The Guru Strategies that drive my investment approach tend to have a distinct value bias. Whether it's deep value strategies like my Benjamin Graham- and Warren Buffett-inspired models, or growth-oriented strategies that include key value components (like my Peter Lynch- or James O'Shaughnessy-based approaches), these methods put a major emphasis on the price you're paying for a stock.
The issue of value is one that's gotten quite a bit of attention lately, particularly when it comes to the broader market's overall valuation. As an asset class, are stocks cheap, or are they pricey? That's the question on the mind of many investors and depending on whom you ask, you'll get some wildly divergent opinions.
Those on the "pricey" side of the debate include top value strategist Jeremy Grantham and Yale economist and noted bubble-spotter Robert Shiller. In January, with the S&P 500 (SPY) trading fairly close to its current level, Grantham said that the index was about 40% overvalued.
While I don't believe Grantham has divulged the exact details of his fair-market calculation, one valuation metric he relies heavily on, according to a 2010 article in Advisor Perspectives, is one that has been popularized by Shiller (though it was actually pioneered by the late, great Benjamin Graham, one of the gurus upon whom I base my models). The variable goes by a number of different names -- the Shiller P/E, the 10-year P/E, the CAPE (Cyclically Adjusted P/E) -- but essentially it compares the S&P's price with its average earnings over the past ten years, with some adjustments for inflation. The theory: Comparing price with earnings for the past ten years smoothes out anomalous one-year earnings results that pop up in any given year. Shiller's latest calculations (which are available on his Yale web page) show that, as of the beginning of April, the 10-year P/E for the S&P was 23.47 -- some 45% or so above the long-term average of 16.
Others point to different numbers that paint a strikingly different picture. Wharton professor and author Jeremy Siegel, for example, said not long ago that stocks were still historically cheap. Based on 2011 earnings projections, he said, the S&P 500 was trading about 13% below where it would be with a modest 15 P/E multiple, according to Reuters. What's more, Siegel said that one must take interest rates into account when determining the market's value. During lower-interest-rate periods (when stocks have less competition from fixed-income assets), investors are willing to pay more for stocks -- he said that historically, if you exclude periods in which rates were above 8%, the average P/E for stocks is 19. That would mean the market was about 43% below average valuation.
Siegel and others say that, while looking at one year of earnings can be misleading, looking at 10 years' worth of earnings can also be misleading. In a recent New York Times article that looked at the Shiller P/E, Siegel said that keeping earnings from the financial crisis -- a "once-in-a-75-year event" -- in the assessment of the market's 10-year P/E "doesn't seem to be realistic."
So, two of the market's top minds offer staggeringly different views that stocks are either 45% overvalued, or 43% undervalued -- and we're only talking about earnings-related valuation metrics. There are, of course, other metrics, like the price/sales and price/book ratios, that can provide other takes on the market's valuation. Right now, according to Morningstar, the S&P 500's components on average are trading for 1.3 times sales, for example, not bad at all. That's actually below the 1.5 upper limit my James O'Shaughnessy-based model uses when examining individual stocks, and in the "good value" range my Kenneth Fisher-based model uses.
The S&P also appears reasonably valued if you use a metric that Peter Lynch used to analyze individual stocks: the P/E/Growth ratio. Using 2010 earnings, the S&P is currently trading for 15.7 times operating earnings, and 17.0 times as-reported earnings. Using an average of its 3-, 4- and 5-year EPS growth rates, meanwhile, we see that the index's earnings have been growing a 22% pace over the long haul. For both operating and as-reported earnings, those figures make for a P/E/G below 1.0, which would be considered attractive by my Lynch-based model.
If we use the S&P 500's projected 2011 earnings, the P/E/Gs are also attractive. Using Standard & Poor's operating earnings projection of $96.99 for 2011, we get a P/E/G of 0.86; using S&P's as-reported earnings projection of $97.26, we get a P/E/G of 0.53. Both those figures would come in under the Lynch model's 1.0 target.
Of course, you could look at S&P earnings or sales from a variety of other periods to determine a P/E/G or a price/sales ratio -- three-year average earnings or sales, five-year average earnings or sales, etc. And, often, you'll find divergent stories of what the market's valuation is. To me, the bottom line is thus this: When it comes to analyzing the stock market's valuation, there's no one metric that you should always rely on, no silver bullet that will tell you just how cheap or expensive stocks are.
Oh, one more thing, just to further muddy the waters: Just because the broader market appears expensive doesn't mean it won't rise. For example, back in the early 1990s, the 10-year P/E climbed above 16 (its current historical average) just four months into a bull market that ended up lasting nearly a full decade. When it crossed that level, the S&P was priced around 372; if you'd sold out of stocks then, and waited to buy back in until the next time the 10-year P/E was below 16, you'd have had to wait until November 2008, when the index was at about 883. That's an annualized gain of about 5% per year that you'd have missed out on by shunning stocks (and certainly more than that if you'd picked good stocks) -- not great, but hardly the disastrous returns you might expect for a period when stocks were usually trading for between 20 and 45 times trailing 10-year earnings.
When it comes to individual stocks, there's also no silver valuation bullet. I believe that's part of what has made my Hot List portfolio -- which has averaged annual returns of 15.1% since its mid-2003 inception, vs. 3.6% for the S&P -- so successful. This portfolio uses all of my individual Guru Strategies, searching for stocks that get the most combined interest from these varied models. By using multiple models (and thus a myriad of valuation measures), the portfolio finds stocks that are attractively priced on a number of different levels. Whatever strategy you use to build your own portfolio, I'd recommend making sure to use a similar multi-faceted approach to finding value.