A well known valuation metric is the PE Ratio (Price / Earnings ratio). This is a measure of a company's share price (P) relative to the annual net income (E). The PE ratio shows current investor demand for a company share. A high PE ratio generally indicates increased demand because investors anticipate earnings growth in the future.
The PE ratio has units of years, which can be thought of as the number of years of earnings required to pay back the purchase price.
The PE ratio is often referred to as the "multiple" because it demonstrates how much an investor is willing to pay for one dollar of earnings.
While the PE ratio is widely used, it is a bit of blunt instrument in terms of valuing a company. One of the biggest challenges of using the PE ratio is that it doesn't consider the growth in earnings of the company. If a company's earnings are rapidly growing, then its conceivable that it should trade at a higher PE ratio. So then the question becomes, what PE ratio is appropriate based upon the earnings and growth rate of the company?
One solution to this problem is to look at the company's PEG ratio.
The PEG Ratio (Price/Earnings to Growth ratio) illustrates the relationship between a company’s stock price, its earning per share, AND the company's growth rate. The PEG ratio consists of the PE ratio divided by the company's earnings growth rate. Using just the PE ratio makes high-growth companies look overvalued relative to others. By dividing the PE ratio by the earnings growth rate, the PEG ratio allows investors to compare companies in wildly different markets by factoring how growth rates affect valuations. By using the earnings growth in the denominator, it helps support the idea that growth is an important aspect to valuing a company.
While not being set in stone, a company with a PEG ratio <1 can be considered undervalued. A company with a PEG ratio around 1 is considered fairly valued, and a company with a PEG ratio much >1 might be considered overvalued, all else being equal.
PEG Ratio = PE Ratio / TTM (Trailing Twelve Months) Earnings Growth Rate*
* Some analysts use a forward PE Ratio and use forecasted earnings growth, rather than trailing PE and historical earnings growth. Using historical numbers rather than forecasted numbers is typically more conservative if growth rates are increasing.
To illustrate a company's PEG Ratio, let's describe a hypothetical company called Blue Star trading at $167.42 per share.
Blue Star EPS (Earnings Per Share) TTM for the following quarters were:
03/31/2020 - 5.12
06/30/2020 - 6.79
09/30/2020 - 7.53
12/31/2020 - 8.16
03/30/2021 - 8.98
So in this case Blue Star could be considered significantly undervalued as the PEG ratio is .247, well below 1.
Both the PE Ratio and the PEG Ratio are great tools that can be used to help value companies and/or compare companies in different industries, as the formulas are straight forward and the information needed is rather easy to ascertain. However keep in mind, calculating these ratios is more than likely just the beginning of the valuation process rather than the end.
-Paul R. Rossi, CFA
Now that we have had some time to reflect back over the last year or so, I think it's important to keep things in proper perspective.
Leading up to the Global Pandemic the markets had been performing quite well (see below).
Once it became clear that the world was facing a global pandemic, the United States and most of the rest of the world essentially shut down a large portion of their economies to stem the spread of the virus. And the markets reacted with veracity.
Here's the 1 month market crash (Feb-March 2020) that will go down in history, for the dramatic speed in which the markets tanked.
However, the rally from the bottom (see below) will also surely go down in the history books as well.
The markets are forward looking and determined that the economy would come back. They rallied well ahead of any vaccines being developed, let alone any being approved, and well before Covid rates began to come down.
When looking back over the past 10 years (see below), we can see that the market volatility in 2020 isn't too much out of the ordinary. The markets don't move in straight lines. Understanding this and not being rattled could be considered a modern day super power.
How about we go back and look at the profits of some of the largest U.S. companies from the time of the space race to the global pandemic (a little over 50 years). The gray bars show economic recessions.
This chart is very telling...company profits are volatile, recessions are quite common, and most importantly companies continue to find ways to grow their earnings over time.
So what can we learn from all of this?
-Paul R. Rossi, CFA
As the economy expands and contracts, so do the financial performances of companies across the 11 stock sectors. The 11 sectors are listed below along with some of the industries within each individual sector.
When the outlook is positive, economically sensitive companies tend to perform better (at least historically), prompting investors to buy their shares. If the outlook turns bearish, investors might swap out of these types of companies and into companies that can better weather economic downturns. The practice of doing this is known as sector rotation.
Cycles that can trigger sector rotations
The economy goes through cycles, and sector rotations occur at each stage. The 3 most common cycles that investors follow are:
The Market Cycle (see below) typically moves ahead of the Economic Cycle, since investors make decisions in anticipation of the future. As such, the current market cycle stage can indicate which sectors will soon become market leaders:
Market Cycle: Market Bottom
What Happens: Systematic risk resulting from a poor economic backdrop brings the whole market lower. Investors prepare to rotate into more economically sensitive sectors.
