Category Archives: Equity valuation

The new darlings of Wall Street: The folly of oil fracking investing


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[Acknowledgment: Thanks to Edward Worsdell for helpful comments on an earlier draft of this post.]

In a recent post we took a deep dive into the debate over whether the US stock market is expensive or not. We concluded that i) the market is indeed quite expensive, ii) the market is not in a ‘bubble’ territory, but rather higher equity valuations on average should be considered the new normal (on the proviso that this new normal state of affairs should not be used to justify current equity valuations), and iii) historical standards can be a deceptive guide in predicting future equity returns and should be used with caution.

However, the market, taken as a whole, has a wide range of investment opportunities. We can find situations where a sector is cheap for a particular reason (e.g. the US retail sector) or situations where a company is trading at mind-blowing multiples because the market is discounting unrealistic expectations about future growth prospects, as in the case of Tesla, with a market capitalisation now higher than well established competitors like Ford or General Motors.

But this post is not about the fate of investors in a single company like Tesla or whether this is an attractive investment or not (we think it is not). Rather, this post will zero in on a sector that has been gaining increasing media attention, a sector that is considered to be the new pride of American industry, one that is highly leveraged and in which Wall Street investment banks have so much at stake in it. Continue reading

The “New Normal”: Some reflections on the discussion on US current equity valuations


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[Acknowledgment: Thanks to Edward Worsdell for helpful comments on an earlier draft of this post.]

Ever since the publication of the book Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh and Staunton (already 15 years ago!), it is basic knowledge that equities, as an asset class, outperform other asset classes in the long-run, in particular fixed income (both bills and bonds). As you can see in the following graph from the Credit Suisse Global Investment Returns 2017 edition, equities on a global basis (and not just US equities) have outperformed both bills and bonds by very wide margins – although this historical advantage seems to have faded away in the last 15 years:

Global Equity Returns vs

Source: Credit Global Investment Returns 2017, p.47

From a theoretical perspective, however, the fact that equities should outperform both bills and bonds over the long-run has a long and distinguished lineage. It was Lawrence Smith, in 1924, in his classic book Common Stocks as Long-term Investments, who was the first to advance the idea (which for many was counterintuitive at the time) that stocks should deliver healthy returns for investors, with the proviso that you should hold them for several years – and over several business cycles. And as it happened, Keynes, who read Smith’s book as soon as it came out, was the first institutional investor (through the King’s College’s portfolio) to introduce stocks as a permanent, core asset in his portfolio allocation (and replacing the core role that real estate had played up to that point). And since then, the rest of the story is better known: from the Buffett’s investment success thanks to his patient approach at the helm of Berkshire Hathaway, to the books by Jeremy Siegel popularising the idea that equities, if bought at reasonable valuations, will do fine in the long-run. Continue reading

Las finanzas conductuales, el (casi) único secreto común a todos los inversores value


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[Artículo publicado originalmente en FundsPeople]

Hace unas semanas, el sector más lector de las finanzas españolas estaba de enhorabuena. Francisco García Paramés, ex gestor de Bestinver, actual gestor de Cobas Asset Management y uno de los mejores gestores (no sólo a nivel nacional) de renta variable de las últimas décadas, publicaba Invirtiendo a largo plazo: mi experiencia como inversor, un libro a mitad de camino entre la autobiografía y una sencilla introducción al estilo de gestión value. Y digo de enhorabuena porque, aunque el libro pase a engrosar la (ya) larga literatura del value investing, es el primer libro escrito por un gestor español de reconocimiento internacional.

Invirtiendo a largo plazo, al igual que la mayoría de los libros sobre value investing (por no decir todos), tiene un carácter eminentemente didáctico. Como explicó Paramés en la presentación del libro, el principal objetivo del texto es elevar la educación financiera del gran público español para que pueda tomar decisiones de ahorro más sensatas. Sin embargo, el libro es también una muy buena excusa para reflexionar, una vez más, sobre las características que definen a un inversor value, y cómo el estilo de gestión de Paramés y sus compañeros en Bestinver contrasta con el de otros inversores value bien conocidos. Para los que prefieran pasar a las conclusiones: la única herramienta que aparece de manera consistente en el arsenal de todos estos inversores (y Paramés) son las finanzas conductuales (behavioural finance), a las que Invirtiendo a largo plazo dedica un capítulo completo. Continue reading

The Meaninglessness of Bottom-up Estimates and a Reverse Engineering Exercise for the S&P500


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Last week Deutsche Bank sent an internal note arguing that, well, it may be about time for the Fed to raise rates, claiming that ‘in fact, it looks more and more like the Fed is behind the curve’. For such a claim, the note reviewed a series of inflation indicators (e.g. PCE, CPI), but the really interesting chart was the last one, in which the analysts’ consensus for the S&P500 earnings per share was plotted, conveying the message that because the consensus expected higher earnings in the future, at some point wage growth would also follow suit, thus bringing higher levels of inflation in the future.

