On Valuations

The first quarter of 2006 is over. Now is a good time to reflect on stock prices and the opportunities they present.

Bargains are scarce. Equities are expensive. In recent weeks, I’ve heard several fund managers say valuations are still attractive. I don’t agree. Generally speaking, valuations are unattractive. Returns on equity are higher than historical levels. A market-wide return on equity of 15% is unsustainable. Price-to-earnings ratios may not fully reflect how expensive stocks are. Price-to-book ratios are more alarming.

There are two additional concerns. Most discussions of the relative attractiveness of equities focus on the S&P; 500 and forward earnings. The S&P; 500 is not the most representative index. It may not be the best index to consider when looking at market-wide valuations.

Forward earnings are (necessarily) estimates. Where current returns on equity are unsustainable, projected earnings that use similar returns on equity may overstate the earnings power of equities in general. This can occur even where the estimates appear reasonable given current earnings. If you start with unsustainable base earnings, you are likely to overestimate future earnings even if you truly believe you are assuming very modest earnings growth.

Assets in general are pricey. Value investors have few places to turn if they continue to insist upon a true margin of safety.

Bonds are unattractive. Long-term inflation risks make U.S. treasury, corporate, and municipal bonds a fool’s bet. There is little to gain and much to lose. The know-nothing investor who buys a top-quality bond today and holds it for decades may very well find his purchasing power diminished.

There may be some select opportunities in foreign equities. But, these are difficult to evaluate. Foreign government obligations are also difficult to evaluate, but that isn’t much of a problem for value investors, because most foreign government debt is priced to perfection. You’ll have to be willing to take a lot of uncompensated risks if you want to own such bonds.

Of course, there are exceptions to every rule. There may be a few bonds out there that are attractive. There certainly are a few attractive stocks out there. But, even those stocks that look very attractive relative to their peers don’t look nearly as attractive when compared to past bargains.

Value investors face a difficult choice. They can assume stock prices will return to historical levels, and hold cash until the correction comes. Or, they can accept the reality they currently face.

There is no logical reason stock prices must necessarily return to historical levels. During the twentieth century, real after-tax returns in diversified groups of common stocks were very high relative to other investment opportunities. There have been various reasons given for why this occurred. Many have said these returns were possible, because of the higher risks involved in holding equities. Over the long-term, risks were somewhat higher than today’s investors seem to remember, but they were hardly severe enough to justify the kind of performance spreads that existed during much of the …

Quarterly Newsletter

Preparing the quarterly newsletter is taking more time than I had anticipated. This comes at the expense of the blog and podcast. The quarter ends on the 31st (Friday); so, the amount of content on the blog and podcast should (at least) return to past levels next week.

I’m delaying the podcast episode “Work Habits” until next Tuesday. Expect this to be a very slow week on the blog as well.

Sorry for the inconvenience. This is a one time delay caused by the design, format, and printing of the newsletter. In the future, I will only have to worry about content.

You can learn more about the quarterly newsletter by clicking the newsletter link on the sidebar. A single issue costs $75. A one-year subscription is $275. The newsletter covers the period ending Friday, March 31st. The April issue should be delivered sometime next week.…

Widest Moat Contest: Final Round

The voting for the Widest Moat Contest closes at 11:59 p.m. tonight. The three finalists are General Electric (GE), Microsoft (MSFT), and Coca-Cola (KO). Here’s where the voting stands:

1. Microsoft (6)

2. Coca-Cola (5)

3. General Electric (4)

Which company has the widest moat?

Vote by clicking the “comments” link below.…

Widest Moat Contest: Microsoft Wins

The final round of voting has closed. Microsoft is the winner of the Widest Moat Contest.

Congratulations to Microsoft – and to George of Fat Pitch Financials.

I will announce my selection for the best comment tomorrow. The author of that comment will receive a copy of Benjamin Graham’s Security Analysis.

The final vote tally was:

1. Microsoft (6)

2. Coca-Cola (5)

3. General Electric (4)

Thank you to everyone who voted.…

Widest Moat Contest: Best Comment

I selected this comment from Dave as the contest’s best:

Initially I was going for GE, but the more I think about it, it seems that Coke has the greatest franchise. GE makes, markets and services great products, but I’m not sure many people buy their products because they are made by GE. (By “people” I mean the average consumer. Aerospace and medical customers may be different.) Their products are extremely capital intensive, which in itself creates a moat, but one which must be shored up with capital constantly.