Best Performing Sectors
Market Cycle: Bull Market
What Happens: The market bottom has passed, and the worst is over. As economic activity picks back up, so do share prices of cyclical stocks.
Best Performing Sectors
Market Cycle: Market Top
What Happens: Economic growth overheats, and interest rates rise. Investors prepare to rotate into more "defensive" sectors that are less economically sensitive.
Best Performing Sectors
Market Cycle: Bear Market
What Happens: Markets begin to drift from highs, and economic activity slows. As investors rotate out of cyclical sectors into defensive ones, selling activity accelerates the market decline.
Best Performing Sectors
Market Cycles tend to lead Economic Cycles which is what happened both in the 2008 and 2020 recessions.
In 2008, the S&P 500 peaked months ahead of US Monthly Real GDP's top. Stocks sold off in anticipation of a worsening economy.
When COVID-19 became a pandemic in early 2020, the stock market was ahead of the 8-ball once again. Such is nature of both stock prices that discount future cash flows, and investors who want to be one step ahead.
In both the Global Financial Crisis and the recent Covid-19 recession, the market rebounded well ahead of the fundamentals, which corresponds to the earlier statement, that Market Cycles lead Economic Cycles.
Layered underneath the Market Cycle is the Economic Cycle. Because economic data is released less frequently, and investors price in their estimates beforehand, the Economic Cycle lags behind market movements. That said, it can provide solid confirmation of prevailing market trends. Sectors tend to perform differently based on the current Economic Cycle (see below) stage:
Economic Cycle: Early Expansion
What Happens: Rebounding GDP, Increased Production, Optimistic Consumer Sentiment, Reflationary environment, Low but Stable Interest Rates, Steepening Yield Curve
Best Performing Sectors
Consumer Discretionary Industrials
Economic Cycle: Late Expansion
What Happens: Tapering GDP, Tapering Production, Strong Consumer Sentiment, Growing Inflation, Spiking Interest Rates, Flattening Yield Curve
Best Performing Sectors
Consumer Discretionary Energy
Economic Cycle: Early Recession
What Happens: Declining GDP, Declining Production, Weakening Consumer Sentiment, High Inflation, Tapering Interest Rates, Flat or Inverted Yield Curve
Best Performing Sectors
Communication Services Consumer Staples
Economic Cycle: Full Recession
What Happens: Falling GDP, Falling Production, Pessimistic Consumer Sentiment, Deflationary environment, Falling Interest Rates, Normal Yield Curve
Best Performing Sectors
Lastly, oversold and overbought indicators can be used to hone in on investment decisions with sometimes added precision.
A very recent example: In late 2020, the Technology Sector triggered a commonly used overbought signal when its relative strength index (RSI) spiked. The sector immediately sold off by as much as 12.9% over the following months.
Sector Rotation in Practice
One argument for using a sector rotation strategy is that share prices of companies within each sector tend to move in the same direction. This is a natural effect of sector classification, companies with similar business models are grouped together as they can be economically affected by many of the same factors. At a minimum, investors can gain baseline exposure to a given sector’s sensitivities using individual stocks. Or, broader exposure can be secured using sector ETFs.
An example is the relationship of crude oil prices with major airliners American Airlines, Delta Airlines, Southwest Airlines, and United Airlines, as well as United Parcel Service and FedEx. Despite operating in different industries, these industrial sector companies all benefit from lower oil prices, causing share prices to move higher when fuel costs decline.
Investors can also use a top down approach and look to macroeconomic indicators to assess the current economic cycle stage. Once favorable sectors are identified, rotations are made out of unfavorable ones and into those that are poised to grow.
Other Factors to Consider
Some Important Warnings:
Finally, past performance isn’t always indicative of future results.