Beyond the dubious claim that the Fed should raise rates (which we think it should not), the really amusing part is to look at the analysts’ consensus estimates for the next 8 quarters. They are as follows:

S&P500 EPS and Consensus 3Q16-2Q18

S&P500 EPS and consensus’ estimates 3Q’16-2Q’18. Source: Bloomberg.

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The rebalancing and the flat decade in the Chinese stock market


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[this is the translation of an article originally published in FundsSociety]

Some days ago, Bloomberg published an article featuring a comparison between the stock market valuations of the Shanghai Stock Exchange against the valuations of other major exchanges in the world. The key message of the article was that, despite  falling 40% from the peak reached in June 2015, the index was still dear according to the median PER – in China, such a measure reached 60 times, in comparison to 20x and 13x in the US and Japan, respectively. To conclude, the article presented several opinions that stressed the low visibility for corporate profits in the short-run, given macroeconomic uncertainty and the difference in valuations and opportunities between the old economy (raw materials, industrials and real estate) and the new economy (technology, leisure, healthcare, etc.).

In fact, although making a one-year corporate profit forecast is a tough task, it is less hard if we make a ten-year forecast. Such a claim, although it may sound counterintuitive, is due to the macroeconomic dynamics that China will have to face in the medium-term. By this, we mean the rebalancing process, which implies reducing the investment share in GDP (and increasing the share of consumption) from roughly the current 50% down to 30% or less. That the rebalancing process implies moving resources from investment to consumption is already a well-known fact, and the investment community is starting to benefit from this insight recommending taking positions in consumption-related sectors and shying away from investment-intensive sectors – although, on the other hand, given analysts’ interpretations on the macroeconomic data published in May highlighting the supposedly ‘low growth’ of investment of around 9%, one wonders whether the analysts have yet understood even the basic concepts of the rebalancing process.

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El reequilibrio y la década plana en el mercado bursátil chino


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Acaban de publicar en FundsSociety nuestra visión sobre los retornos del mercado bursátil chino durante la próxima década. Puede consultarse aquí. En resumen, creemos que los índices chinos estarán en el mismo nivel de aquí a diez años (en el mejor de los casos, asumiendo múltiplos de valoración constantes), ya que el proceso de reequilibrio no sólo implica mover recursos de la inversión al consumo, sino también de los beneficios a los salarios.

Dado que la participación de los beneficios en el PIB tiene que caer a la mitad si se quiere completar el proceso de reequilibrio, y teniendo en cuenta que en el mejor de los casos el PIB en términos nominales crece al 7% en la próxima década, los beneficios en términos absolutos quedarían igual que hoy. Una aplicación muy elegante de la ecuación de beneficios Levy-Kalecki.



On the dismal performance of pension funds in Spain: 2000-2015


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February is always a very sad month for the Spanish financial industry, and this February has not been an exception. Pablo Fernández, professor at the IESE Business School, and collaborators have published the latest version of their annual paper on the returns of pension funds in Spain. The paper of this year, ‘Return of Pension Funds in Spain. 2000-2015’, studies the track-record over the last fifteen years of the 322 Spanish pension funds that have been in existence at least for fifteen years. You can find the paper here. The main takeaway? The performance of the pension fund industry in Spain has been simply terrible. Well, it has been even worse than that. As the authors succinctly explain in the abstract (unfortunately the paper is only in Spanish):

During the last 15 year period (2000-2015), the average return of the pension funds in Spain (1.58%) was lower than the return of government bonds (5.40%). Only 1 fund (out of 322) had a higher return than the 15-year government bonds. Nevertheless, on December 31, 2015, 7.8 million investors had 67.6 billion euros invested in pension funds.

What the abstract does not say (but the paper does) is that with an average return of 1.58%, pension funds were not even able to beat inflation! More details: only 2 funds (out of 322) outperformed the Ibex 35 (the main Spanish stock market index), only 1 fund outperformed 15-year government bonds and 47 displayed in average negative performance. Although the paper gives us more interesting details (very small correlation between fund size and return, no correlation between number of beneficiaries and return, etc.), the crucial part is about returns and how pension fund performance compares against other benchmarks. In other words, pension fund performance has been simply embarrassing and it should make us to think why one should invest in one of these vehicles. And as it was reported by Félix López one year ago in this blog, the 2014 paper by Pablo Fernández and collaborators reached the same conclusion: pension fund performance has been consistently dismal.

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Superforecasters, value investors and the (less than) ten commandments of value investing


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This is a follow-up on my previous post, where I dealt with the latest Tetlock-Gardner’s book, Superforecasting: The Art and Science of Prediction. As I mentioned there, there are several valuable lessons to learn. Although the best way to hone our forecasting abilities is obviously getting some practice in prediction tournaments, it would be wrong to think that this is the only field where we will be able to apply our new knowledge. As long as we try to answer very specific questions with a reasonable time spam, we keep record of our initial forecasts and we commit to update our beliefs on a regular basis, then this routine qualifies as a useful exercise to improve our forecasting abilities. And it seems that investing in equities meets these requirements.