Coke, on the other hand, has a product which no one needs, but many want, and which many display a strong preference for. It is more like cigarettes in this way. In my younger days I was addicted (habituated is more precise) to Coke. I drank a quart every day. This is a wide and deep moat for sugar water. It is unbelievable! The main competition is from Pepsi, which with it’s Frit-Lay division, is the only real threat to Coke. And Pepsi has no international distribution to match Coke.

I believe that Coke has the moat and it is theirs to lose. I’ll admit that they have been trying over the last 10 years, but I think they may be waking up some. I didn’t mention MSFT because I don’t think it’s worth mentioning. A great company with a moat more fragile than most would like to believe.

Dave will receive a copy of Benjamin Graham’s Security Analysis. Congratulations!…

On Probability, Observation, and Investing

Investors need to think about exactly what they mean when they use terms from probability. They need to appreciate the role of the observer (and his limited knowledge). For instance, if I flip a coin and cover it before you can see how it has landed, is it really correct to say there’s a 50% chance the coin has landed head-side up?

The problem is that we know that the class of (fair) coin flips will be populated by as many instances of heads as tails; therefore, if we know that a coin flip belongs to the class of fair coin flips (but know nothing else about the special case), we may say that there is a 50% chance the coin will land head-side up.

But, there is one somewhat unsettling matter to consider. Once I have flipped the coin and it has landed, we can all agree that it has either landed head-side up or tail-side up. The event has already occurred. But, it hasn’t yet been observed. Of course, I could lift my hand a bit and sneak a peak. Then, I’ve observed the outcome, but you haven’t.

Speaking probabilistically, you might still say there’s a 50% chance the coin has landed head-side up. But, you would now know that there is a difference between the knowledge possessed by different observers. The unsettling part comes when you realize that a probabilistic statement can not be made independent of the observer (and her knowledge).

It may seem a trivial problem when we consider the observer to be a single individual. But, all our knowledge is dependent upon observation, and all our probabilistic statements are dependent upon our knowledge – so, all of our probabilistic statements are dependent upon our knowledge.

That’s obvious, because we only make such statements where our knowledge is limited (we know something about the class but not the special case). The problem for investors is that two analysts with the same data may interpret that data differently such that they arrive at two very different conclusions. Essentially, they will make two different probabilistic statements (largely based on what data they believe pertains to the special case in question).

For instance, you can make a statement about stocks trading at a P/E of 12, or stocks trading below book value, or stocks that have achieved a ROE of greater than 15% in nine of the last ten years. But, that may not be the best class to consider.

I just mentioned Harley-Davidson (HDI) in a previous post. Does Harley-Davidson belong to the class “stocks with a P/E of 15”? Or, does Harley belong to the class “stocks of companies with entrenched consumer brands”? After all, some stocks with a P/E of 15 may be in commodity businesses.

The investor needs to reference several different past records at once. She needs to consider the past record of entrenched consumer brands (how many had their earnings power diminished? How many of the brands lost their luster? …

Off Topic: On Cause and Effect and Inherent Randomness

This is an off-topic post (i.e., it doesn’t pertain to investing). Below, I have reprinted a comment written in response to my post On Technical Analysis and my response to that comment.

Amanda Gerrish writes:

Good article. However, I must take exception to your idea that there are no truly random events in nature. Quantum physics proposes that all quantum processes (sub-atomic events) have an inherently random element. These events are not apparently random because we don’t have enough information, or we don’t have the correct model. They are inherently uncertain. At best, we can assign probabilities. Since all macroscopic events (including human actions, markets, the weather, etc.) are built upon microscopic (sub-atomic) events, this implies that there is an inherent, irreducible uncertainty or randomness to all events. Well, at least, if you believe quantum mechanics.

My response:

You make a good point about quantum mechanics, but I have seen it taken too far. For instance, one philosopher argued that an inherently random element supports the case against the existence of God (or a prime mover of any sort). I have a few problems with this argument. The biggest problem is that it favors accepting the existence of an uncaused event over the prudent course of withholding judgment because far too little information is known.

When I say far too little information is known, I mean simply this: an inherently random element does not fit with the law of cause and effect. So, we have three options. One, we could throw out the law of cause and effect and assume that the best we can ever do is establish correlative rather than causal relationships. Two, we could throw out the idea of an inherently random element in quantum mechanics. Or, three, we could withhold judgment, because we feel our understanding of these matters is insufficient.

