On Normalized P/E Ratios and the Election Cycle (Again)

Today, I’ll be detailing how I calculated the normalized P/E numbers I referenced in two previous posts: “On 15-Year Normalized P/E Ratios for the Dow” and “On Normalized P/E Ratios and the Election Cycle“.

That explanation will come later in the day. First, I’d like to revisit two topics about which I’ve received quite a bit of email over the last twenty-four hours. The two topics readers seem most interested in are the election cycle and the relationship between 15-year normalized price-to-earnings ratios and one-year point growth in the Dow.

First, let’s tackle the election cycle. When writing about this (normalized P/E) project, I run a lot of numbers I never report to you. For the most part, I only share interesting or unexpected findings. However, I still routinely check to make sure I’m not missing something obvious. Despite these checks, I encourage (and ultimately depend on) your attempts to keep me honest by pointing out the possible holes in my logic.

So, let’s poke a bit at the findings from the last post and see if we can find a hole.

The Hypothesis

One obvious explanation for the election cycle effect is that mid-term years might tend be abnormally cheap years. Is this hypothesis supported by the data?

Technically, mid-term years do have below-average 15-year normalized P/E ratios. But, I wouldn’t say these years have abnormal 15-year normalized P/E ratios, because other randomly selected groups from within this same set of years (1935-2005) would also have normalized P/E ratios that fall a bit below the average for the entire set.

The Comparison

The “full set” (1935-2005) had an average (mean) 15-year normalized P/E of 14.08, a median of 13.59, and a range of 6.88 – 30.84. Just under 44% of the years in this set had a normalized P/E of less than 12.50.

The “election cycle set” (1938, 1942, 1946…) had an average 15-year normalized P/E of 13.46, a median of 13.00, and a range of 6.88 – 28.05. Just over 47% of the years in this set had a normalized P/E of less than 12.50.

The 12.50 Rule

The importance of this last check (percentage of years with normalized P/E of less than 12.50) is based purely on logic. Before beginning this study, I felt that when the Dow has a 15-year normalized earnings yield of 8% or more (i.e., a normalized P/E of 12.50 or less) there is a very good chance it is an attractive purchase for long-term investors, because other assets don’t tend to offer long-term returns superior to those expected from an asset priced at 12.5 times its “earnings power”, and sometimes present greater risks (including a loss of purchasing power) than a diversified group of large businesses like the Dow normally does.

Obviously, the fact that, since 1935, the Dow has been (what I would call) “undeniably cheap” nearly 44% of the time helps explain why it has done so much for long-term investors. Stocks are not inherently attractive; …

On Gold and Rome

Over the weekend, Bill Rempel put up an interesting post entitled “Not Bullish on Gold”.

Bill makes two important points early in his post:

1) Gold is not “original money”
2) When a government controls money, it will manipulate the situation to its advantage

Inflation is not a modern phenomenon; it is a governmental phenomenon. Many otherwise intelligent people completely miss this point. For those investors with more knowledge of history than economics, Spain’s experience with New World gold probably stands out as a clear example of inflation. That’s good, because knowledge of two or more separate occurrences of the same phenomenon under seemingly different conditions is often the key to better understanding that phenomenon.

There’s another excellent example of inflation that is rarely studied. It happened roughly two thousand years ago in Europe, Africa, and the Middle East.

If you have any interest in inflation during Roman times, I’d recommend Kenneth Harl’s Coinage in the Roman Economy, 300 B.C. to A.D. 700 (Ancient Society and History). I should warn you this book was not written to address inflation specifically or even economics generally. It certainly sheds some light on those topics, but the subject of the book is exactly as the author describes it on page one:

“The objective of this book is an examination of how the Romans used coined money – its role in payrolls, tax collection, trade, and daily transactions – over the course of a millennium, 300 B.C. to A.D. 700. Although there are many books about Roman coins, they are, for the most part, numismatic works devoted to the study of coins as objects rather than as evidence for the economic and social life of the Roman world. This is an attempt to redress the imbalance by dealing with coins both as fiscal instruments of the Roman state and as the medium of exchange employed by the Roman public.”

I find this stuff interesting. If you do too, read the book. However, if your only interest in Roman monetary history is better understanding inflation (in modern societies), you’ll want to skip the book – but learn the history. I can’t cover Roman monetary history in a single blog post; however, I will try to touch on some highlights that relate to Bill’s post.

The first point worth mentioning is that Rome’s early monetary history clearly demonstrates that gold is not “original money”. Early Italian people used iron and bronze as money long before adopting gold. Before that, they may have reckoned prices in cattle.

In fact, Pliny the Elder wrote that the first forms of money (pecunia) were actually substitutes for cattle (pecus), and that’s where the Latin word pecunia came from. There may be some truth to this, as the English word “fee” is believed to be derived from a German word for cattle, which is itself quite possibly a cognate of pecus. Clearly, there was some connection between cattle and wealth in these societies; however, …

Column: Warren Buffett and the Washington Post

Guest Columnist Max Olson’s latest article is entitled “Warren Buffett and the Washington Post”. In this article, Max attempts to “reverse engineer” Berkshire’s 1973 investment in the Washington Post Company.

