Digging Down to the Roots

(or Bill Gross's Wednesday Morning, 3 A.M. Moment)

However bold an investor might be when committing to purchase of an investment, every morning he must experience 3:00 a.m. He may sleep through most days, and on approximately half of the remaining days his investments will be showing a recent, happy gain. Eventually, though, there will come a time, a market decline, a very bad day, a sleepless night, and that investor may find himself at 3 a.m. facing a confluence of events without sleep. At such times his mettle is tested. If he bought his investments for the wrong reason, the morning may find that they are all sold, dispensed to reduce the heavy load on his mind and digestion.

Hence, it is a useful investment skill to prepare for such confluences of events. When the market goes against your position, and it seems that all sentiment is against continuing to hold it, and that any bystander would implore you to get rid of that bad investment before you lose any more money, that is when you really discover whether you should be in the investment business at all. In such circumstances, the intelligent investor will glide through because they will have prepared in advance for just such an eventuality.

Of all the "trading" and "speculation" skills, there are none I know of that are quite as powerful as knowing the underlying value of your investments. If you can calculate the value, now and in the future, if you can have high confidence about the future earnings potential, then you win. The market may be mostly efficient, but it is not always efficient, and the market price is frequently wrong. When you know the value of a company, and the market is undervaluing it by offering to sell shares of it for less than what the company is worth, then it is not only prudent to refuse to sell, but to buy more. This is right at the core of the value investment philosophy, and if you want to know more, read The Intelligent Investor or read any of the Berkshire Hathaway annual reports. 

It has been fashionable for several decades among the academic community that follows the equity markets to use a much different model of stock prices, one that insists that the price reflects all information presently available to participants. Under this "random walk" model, the individual investor cannot, on average, exceed the performance of the equity market. Many professional investors subscribe to this philosophy to some degree.

One of the hazards of subscribing to the efficient market theory is that it removes the impetus to perform company valuation. If you believe that stocks are efficiently priced, then why read any balance sheets or income statements or perform any analysis of the company's prospects? The more you believe this, the less it is rational to perform any analysis at all, because that would consume time that could be devoted to some other pursuit.

Without knowing PIMCO's Bill Gross personally, I would venture that he might be suffering from some of this malady at the current time. In his recent column Cult Figures he says that 

"If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?"

This might reflect a thinking pattern that results from failing to perform analysis on individual companies. There is also a dissonance here:  He asks a question about a long-standing "skimming" that would seemingly imply an inefficient market, that has lasted for over 60 years! I would have to conclude that an irrationality has crept up and bitten him, causing him to write from envy, not thought.

Can stocks, starting from current prices, return as they have in the past? First we need a benchmark. Roger Ibbotson was gifted with a pile of data at just the right time in history, in 1973, a pile of stock and debt security prices that he and Rex Sinquefield used to calculate the long-term real returns of asset classes. Their results:

small stocks   12.1%

large stocks   9.9%

long-term government bonds   5.5%

Treasury Bills   3.6%

inflation   3.0%

He then founded a company, later sold to Morningstar, that published the numbers annually as "Stocks, Bonds, Bills, and Inflation." You can see a descendant of this study for yourself at Morningstar's web site. (The results above are actually generated by Morningstar for the period ended 2011.) The influence of such a report on the sleep for those investors who are awakened at 3:00 a.m. cannot be underestimated. When you see that stocks have returned 10% annually from 1926 to 1973, even with the Great Depression intervening, it gives you a different sort of confidence. 

Consider the psychology of the stock market at most times in history. The fundamental idea is to spread the risk of owning a large asset over a large number of people. Stock shares are good for this; they accomplish that job fairly well.  But then follows a major problem:  What are the shares worth?  Stock shares are worth whatever the market will bear, or what they will earn for their owners in the future, or what a rich investor will pay for a collector's item, or somewhere in between. None of these valuations are stable. They depend on psychology. So when a secondary market for shares opens (a bourse), is it any surprise that the resulting crowd behavior causes stocks to seem like lottery tickets? Although they ought to know better, sometimes even the managers of the business think of their shares as lottery tickets.

But that is crowd psychology. It isn't necessarily real. Business valuation is real. Gross' point seems to be that stocks will likely disappoint, returning far less than their historical long-term rates of return. I think this is a mistake. The reason he is wrong is that he is making a argument based on aggregation of a huge market and a vague sense of "fairness", when real companies don't work that way.

Consider a single company in isolation. Suppose that its book value is $10, and it earns $1 per share each year, and we haven't yet determined whether or by how much its future earnings will grow. Taken all itself, this stock returns 10%, assuming that it sells at book value. It doesn't matter whether the market is high or low, or it has outperformed for the last 26.4 years, or Bill Gross is unhappy. If you buy that entire company, you get a 10% return on your money, and Gross and others can grump all they want to, but it won't reduce the company's return on your investment to match that of 2-year Treasury bills.

Let's suppose that you buy it at $10, then the price drops to $5. The company still earns $1 per share, because earnings aren't driven by stock prices.  So, it buys back half its shares. Now every share has a book value of $20, and earnings of $2 per share. If the price hasn't risen to $10, should our intrepid investor sell? Of course not!  He buys more!

So we see Gross' Mistake #1:  Stock prices can gain while overall company values do not. Profits are not affected by share prices. Share buybacks produce gains for shareholders while trimming total market capitalization. If stock PE ratios drop in the future because of weak top-line growth, then share repurchases can still supply the out-sized gains that have traditionally been accorded to stocks.

Switching gears, let's look at the relative prospects of stocks and bonds, right now, at current valuations and yields. Bonds have had an amazing 30-year run, with diminishing inflation and unrelenting drops in yields and interest rates over that time. Anyone holding long-term bonds through that period has enjoyed unusually strong capital gains and real yields. Consider the mortgage market, for example. 30-year mortgage rates are about as low as they have ever been, throughout the history of the U.S.  The bond market is presently sitting at the very topmost peak of an enormous, long-running bull market for bonds. There is nowhere to go but down for bonds.

Imagine for a second that you were a bond manager. Imagine that you made your living investing in bonds for other people. Imagine that your income goes up when bonds do well, and it drops when they go down. Wouldn't you be concerned at this moment?  When just a little bit of inflation, just a small up-slope in yields could wreck the whole thing?

This is exactly what PIMCO is facing. Having ridden the bond wave to become a titanic money manager, they face the possibility of a huge bear market in their primary business. Wouldn't that scare you?

So perhaps this is Gross's Mistake #2:  PIMCO, having little appreciable corporate history or practice in equity investing, fears that it is about to be locked out of the investing party. Gross was writing from his real feelings, which is a minor panic. If you are driven by the Efficient Market Theory, then you might be trying to convince yourself that bonds and stocks have equal prospects going forward, however bleak that might seem to you.

That does seem to be Gross' conclusion. It is almost an "if I can't have it then no one can" moment in which his prediction is that no investment classes will do well in the future.

In summary, the returns supplied by bonds depend on the macro economy, especially inflation and expectations for future growth, but stock returns do not. They depend on return on equity. A stock earning 10% on its book value and selling at book value will supply a 10% rate of return, even if its top line grows at 0%. Although revenue growth is welcome, it is not absolutely necessary. An excellent manager can manage high profits even in a revenue-constrained business, and savvy investors will track the real generation of value, not market maniacs who trade on emotion and feeling.