Value Investing / Main Index / previous / next

July, 2002


In a recent "Barron's" article, "After the Bubble," by Jonathan R. Laing, 7/1/02, pp. 19-21, it is pointed out that the price to earnings ratio of U.S. stocks, as represented by the Standard and Poor's Composite, and going back to 1880, was never higher than its 44.3 level in January, 2000. Earlier peak P/E ratios occurred in June, 1901 (25.2), September, 1929 (32.6), and January, 1966 (24.1). Although it was down to around 25 last month, the current P/E remains quite lofty by historical standards. The norm is about 14.

In contrast to many investors' expectations, that we are a few months away from resuming the 15-20% annual equity returns more typical of the 1990s, the article indicates that, after such peaks, a long period of time, close to twenty years, is required for restoration of improved stock market average yearly returns.

From August, 1901, to August, 1920, the median annual stock market return was 4.3%. It was 2.3% from September, 1929, to September, 1949. The figure was 5.1% from January, 1966, to August, 1982. Thus, given that equity prices remain high relative to earnings, stock market total returns could well be only about 5% for the next 15-20 years.

In this environment, how can we protect ourselves and hopefully also attain somewhat higher share price appreciation plus dividends over the coming couple decades?

Even during the generally disappointing return periods cited, contrarian, bargain, or value investors like Benjamin Graham, John Templeton, Warren Buffett, or John Neff were making respectable profits in the market, averaging 15% a year or better. But a principle they applied that most do not is that of a "margin of safety."

In his classic work, The Intelligent Investor, Benjamin Graham suggested that passive investors, who do not actively research the best value stocks, may achieve their margin of safety against the likelihood at times of falling equity prices, by keeping a percentage of their liquid assets invested in bonds. Then, if stocks do fall substantially, they can be rebalanced with the bond assets.

For instance, if one begins with $1,000,000, half in bonds and half in stocks, but the stocks fall 20%, from $500,000 to $400,000, so that the total is now $900,000 (assuming, for simplicity, that the value of bonds has remained the same), a rebalanced portfolio would then have $450,000 in bonds and $450,000 in stocks. The $50,000 in new stock purchases would be made while stocks are relatively low in price.

Later, once equity prices broadly increase again, raising one's stock portfolio, for instance 22.22%, to $550,000, the assets can be rebalanced once more, with stocks being sold high to purchase more bonds, and restored again to the fifty/fifty ($500,000 each) relationship between the portfolios.

Although it might seem in the above example that nothing has changed, since one again has $500,000 each in bonds and stocks, actually one has achieved a major objective of investors, to buy low and sell high, and has, at the same time, maintained a relatively low risk total portfolio.

In practice, even in fairly weak equity markets, stocks tend over the long-term to go up a little more than they retreat. Thus a more likely scenario might be that, instead of going up just 22.22% in the next bull market, one's equity portfolio might rise 33.33%, to $600,000. At the same time, the bond assets would have been providing an annual yield and the stocks some dividends. If we assume the yield income was not required for expenses and was protected from taxes in a retirement account, it is reasonable to expect that, over a hypothetical three year period, these combined dividend additions would have added at least another $120,000 (4%, times the original $1,000,000, times three). Thus, even if the stock portfolio were very volatile, falling 20% the first year, rising 33% the second, and falling 20% again the third year, the total, including a combined yield of $120,000, would be about $1,063,000. In contrast, an all equity portfolio would have fared worse, ending at just about $913,300, including $60,000 in stock dividends over the period. (Note: assumes, again for simplicity, that stocks would average dividends of 2% and bonds 6% per year of the initial investments, through the three year period. At the time of writing, the "Value Line" yield is 1.9%, while the Aaa corporate bond average yield is 6.5%.)

Of course, in a bull market, the approach of simply buying and holding all stocks would do much better. However, in a bear market, a volatile one, and/or one that stays within a trading range, the balanced or allocated portfolio approach would likely provide about equal or better overall returns, with less risk.

And Graham knew that even bull markets are of uncertain length. Sooner or later they get overvalued. Since they do not keep going to the sky, at some point the trend reverses. Then, as now is the case, people are inclined to see much cause for worry, just as, until then, they saw mainly optimistic scenarios.

Thus, for the average investor, he felt it best always to have a significant investment in bond assets and to appropriately rebalance periodically.

On the other hand, for the individual willing to take a more active role in his or her investments, he recommended a different kind of margin of safety, one based on an analysis of the value of the company whose shares were to be purchased.

His was a banker's approach. He used straightforward accounting methods to arrive at a correct current value for the entire company, then subtracted all debt, preferred shares, or other obligations, and divided the result by the total number of common shares, for the fair value of each.

But since there is always an element of risk in stocks investing, he used this just as a starting point. He would normally only invest if he could buy the shares for less than that amount after subtracting also the per share value of all fixed assets, like plants, equipment, trucks, inventory, etc. His ideal investment was one for which he could get all the assets of any kind for less than two-thirds the value of the current accounts (such as cash and amounts owed the company).

Eventually, though, he developed other simple formulas for investors to evaluate potential stock bargains, including that debt to equity were less than one and:

  • price to book value were .66 or below; and/or
  • 100 divided by the price to earnings ratio (i.e. the "earnings yield") were at least twice the AAA (or Aaa) corporate bond yield; and/or
  • the company's dividend yield were at least 2/3 the AAA (or Aaa) corporate bond yield.

He and his associates tested these criteria, for margin of safety in buying a stock, through several decades of up and down markets and found that, when an asset could be acquired for less than 2/3 of its net quick assets (his original formula) or when at least two of the other criteria were met, the annual appreciation averaged about 18-19 percent.

His simple rules for when to sell were:

  • After the stock had gone up 50%; or
  • After two years, whichever first; or
  • If the dividend were omitted; or
  • If earnings had declined enough that the current market price were 50% or more above the new target buying price.

In today's still fairly high-priced stock market (relative to historical norms), not many equities would meet any of these bargain criteria. But if one is found, it may be worth serious consideration.

I think Korea Electric Power, ADR (KEP), may be a good margin of safety buy candidate. At the recent price of $10.34 (written 7/17/02), its price to book value was just .47, its price to earnings 5.7, and its debt to equity .39. It also has an above average (2.1%) dividend.

I believe that, to the extent one can purchase equity assets that meet such strict criteria, for a margin of safety below their intrinsic value price, it is reasonable to dispense with the portfolio allocation method of protecting one's assets from loss. But for this one should average one's purchases over both time and a large number of individual stock holdings.

Thus, if one bought at least half the equity assets using criteria that most value investors would agree involve inherent avoidance of risk, the bond asset portion of one's total portfolio might safely be reduced to 25%.

The rules of good investing probably have not changed. But for many they may seem new, as the easy profits of the last equity bubble are behind us. With a little extra digging and due regard for risk avoidance, however, it should still be possible to achieve worthwhile returns in stocks.


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.)

Value Investing / Main Index / previous / next