Read “Warren Buffett and the Washington Post”…

On a Small Project

There haven’t been many posts recently (and there won’t be a post today) because I’ve been working on a small project in preparation for an upcoming post – actually, the project will probably spawn several posts.

I don’t normally write posts on “macro” subjects. But, there is one terribly important subject that I do need to address: what kind of returns you can expect over your investment lifetime.

I’d like to include some graphs in the post. Unfortunately, to have them drawn the way I want a little number crunching is required. It’s simple work; but, it takes up a lot of time. I’m almost done. I might even have the post for you on Friday.

Until then, here are two items to keep you busy:

A video of Warren Buffett taking questions from some MBA students

An update on what stocks Buffett has been buying and selling recently…

Festival of Stocks #10

Welcome to the tenth Festival of Stocks. The Festival of Stocks is a weekly blog carnival dedicated to highlighting the best recent posts on stock market related topics.

I am proud to present this week’s best entries to the Festival of Stocks. The articles are listed by category. The stock tickers are linked to Yahoo Finance. I have included my post “On Overstock’s Terrible Third Quarter” in this week’s festival; it is a follow-up to a series of earlier posts on that stock.

Overall, I was very pleased with this week’s submissions. What today’s festival lacks in quantity it more than makes up for in quality. The festival includes six posts discussing specific stocks, three posts on topics in investing, and a poem. Yes, you read that right. This week’s festival concludes with a poem. It’s the proverbial cherry on top of this satisfying stock sundae.

Enjoy.

Stock Analysis

Hotung Baby! By Margin of Safety
Margin of Safety revisits Hotung Investment Holdings, a Taiwanese venture capital firm. The author notes that Marty Whitman’s Third Avenue Management recently added to its stake in the company, despite a nearly 50% increase in the share price over the last year.
Stocks: HTIVF

Legg Mason: Unloved for Now? By Banker Notes
Banker Notes provides a brief overview of the investment case for Legg Mason (LM). At a price-to-book ratio of just under 2, the stock looks “relatively cheap”.
Stocks: LM

uWink: A Promising Project from Gaming’s Most Legendary Entrepreneur By Value Blogger
Kevin Kelly and Zac Bissonnette take a long look at uWink (UWNK), a small public company with an innovative restaurant concept and the leadership of Nolan Bushnell, “the 68-year old entrepreneur-extraordinaire” who founded Atari and Chuck E. Cheese.
Stocks: UWNK

Mueller Water Products, Walter Industries Remain Strong Buys By Controlled Greed
John Bethel revisits two of his holdings, Mueller Water Products (MWA) and Walter Industries (WLT). Both stocks sold off sharply last week, so now would be a good time to take a serious look at them.
Stocks: MWA, WLT

Western Union Purchased By Fat Pitch Financials
George of Fat Pitch Financials explains the logic behind his purchase of Western Union (WU). The global leader in money transfers was spun-off from First Data (FDC) earlier this year. George thinks this spin-off of a wide moat company is a fat pitch – and he’s swinging.
Stocks: WU

On Overstock’s Terrible Third Quarter By Gannon On Investing
After Monday’s announcement of a year-over-year revenue decline for the third quarter of 2006, I’ve changed my tune on Overstock.com (OSTK). Earlier this year, I argued Overstock was worth at least $1.5 billion. After the company reported a year-over-year decline in revenues for the third quarter of 2006, I realized I didn’t understand the business.
Stocks: OSTK

Investing

Observations on Risk-Don’t Confuse Liquidity with Brains By Value Discipline
Rick of Value Discipline takes on the topic of risk aversion: “Risk aversion unfortunately tends to …

On Overstock’s Terrible Third Quarter

I did not expect to learn anything significant about Overstock.com (OSTK) until the fourth quarter results were in, because the Christmas season is so critical to the company’s success. However, Monday’s announcement of a year-over-year decline in revenue was completely unexpected.

Based on Byrne’s remarks and the reported results, it looks like Overstock got everything right except conversions. I was pleasantly surprised with how well the company managed its IT systems and its inventory. In the past, management had made mistakes in these areas and Overstock paid the price. This quarter they did a great job on both fronts.

Unfortunately, the fantastic growth that had allowed Overstock to move forward despite serious missteps (in previous quarters), was totally absent this quarter.

In his letter to owners, Byrne wrote:

“In the past we ran at an A- and regularly generated 100% growth: now I think we are running at an A+ but seeing no growth. I am not entirely sure what to make of that.”

I agree. That’s the real story. The company gave its best performance – and posted its worst results. The CEO can’t explain it and I can’t either.

