustrate that the P/E Ratio's true value can only be understood when you are evaluating it in relation to a company's past, present and future earnings prospects, I offer the following examples utilizing the F.A.S.T. Graphs™ earnings and price correlated research tool.

In order to underscore the importance of how the P/E Ratio can be utilized to determine fair valuation (risk control) and as a result forecast future returns, my examples will include companies with characteristically different earnings growth rates. Additionally, with each example I specifically chose periods of time when valuation was in alignment (or very close to it) for both the beginning and the end of each timeframe. My purpose for the latter was to illuminate not only the functional relationship of earnings and stock price over the long run, but also to clearly illustrate that the broad stock market has in fact little to nothing to do with the performance of each company reviewed.

Example 1 - Moderate Growth High Yield: AT&T Inc. (NYSE:T)

With this first example, we see clear evidence of how monthly closing stock price (the black line) tracks earnings (the orange line) over the long run. Moreover, we clearly see that a P/E Ratio of 14 to 15 represents fair value, or a sound valuation for purchase of this blue-chip high-yield company.

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For the reader's added perspective, I include the following earnings and price correlated graph on the S&P 500 index to illustrate that AT&T generated almost precisely the same earnings growth rate as the broad market (4.5% for AT&T versus 4.7% for the S&P 500 index). Of course, the principle that earnings drive market price over the long run applies equally to the index.

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When we review the capital appreciation component of total return on AT&T over this timeframe, we discover that it almost perfectly coincides with the company's earnings growth rate. Remember, I chose this timeframe because fair valuation was manifest at both the beginning and the end of this period of time.

As an interesting aside, we see that capital appreciation of the S&P 500 index also correlates to its earnings achievement. The slightly higher rate of annual capital appreciation over its earnings growth rate is clearly attributable to the S&P 500's current moderate overvaluation.

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Example 2 - High Growth Moderate Yield: Ross Stores Inc. (NASDAQ:ROST)

With this second example, I introduce clear and undeniable evidence that the stock market has nothing to do with investing in individual stocks. With the addition of the S&P 500 index above, we see that earnings growth of the broad market was 4.7% per annum. However, over the same timeframe, Ross Stores grew earnings at 19.2% per annum. Importantly, we also see that fair value for this high-growth example is clearly represented by a P/E Ratio of approximately 19 consistent with the company's earnings growth rate.

These results provide clear evidence that neither the stock market nor the general state of the economy had anything to do with the earnings achievements of Ross Stores and the accompanying shareholder returns. This begs a simple question: Should long-term shareholders of Ross Stores even care what the stock market had done? Of course, the answer is emphatically no.

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When you evaluate the capital appreciation component that Ross Stores generated with that of the S&P 500 index, we discover that there is no relationship or correlation. Ross Stores generated annual capital appreciation that was more than three times what the overall market generated.

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Example 3 - Weak Earnings: General Electric Company (NYSE:GE)

This third example is offered to provide additional evidence that the performance you can expect from common stocks is independent of the general market. It should be no secret that General Electric suffered greatly as a result of the financial debacle that led to the Great Recession of 2008. Consequently this company, once considered one of the bluest of all blue chips, experienced significant earnings stress, which led to an earnings achievement since 2006 that was significantly below the broad market.

Of course, it should be noted that fair valuation calculations at the beginning of this time period were not relevant due to the forthcoming collapse of earnings. Also, the reader should note that General Electric appeared fairly valued in 2007 prior to the forthcoming earnings collapse. However, the main point of this example is to further illustrate the notion that it is a market of stocks, not a stock market.

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As a result, General Electric shareholders suffered losses during a time when the broad market generated positive capital appreciation. Moreover, even when dividends are included, General Electric shareholders suffered a net total return loss.

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Bonus - General Electric 6-year FAST Graph With Performance

Since General Electric has reduced its exposure to financials, we discover that the correlation between earnings and price has resumed. Since 2010 General Electric has grown earnings at 9.8% per annum and has resumed annual dividend increases.

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Summary

This article contained only a few of many examples that could have been presented. They were offered to reveal the important investment principle that portfolio returns will be a direct result of the performance of the individual holdings in the portfolio. Each individual company will generate its own unique performance results and many will be vastly different than broad stock market returns.

As an aside, each of the examples utilized in this article represent attractively-valued current investment opportunities in spite of the moderate overvaluation of the broader market. This provides further evidence that investors should focus on the individual stocks they are interested in investing in, independent of the broad stock market.

Conclusions

The broad market has clearly had a strong run over the past several years, and as the S&P 500 earnings and price correlated graph above illustrates, it is clearly moderately overvalued. However, even when evaluating the broad market, I find it difficult to claim that we are in bubble territory. Therefore, I find it very troubling to see all of the many articles bemoaning an imminent catastrophic collapse. Many pundits enjoy reporting so-called evidence with supporting macroeconomic graphs to prop up their doomsday thesis. But the truth is, they really don't know what the market might do in the near term, and frankly, neither do I.

I contend that all the worry about the stock market is really much ado about nothing. Investors should only worry about the stock market if they are fully invested in index funds. However, if you are invested in individual stocks, as I am, then worrying about what the stock market might do makes no sense to me. The stock market is not going to generate my future returns. My future returns are going to be a direct function of how well the businesses I own are capable of performing as operating businesses in the future.

But most importantly, I am confident that it is much easier to evaluate the prospects of an individual business than it is the broad market. For these reasons, I believe in building portfolios one company at a time, and like Warren Buffett has advised, the level of the overall market will have no bearing on my decisions. Whenever I can find a great company at a sound valuation and I simultaneously have money to invest, I proceed with confidence. For as Warren Buffett also said: "fear is the foe of the faddist but the friend of the fundamentalist."

Disclosure: Long T, ROST, GE at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Source: A Frothy Market Has Nothing To Do With Investing In Individual Stocks