Hic sunt dracone (Here be dragons)
Hunt-Lenox Globe from 1510
The future can be approached in two different ways, which can be called the way of prediction and the way of protection.
Benjamin Graham, The Intelligent Investor
Legend has held that ancient maps were inscribed with the words Here be dragons to mark uncharted territory. For investors, the future is the great unknown. To be an investor, however, one must believe that the dragons over the horizon will be friendly or at least ultimately tamable. The views of prognosticators vary widely on the prevailing mood of the feral beasts that lie in wait for investors today.
Depending on your preferred metric of earnings, the U.S. stock market is valued either just right or at a precarious premium. The wary bear looks at the current market valuation relative to the ten-year average of inflation-adjusted corporate earnings and sees a market trading at levels not seen since the height of the 2000 tech bubble. The sanguine bull looks at forward estimates of operating earnings for the coming year and sees a market trading right around its recent historical mid-point. The bullish investor also points to the continued low level of interest rates as supporting current valuations with the 10-year Treasury rate still around 3%, more than justifying a forward earnings yield (Earnings/Price) on the S&P 500 Index near 6%.
Low interest rates have frequently been cited the past couple of years as a cause and support for healthy equity valuations. Indeed Benjamin Graham, the father of value investing and author of The Intelligent Investor, often cited the spread of the earnings yield above the high-grade corporate bond yield as one measure of the margin of safety for a security. At one point, Graham even recommended that a security’s earning yield should be at least two times the high-grade bond yield. With the AAA bond yield around 4% today, that would imply an appropriate price-to-earnings (P/E) multiple of 12.5x (1/8%) and no margin of safety given the market’s current 32x P/E multiple for ten-year average inflation-adjusted earnings or 17x for forward operating earnings.
It should be noted, however, that when the first edition of The Intelligent Investor was published in 1949, stocks traded at a healthy spread to high-grade corporate debt unlike the past several decades. (See the graph of historical AAA bond yields and stock earning yields below.) In later editions of The Intelligent Investor, Graham relented to the reality of higher interest rates and the growing willingness of investors to pay up for equities’ growth potential to recommend that an investor’s stock portfolio as a whole have an earnings yield that was at least as high as the current high-grade bond yield – e.g., for the present moment, the current AAA bond yield of roughly 4% would imply an appropriate earnings yield of 4% or a P/E multiple of 25x. Using that yardstick, the market would seem to be fairly valued today, in between being undervalued or overvalued depending on the earnings metric used.
But will the stock market decline if rates move higher? As Graham’s change of heart indicates, there is not a strong historical connection between interest rates and equity valuations. As seen in the graph above, until the 1960s, low rates were accompanied by much lower stock valuations (i.e., high earnings yields) than we see today. If interest rates move higher as the result of continued strong economic growth, equity valuations may not come down much or at all. If rates increase because of rising inflation, the story may be different. As it has been said, predicting is difficult, especially about the future. Focusing on protection is a more reliable way of handling the uncertainty of tomorrow.
A margin of safety can be built when future stock returns are broken down into three components: 1) the return from dividends, 2) the growth of earnings, and 3) the change in the valuation multiple. Roughly approximated:
% Stock Return = % Dividend Return + % Growth of Earnings per Share + % Change in P/E Multiple
This understanding of equity returns is at the core of our dividend-value investment philosophy. Value stocks trading at lower valuations reduce the downside risk of contracting price multiples (i.e., declining P/E ratios). Meanwhile, dividends provide stability with a solid base return and have historically proven to be a good hedge against inflation. (See below the graphs of nominal and inflation-adjusted 10-year stock returns and their component parts that highlight the benefit of dividends.) A track record of regular, increasing dividends is also a good indication of a quality business whose low current valuation may just be caused by transitory factors. Forecasting the third component of stock returns, future earnings growth, will always be the most uncertain; however, with the protection of a diversified portfolio of dividend and value stocks, good long-run returns are less dependent on predicting the fickle moods of the dragons beyond.
Everett is a Senior Financial Advisor for Alpha Omega. Everett has more than 18 years of experience in the financial services industry. For feedback or questions regarding this blog post, please contact Everett at firstname.lastname@example.org.
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