-Paul R. Rossi, CFA
“Never confuse genius with luck and a bull market.” - John C Bogle
“If you don’t recognize luck when it happens to you can fool yourself into thinking past performance was indicative of skill in a way that leads you to regrettable decisions.” - Morgan Housel
“One lucky break, or one supremely shrewd decision—can we tell them apart?—may count for more than a lifetime of journeyman efforts.” -- Ben Graham
"People often assume when a decision is followed by a good outcome, the decision was good, which isn't always true, and can be dangerous if it blinds us to flaws in our thinking." - Philip Tetlock
“In a necessarily uncertain world, a good decision doesn’t necessarily lead to a good outcome, and a good outcome doesn’t necessarily imply a good decision or a capable decision maker.” - John Kay
“The greatest trick the market plays on beginners is making you think luck is skill. It waits for you to double or triple down on your next bet and then it teaches you your first lesson.” - Ian Cassel
"Making money through an early lucky trade is the worst way to win. The bad habits that it reinforces will lead to a lifetime of losses." - Naval Ravikant
"During 'bull' markets, many investors tend to give themselves too much credit for favorable results and to give insufficient credit to the positive environment that played a large role in creating the results. This can lead to overconfidence on the part of the investor and resulting mis-assessment of risks." - Ed Wachenheim
"Just because you made money doesn’t mean you were right, and just because you lost money doesn’t mean you were wrong. It is all a matter of probabilities. If you take a bet that has an 80% probability of winning and you lose, it doesn’t mean it was a wrong choice.” - Tom Claugus
"Every once in a while, someone makes a risky bet on an improbable or uncertain outcome and ends up looking like a genius. But we should recognize that it happened because of luck and boldness, not skill." - Howard Marks
“The absence of loss does not necessarily mean the portfolio was safely constructed. So, risk control can be present in good times, but it isn’t observable because it’s not tested. Ergo, there are no awards. Only a skilled and sophisticated observer can look at a portfolio in good times and divine whether it is a low-risk portfolio or a high-risk portfolio.” - Howard Marks
“The correctness of a decision can’t be judged from the outcome. Nevertheless, that's how people assess it. A good decision is one that’s optimal at the time it’s made, when the future is by definition unknown. Thus, correct decisions are often unsuccessful, and vice versa.” - Howard Marks
"It is all about believing in yourself and not confusing a bull market with brilliance and a bear market with stupidity.. markets are markets. You can't take it personally." - Mark Kingdon
“Just because you did something that worked doesn’t mean that it wasn’t risky or wasn’t smart.” - David Abrams
"Numbers can be very misleading because very smart people can struggle and very mediocre people can excel for periods of time." - Jim Chanos
"The mere fact an aggressive strategy wins in a winning period doesn't prove it's the right strategy for all periods." - Howard Marks
"Just because you buy a stock and it goes up does not mean you are right. Just because you buy a stock and it goes down does not mean you are wrong." - Peter Lynch
“One thing about investing is, I think it’s good not to think that one is a genius, because the stock market will bury you.” - Jean Marie Eveillard
“It’s dangerous to think you know too much and have your ego all involved in showing how smart you are and all that. It’s not an accident we use all of this self-deprecatory humor at Berkshire. It’s required for sanity. It really is.” - Charlie Munger
"When you are having a good run of it, you are not as smart as you think you are, and when you are struggling with it, you are typically not as dumb as you look." - John Harris
“Ego is the enemy of investing.” - Jake Rosser
“Anytime that you think you’ve become a financial genius – when, in fact, you simply have had good luck to turn a profit – it is time to sit back and do nothing for a while. If you stumble upon success in a bull market and decide that you are gifted, stop right there. Investing at that point is dangerous, because you are starting to think like everybody else. Wait until the mob psychology that is influencing you subsides.” - Jim Rogers
“I have seen a lot of people who confuse money with brains and more than a few traders who develop an unbounded view of their own infallibility … and usually such hubris precedes some sort of market retribution. I am sure that most of us in this room have seen that biblical injunction of pride coming before the fall strike someone near us in the trading world — if not hit us directly between the eyes.” - Bruce Kovner
“Success tends to breed confidence and then, eventually, overconfidence — and why would one examine what he’s doing when it’s so successful, even if it’s silly!” - David Polen
"Any investor can chalk up large returns when stocks soar....In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm thinking its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond." - Warren Buffett
"Good decision-making can lead to bad outcomes and vice versa. If we believe that we predicted the past better than we did, we may also believe that we can predict the future better than we can." - Peter Bevelin
"The riskiest thing is getting lucky - a false positive. You have a positive result, but your process was poor. That's the most dangerous because, after a few false positives, you typically go bigger, and that leads to the old saying of "succeed small, fail big.” So we think about this pretty carefully." - Ken Shubin Stein