In particular, I realised on further reflection that there are many similarities between the way superforecasters make their predictions and the way value investors select their investments. So I was wondering whether superforecasters can give us some insights for value investors or not. And indeed they can. Although the comparison may seem a bit awkward at first, we should remember that the purpose of the book is how we can improve the way we make our forecasts, and in this regard value investors have to make forecasts as everyone else. Therefore, although the most succesful value investors already incorporate many of the procedures regularly used by superforecasters, it is worth attempting to make a systematic comparison in order to see what parts of the value investing approach can benefit from superforecasters’ abilities.

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Do dividends and capital gains really “misbehave”?


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I finished reading the truly amusing book, Misbehaving, by Richard Thaler, a couple of weeks ago (see here for my review of the book), and beyond being a highly readable book (the book of the summer, in my opinion) with many entertaining stories, there is a passage which I found particularly interesting. It is in Chapter 17, where Thaler mentions a debate that took place in October 1985 at the University of Chicago on the empirical relevance of the Modigliani-Miller (M&M) dividend irrelevance proposition.

The M&M dividend irrelevance proposition says that the value of a company is independent of dividend policy – i.e. it does not matter whether the firm decides to pay more or less dividends. The argument is based on arbitrage: an individual investor will be indifferent between receiving cash-flows as dividends or as capital gains and, moreover, he or she will be able to undo corporate decisions by creating “home-made” dividends – i.e. selling (parts of) the shares. This result was achieved without taking into account the tax structure, because once the tax structure was included it distorted the relative value of dividends and capital gains for the investor. As it happens, in the 1980s dividends and capital gains were very different taxed in the US. It is worth quoting Thaler’s passage in full:

One of the key assumptions in the Miller-Modigliani irrelevance theorem was the absence of taxes. Paying dividends would no longer be irrelevant if dividends were taxed differently than the other ways firms return money to their shareholders. And given the tax code in the United States at that time, firms should not have been paying dividends. The embarrassing fact was that most large firms did pay dividends.

The way taxes come into play is that income, including dividend income, was then taxed at rates as high as 50% or more, whereas capital gains were taxed at a rate of 25%. Furthermore, this latter tax was only paid when the capital gain was realized, that is, when the stock was sold. The effect of these tax rules was that shareholders would much rather get capital gains than dividends, at least if the shareholders were Econs […] So the puzzle was: why did firms punish their tax-paying shareholders by paying dividends? ” (p.165, italics in the original)

An early answer to this “puzzle”, based on behavioural theory, was offered in a paper by H. Shefrin and M. Statman presented at the Chicago conference. They proposed to resolve the dividend puzzle using a mixture of self-control theory (people may wish to consume just dividend income, so as to enforce themselves to preserve capital for retirement), desire to segregate (if the value of stocks goes down, the dividend gain is viewed as a “silver lining”) and regret aversion (it is not the same to consume out of just-received dividends than to consume out of the selling of shares). They made very clear throughout their paper, that they want to emphasise that the dividend-and-capital-gains equivalence may not hold even in the absence of taxes and transactions costs (the best-case scenario for M&M) due to behavioural considerations. Continue reading

Shiller, Tobin and the “This Time is Different”: Analysing the US stock market with the rule of the 0.20


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[this is the translation of a previous post]

Robert Shiller, professor of economics at Yale University (and Nobel prize winner in 2013), has published the third edition of his book Irrational Exuberance. Beyond the fact of being a very entertaining and highly advisable book, the most important thing about its publication is not the book per se, but rather the timing: the first edition was published in 2000, just before the burst of the bubble, and the second edition was published in 2005, two years before the US real estate meltdown. In both editions, Shiller warned about the unsustainability of stock market and real estate valuations, respectively, and as it happens, he was right. In this new edition he introduces the concept of new-normal boom, putting his finger especially on fixed income valuations – though he also mentions stock markets. The right timing of the two previous editions makes many analysts wonder whether we are at the gate of another financial crisis.

This post does not intend to review Shiller’s book, but rather to make a contribution to the debate about the stock market valuations of the US economy – a debate that has been raging in the blogosphere for several years. It is worth remembering that there is no similar debate in Spain (in terms of quantity and quality), although it would be highly beneficial. To understand what is at stake in the US debate, the best way is to begin with some numbers. The following graph, courtesy of Shiller,  is a good starting point. It shows the historical evolution of the S&P500 and corporate profits, both of them deflated by a consumer price index in order to improve comparability over time:

S&P 500 and corporate earnings, historical

Own elaboration

It is clear that the basic intuition ‘higher corporate profits – higher prices’ is confirmed (with some important exceptions, as in the 90s). However, it can also be seen that since the 90s stock valuations (how much one is willing to pay for a dollar of profits) have gone up notably: especially, since the Global Financial Crisis in 2007, the S&P500 in real terms has increased more than corporate profits, which has provoked the increase in many valuation metrics. What metrics? Continue reading