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May, 2002


An alternative title for this column might be: "The Meaning of Earnings Yield and Its Significance for the Value Investor."

As with low barometric pressure for ship captains, a low earnings yield can spell trouble ahead for an investor. When the earnings yield is extremely low, it can indicate that conditions are right for the stock market equivalent of a "perfect storm."

Earnings yield is defined as the reciprocal of the more popular price to earnings (P/E) ratio (100 ÷ P/E). It is a measure lending itself better to comparison with the coupon, or yield, one receives from a bond investment.

If a stock has a P/E of 5, its earnings yield (100 ÷ 5) is 20 and, everything else being equal and if the company's debt is low, implies an excellent investment opportunity relative to the essentially risk-free long-term U.S. government bond yield (recently about 5½%).

In traditional Benjamin Graham valuation terms, if one can trust the accounting (a major question at any time, but particularly following recent news from Enron, Global Crossing, Adelphia Communications, Arthur Andersen, and others), a low-debt company with an earnings yield at least twice that of the average Aaa-rated corporate bond (approximately 6.7% currently) is considered to have an adequate margin of safety and, if available as one of a large portfolio of such assets (to diversify risk), is likely a terrific bargain.

This happy situation prevailed in early 1982 for the U.S. equity market generally. But, twenty years later, after the longest bull market for stocks in history, the circumstances are reversed.

Now the earnings yield of a combined New York Stock Exchange and Nasdaq stock portfolio would be less than half the yield of the average Aaa-rated corporate bond. Nor is corporate debt as low as a generation ago.

Even after the market setbacks that began in March, 2000, the excesses of the nineties remain largely intact, as reflected in an earnings yield that would worry many value investor "meteorologists." (Note, for instance, that the Wilshire 5000 Index P/E is now 31.5, for an earnings yield of just 3.17.)

The stock market overall would have to fall about 50% or the nation's corporations double their earnings (not realistically anticipated anytime soon), or a combination of the two, just to get the earnings yield to match the bond yield of our best companies.

Studies of earnings yield as a predictor of future return have demonstrated that, with few exceptions, the present situation is followed by years of underperformance for stocks.

At this time, with rising deficits again and other unfavorable factors making the real (after inflation) return of bonds also uncertain, and with the yield of money market funds or short-term certificates of deposit negligible, it is hard to find reason for much optimism for the average investor.

Perhaps the best he or she may do, in light of possible looming turbulence and the lack of satisfactory safe havens, is to return to the basics, prepare for the worst, and "batten down the hatches" until any storms pass.

Step one might be to lower one's level of debt.

Step two, to keep expenses substantially below income.

Step three, to assure a reserve of six months' worth of stable assets, on which to rely if things get bad and for any reason one loses a key source of income.

Step four, to invest extra funds very conservatively. For instance:

  • Half in stocks with excellent earnings yield (preferably also with low price to book or a high, stable dividend) and low debt, or in tried and true value, or low risk growth and income, mutual funds;

  • Half in low risk bond assets and real estate investment trusts.

  • Balance the allocation once a year or after the market value of equities vs. non-equities has changed at least 10%, i.e. if stocks are now 55% of the total portfolio and non-equities 45%, rebalance to a 50/50 allocation.

Step five, to adjust expectations. Traditionally, stocks return about 11% a year before "frictional costs," taxes, or inflation. In the current environment, they may not do nearly as well. A cautiously allocated portfolio may now only provide a 5-6% average return, with some years much better, but some much worse.

This is certainly not a forecast of disaster. Stock markets are too mercurial for short-term calls and may, indeed, go either significantly up or down before returning to their historical mean. But with earnings yields as low as they are today, it may be best to err on the side of safety.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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