"We have talked about how a sound investment process likely leads to a good investment result. A good result, though, says nothing about whether the process involved was a good one, and, thus, whether or not the success might be replicable." - Seth Klarman
"In a bad year, defensive investors lose less than aggressive investors. Did they add value? Not necessarily. In a good year, aggressive investors make more than defensive investors. Did they do a better job? Few people would say yes without further investigation. A single year says almost nothing about skill, especially when the results would be expected on the basis of the investor's style." - Howard Marks
“Short-term performance is an imposter." - Howard Marks
"One of the allures of this business is that sometimes the greatest ignoramus can do well. That is unfortunate because it creates the impression that you don't necessarily need any professionalism to do well, and that is a great trap." - Michael Steinhardt
“Return alone—and especially return over short periods of time—says very little about the quality of investment decisions.” - Howard Marks
“A year is far too short a period to form any kind of an opinion as to investment performance, and measurements based on six months become even more unreliable. One factor that has caused some reluctance on my part to write semi-annual letters is the fear that partners may begin to think in terms of short-term performance which can be most misleading. My own thinking is much more geared to five-year performance, preferably with tests of relative results in both strong and weak markets.” - Warren Buffett 1960 Partnership letter
"Short-term performance measurements are meaningless, and it is impossible to forecast with any certainty what the relative performance of a manager will be in any given year. In fact, even a several-year span can be misleading, as a manager may be able to achieve above-average results by owning very high-risk stocks in a generally rising market (as we had in the 1960s) but be virtually wiped out in the same class of stocks in a bear market. The only true test of a money manager's ability is if he can obtain above-average results over a full cycle that includes both bull and bear markets. A great investment manager must be ‘a man for all seasons’." - Barton Biggs
"It can take years to judge the quality of an investment decision. Those who believe that they are quite witty because of a few years of strong performance – for a stock or for the whole portfolio – should develop a strong auto-skepticism reflex." - Francois Rochon
“If I had to choose a great single fallacy of investing, it’s that when a stock’s price goes up, you’ve made a good investment. People take comfort when their purchase at $5 goes to $6, as if that proves the wisdom of the purchase. Nothing could be further from the truth.” - Peter Lynch
“One reason the financial industry mints so many extraordinary egos is because it’s easy to take personal credit for what works and claim to be a victim of what doesn’t. Industrial engineers can’t simply be in the right place at the right time, or blame their failures on the Federal Reserve. But investors can, and do. An iron rule of investing is that almost nothing is certain and the best we can do is put the odds of success in our favor. Since we’re working with odds – not certainties – it’s possible to make good decisions that don’t work, bad decisions that work beautifully, and random decisions that may go either way. Few industries are like that, so it’s easy to ignore. But it’s a central feature of markets. Unless you’ve enjoyed a period of success that you realize you had nothing to do with, or can admit that a long period of loss was due to your own mistake, you’ll have a hard time grasping reality in a way that lets you do at least the average thing when everyone else is losing their minds.” - Morgan Housel
“The stock market provides an uneven feedback loop for investment decisions. This unusual economic microcosm may sometimes reward poor decisions and often penalizes good ones… When a blackjack player receives a 3 after he hits on 18, he may celebrate a victory, but clearly the decision to hit was incorrect, based on all available information at the time. Good portfolio managers have this concept ingrained in their thinking They realize positive outcomes are sometimes confirmation of a good decision, and sometimes they are not. What matters is process.” - Brian Bares
-Paul R. Rossi, CFA
Over the weekend (Saturday May 1st), Warren Buffett and Charlie Munger held their annual shareholder meeting for Berkshire Hathaway, and as usual, it was a filled with timeless wisdom for investors and non-investors alike. I highly recommend you listen or watch the entire meeting, as both Warren and Charlie continue to dazzle us with their insightful thoughts and ideas. If you don't have 3+ hours to watch the meeting I would recommend you read the short conversation (see below) between author Robert Hagstrom and Lauren Foster of the CFA Institute.
If you've ever Googled "Warren Buffett" and "books to read," you'll find Robert Hagstrom's first book on the list, "The Warren Buffett Way."
The Warren Buffett Way spent five months on the New York Times bestseller list in 1994 and '95, and is routinely included in lists of the best books to read on the Oracle of Omaha. Robert is a CFA charter holder and a Senior Portfolio Manager at Equity Compass, where he launched the global leaders portfolio. He also serves as Chairman of the Investment Management Committee for Stifle Asset Management. A recent conversation between Robert and Lauren Foster of the CFA Institute is all about this concept of a money mind.
What exactly is a money mind?
What are the components?
And importantly for investors, can they be learned?
Below is a quick excerpt between Lauren Foster of the CFA Institute and Robert Hagstrom.
Click the PDF below to get the entire conversation and learn more about the Money Mind.
-Paul R. Rossi
Paul R. Rossi, CFA