I favor the third course, largely because I think our understanding of time remains inadequate. In several different places, the study of physics has bumped up against our ignorance of what time really is, and just how it works in the extremes. This gets us into some very strange sounding discussions. However, we will need to address them eventually.

Are there more dimensions than we perceive? Is our perception of time flawed? Can actions occur outside of time? Is any “inherently random element” actually the result of a cause that did not occur in the dimensions we perceive? Simply put, is it possible we can’t perceive the cause, or even the general laws under which the cause operates, and therefore can not conceive of the effect as being anything but random?

I wouldn’t put it into these words, but I think eventually people will say that it’s possible there may be causes operating “outside of time” – simply meaning that there may be causes that do not operate according to the principles of time as we know them. As strange as it sounds, I think the logical idea of …

News Item: Harley-Davidson (HDI)

In early April, Harley-Davidson (HDI) will open its first dealership in China amid a flurry of festivities. Harley-Davidson named Beijing Feng Huo Lun as its first authorized dealer in China. The dealership, located just outside downtown Beijing, will have a staff of 14. It will operate under the Beijing Harley-Davidson name.

The dealership will sell Harley-Davidson motorcycles, parts, and accessories. Harley-Davidson apparel and collectibles will be sold as well.

Harley-Davidson’s management believes the move into China represents a long-term opportunity. Progress will be gradual. Ownership and riding restrictions remain impediments to the company’s growth. Disposable income is still too low in China to support a large “premium, heavy-weight” motorcycle market. The company hopes that ownership and riding restrictions will be reduced as disposable income continues to grow.

On Friday, Harley-Davidson’s share price rose $1.88 to $51.07. At their closing price, shares of Harley-Davidson offered a 6.68% earnings yield.

Over the last ten years, Harley-Davidson’s book value per share compounded at a 17.78% annual rate. During that same period, annual EPS growth was 21.92%.…

New Podcast: “Buffett Businesses”

Listen to the Gannon On Investing Podcast: “Buffett Businesses”

A new podcast episode entitled “Buffett Businesses” is now available. This podcast wraps up Buffett week.

Enjoy the show.

Summary: The entire show is a discussion of the kind of business Warren Buffett looks to invest in. The discussion focuses on owner’s earnings, return on equity, and earnings growth.

Run Time: 29 minutes

Next Show: “Work Habits”…

Value Investing Directory: New Additions

Visit the Value Investing Directory

Navigation

The “Navigate Directory” section will remain at the top of your screen after you pick a new category. To navigate the directory, simply click on a category and then scroll down to see the listings within that category.

After you click on a category, the “category tree” will remain at the top of your screen; however, the listings below will change. Therefore, you need to remember two things: 1) Scroll down to see the listings 2) Choose “deeper” sub-categories to refine your search. For example, there are fewer listings in Blogs > Investing Blogs > Value Investing Blogs than there are in Blogs > Investing Blogs, because all value investing blogs are also listed as investing blogs.

The directory now includes 5 new listings. First, let me discuss the submission process. Then, you can view the list of new additions.

Submissions

To submit a site for inclusion in the Value Investing Directory please send an email to geoff@gannononinvesting.com with the site’s URL. All submissions will be evaluated within 48 hours; however, most submissions will be rejected.

Prospective sites are evaluated on the basis of utility alone; neither reciprocal links nor payment is required. Linking to the Value Investing Directory (or any other part of the Gannon On Investing website) will not affect the evaluation process.

If you would like to propose a new category, request a change to your site’s listing, or request the removal of any site, please send an email to geoff@gannononinvesting.com. All reasonable requests will be considered; however, I reserve the right to list and describe sites in whatever manner I deem to be most useful.

New Additions

Personal Favorites: Seeking Alpha, Wall Street 2.0

Worth a Look: pfblogs.org, Phat Investor, Rule #1 Investor

All new additions by category:

Resources

Online Resources > Value Investing Sites > Rule #1 Investor

Online Resources > Blog Aggregators / Networks > Phat Investor

Online Resources > Blog Aggregators / Networks > pfblogs.org

Online Resources > Blog Aggregators / Networks > Seeking Alpha

Online Resources > Blog Aggregators / Networks > Wall Street 2.0

Visit the Value Investing Directory…