At the beginning of this year, I thought Overstock could grow sales at 10-15% for the year. I expected to see total sales for 2006 of between $875 million – $925 million. In the first three quarters of 2006, the company only generated about $500 million in sales. So, Overstock would need $375 million to $425 million in sales during Q4 to get to where I expected them to be at the end of the year. To put that in perspective, the company had sales of $318 million in Q4 of ’05.

So, Overstock would need to post year-over-year growth of 18 – 34% during the fourth quarter of this year just to reach a target I thought was sufficiently conservative when I set it about a year ago.

Then, there’s the issue of cash. Like I said, Overstock did everything right this quarter and still posted very poor results.

In February, I wrote that “Insolvency could only occur through gross managerial ineptitude”. Clearly, I was wrong. Overstock’s management is not inept; in fact, they’ve made meaningful improvements to the business in the first nine months of 2006. Overstock is a much more efficient operation today than it was a year ago.

However, there is a real risk of insolvency. If Overstock’s fourth quarter results don’t show year over year growth of at least 15-20%, it seems nearly certain they will have to raise cash in 2007.

Even if the fourth quarter looks great, there may be a need to raise cash. If the company has to raise cash while its prospects appear terribly dim, the terms on which the cash is raised are likely to be extremely detrimental to current shareholders.

Overstock has a solid business model. Unfortunately, the logic of that model is predicated upon sales volume growth. The business simply …

Guest Columnists Wanted

I’m always looking for additional contributing writers. Contributors must be:

1) Passionate about investing
2) Curious about investing
3) Able to think and write clearly about investing
4) Willing to work with an editor (me)
5) Willing to work for free

If you’re interested in writing for the site, please send me an email.…

Guest Columnists

As part of my continuing effort to increase both the amount of content and the diversity of content on this site, I’m proud to present two new guest columnists: Max Olson and Steven Rosales.

I’ve added a “Columns” section to the website. If you look in the “Navigate Site” box on the right-hand side of your screen, you will see that the third link down now reads “Columns”. This link will take you to the Gannon On Investing Guest Columns Page, which presents all the articles written by guest columnists in reverse chronological order (i.e., in the same manner as a blog).

If you’d prefer you can jump directly to a specific column by following one of the links a little further down on the page. Once again, if you look to the right-hand side of your screen, you will see that the third box down is entitled “Guest Columnists”. Currently, there are two links in that box: “Max Olson” and “Steven Rosales“. Simply click on the name of a columnist and you’ll see his latest articles.

For now, I’ve only posted one article from each guest columnist. Of course, you’ll see many more articles appear in the days ahead.

Please take this opportunity to sample the work of each writer.

Column: Max Olson

Column: Steven Rosales

Max’s articles will cover a variety of different topics in value investing. Steven has a series of articles planned. His first article serves as an introduction to that series. Therefore, I’m reprinting it below:

I am a new investor. What does that mean? Simply that I do not have much experience investing. While I had read books about investing and was aware of the stock market, I had never given much thought to investing.

I saw the stock market as a competition where I was at a disadvantage; investing involved too much risk for the potential reward. Therefore, as of January 1, 2006, I had never purchased a stock. But that has changed. It changed because I reached a point in life where I had funds to invest and needed to make some decisions on how to invest them.

Now many people think that the best way to invest is to place your money with a mutual fund. I was one of those people up until November 2005 when I read John Bogle’s book on mutual funds. Two things about this book stood out to me. The first was that whether the fund increases or decreases my investment, the people who are running it get paid, and that these “fees” impact my investment results (if I am up 10% on the year, and I have to pay a total expense fee of 1.5%, I have actually only made 8.5%).

The second point that stood out to me was the fact that the vast majority of money managers do not outperform the stock market. In his book, Bogle points out that most people would be better off just …

Book Review: Pit Bull

Gannon On Investing’s contributing writer, Steven Rosales, reviews Martin Schwartz’s Pit Bull.

Read Book Review…

Value Investing News: Top Ten Stories

Here are this week’s top ten stories from Value Investing News:

1. Proof that losing money really is scary
2. What’s Berkshire Hathaway Worth, Anyway?
3. Berkshire Press Release: Equitas Reinsure & Run-Off Deal
4. The Cost of Anchoring
5. (Geoff Gannon) On the Round Table Discussion
6. Jeff Matthews Is Not Making This Up: Baby Boomers Remembering When
7. Free Advice from All-Star Managers
8. The Worst Has Yet to Come for Regional Airlines
9. ValueBlogReview: Morningstar’s Classroom
10. Buffett in Lloyd’s deal

Please be sure to vote either up or down on these stories as you read them. You will earn points each time you vote that will go towards winning the monthly prize, which is the The Little Book of Value Investing this month. All you have to do is register and log in to be able to vote and submit your own favorite value investing articles.

Voting also helps generate a customized list of recommended articles tailored to your preferences.

As I’ve said before, I’m a huge fan of Value Investing News. When you use the site, you’ll notice that a user named “Geoff” has submitted a lot of stories to the site. So, if you want to know what I’m reading, just browse Value Investing News.

The more people use the site, the better it will become.…