Good Things Happen to Cheap Assets

Fountain pen and glasses on stock chart.

Good things happen to cheap assets. In other words, buy low and sell high.

Simple concept. Difficult implementation.

Most investors buy high and sell low. That is, bad things happen to overpriced assets.

The fundamental question for any investor should be value. ‘What is a reasonable amount to pay for an asset?’ Far too many people don’t know the answer to this question, if they ask it at all.

Kerry Packer’s sale of Channel 9 to Alan Bond in 1987 is a classic example. When offered a figure far in excess of fair value, Packer did not look a gift horse in the mouth. Packer sold high and Bond bought high. Packer summed it up nicely when after the sale he said, ‘You only get one Alan Bond in your lifetime’.

But, like Bond, the majority of investors, the herd, fail to understand value.

One of the better long term valuation metrics for the share market is the cyclically adjusted price-to-earnings (CAPE) ratio. To determine the CAPE ratio, divide price by the average of 10 years of earnings (adjusted for inflation). The long term CAPE ratio average for the S&P 500 index is 16.6x.

Warren Buffett’s mentor Benjamin Graham recognised the merits of this valuation mechanism over 80-years ago. Market fads come and go, but knowing a fair price for earnings has always been the name of the game for long term wealth creation.

Over the past 100 years, shares have returned an impressive average of 7% per annum (after inflation). Yet most investors fail to capture those gains.

Nevertheless, the market’s long term average gains underpins the investment industry’s advocacy of ‘shares for the long term’. However, if you dig a bit deeper, you find the ‘shares for the long term’ message is more self serving than it is sound advice.

Investors do not have 100-year timeframes…at least not yet.

A 30 year horizon qualifies as long term, and in this case, theoretically, a portfolio weighted heavily towards shares is warranted.

But remember:In theory, there is no difference between theory and practice. But, in practice, there is.

According to life expectancy tables (for a 55-year-old male), my investment time frame is in theory 25 to 30 years. And my risk profile — based on experience and knowledge — would be skewed towards high risk.

Based on this information, a financial planner would most likely recommend putting the majority of my portfolio in domestic and international shares. From a compliance perspective, the financial planner would be well covered if theory didn’t translate into practice.

ASIC’s ‘know your client’ rule requires a planner to ask lots of questions about you, but by and large they fail to ask the most critical question: What is a reasonable amount to pay for an asset?

It is because I asked this question that my portfolio, at present, is heavily in cash and term deposits. I believe markets are a high risk/low reward equation. Why bother exposing capital to an investment that has a high probability of (significant) loss in the not too distant future?

The industry rarely asks this question because of the belief that there’s never a bad time to invest.

The CAPE ratio begs to differ. Over the long term, markets move in a valuation channel ranging from cheap to expensive and back again.

Buying high always leads to much lower long term returns. Conversely, buying cheap rewards investors handsomely over the long term.

The greatest equity bubble in history was not, contrary to popular belief, the dotcom boom. It was the Japanese share market in the late 1980s.

From 1984 to 1990, just six years, the Nikkei 225 index quadrupled.

At its peak, the Nikkei 225 index had a CAPE ratio of 100x…six times the US average.

In the rush to participate in the booming market, no one asked questions about value or reasonable prices. The bigger fool theory took over the market.

Hasty investors in the Nikkei have had 25 years to repent in leisure. The Nikkei 225 is still 55% below its 1990 peak. Shares for the long term? Not always.

Perhaps you’re thinking the Nikkei bubble is an extreme one off event irrelevant to your portfolio.

The All Ords CAPE ratio average is 21x. The high average is due to data only being compiled since 1983 — the start of the market boom. My suspicion is a 100-year average would be closer to the US’, at 16x.

In late 2007, the All Ords CAPE ratio touched on 30x…even using the higher average, this was expensive.

It’s been more than seven years since the Australian share market hit its peak, and the market is still 18% below its all time high.

At the start of the boom in ’83, the All Ords CAPE ratio was around 7x…well below the average.

Since then, the All Ords rose from 500 points to 5500 points…a compound growth return of nearly 8% per annum.

Today the All Ords CAPE ratio is 16x…in line with my suspected long term average…neither cheap nor expensive.

However (and there is always a ‘however’), the US share market (S&P 500 index) is trading on a CAPE ratio of 27x…well into the overvalued range.

Whether we like it or not, the US share market casts a huge shadow over the world markets. When (not, if) the plug is pulled on the US market, our market will be drawn into the whirlpool.

Considering the two crashes since 2000, it wouldn’t be unprecedented for the US market to fall 50% or more. A fall of this magnitude means the All Ords is destined to head lower…even though we are in theory not expensive. This doesn’t even take into account the slowdown in China.

Think about this for a minute: The CAPE ratio of the All Ords in 1983 was 7x…well below average. Remember, average markets can still fall into the ‘below average’ range.

In 1982/83, the US market’s CAPE ratio was also around 7x. If the US were to plummet back into this range, it’d be a 75% correction from the current level. Food for thought.

The US share market, on every long term valuation metric, is either modestly or excessively over-valued. Buying high is not the strategy for investment winners.

This is a market you want to be selling — not buying.

Good things happen to cheap assets. Good things also come to those who wait. Be Patient. Better buying awaits cashed up investors.

Vern Gowdie
Editor, Gowdie Family Wealth

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Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.

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