by John Mauldin
In this issue:
It's All About Values
Hedging Your Bet
Mean Reversion of National Wealth
The Sage of Omaha made a bet that was written up in a recent
Fortune magazine article. Basically, Warren
Buffett bet that the S&P 500 would outperform a group of funds of hedge
funds over the next ten years. A million dollars to someone's favorite charity
is on the line. This week we will analyze the bet, using it as a springboard to
learn about valuation and value investing. As we will see, there are times that
making a bet on the S&P 500 to outperform hedge funds (or bonds or real
estate or whatever asset class) makes sense and times when it doesn't.
But first, an apology is in order. I get to travel a lot
with my daughter and business partner Tiffani (actually, she runs the business)
and meet new people. Over the years, she has become as fascinated as I have
with their individual stories. Everyone has a story to be told or a lesson to
teach. We have decided to write a book about those stories, looking at the
differences in perspective between old and young, retired and working, those
who are wealthy and those who aspire to wealth. What are the differences in
attitudes, in work habits, in how you manage money, in how you look at the
future, and a score of other items? How do all of these things correlate?
We sent an email to some of you a few days ago, asking you
to fill out a survey to help us gather data, with the intention of sending it
to everyone over time. After you complete this survey, I offer an audio stream
of a speech I recently made.
The survey software we're using had been stress tested to
handle 50,000 surveys in a 24-hour period. For whatever reason, though, the
server on which the survey was hosted simply collapsed under the number of
people trying to complete the survey and listen to the speech.
I am sorry about the frustration some of you had not being
able to get into the survey. We are working on getting the problem fixed and
will send an email out sometime next week with a properly working link. I am
really quite excited about this project, as we will all learn a lot, Tiffani
and I most of all. Thanks for your help, patience, and indulgence.
Warren
The Motley Fool did a foolish thing and made me one of five
nominees for Investor of the Year for 2007. Warren Buffett of course won, but I
was surprised (as was The Motley Fool) that I came in second. Buffett is the
clear winner in investing, and his wisdom is followed by a large legion of
fans, among which I am one. So, let me get myself in trouble and disagree with
him on a small matter.
Carol Loomis (one of my favorite financial writers) writes
in this week's Fortune about a bet that Warren Buffett made with a hedge
fund management company. You can read the fascinating story at http://money.cnn.com/2008/06/04/news/newsmakers/buffett_bet.fortune/index.htm.
Quoting:
"And to that there is a certain history, which began at
A
Which way would you bet? If the online response at Fortune
is any indication, 90% of you would bet with
The basic premise to Buffett's position is that the high
fees simply eat up any potential for extra profits, over those of a simple
index fund. As Buffett writes:
"A number of smart people are involved in running hedge
funds. But to a great extent their efforts are self-neutralizing, and their IQ
will not overcome the costs they impose on investors. Investors, on average and
over time, will do better with a low-cost index fund than with a group of funds
of funds."
And he is right about the fees. Hedge funds, and especially
funds of funds, must do much better than average to overcome their high fees.
Loomis sums it up as follows:
"As for the fees that investors pay in the hedge fund
world - and that, of course, is the crux of Buffett's argument - they are both
complicated and costly. A fund of funds normally charges a 1% annual management
fee. The hedge funds it puts that money into charge an annual management fee of
their own, which for funds of funds is typically 1.5%. (The fees are paid
quarterly by an investor and are figured on the value of his account at the
time.)
"So that's 2.5% of an investor's capital that
continually goes for these fees, regardless of the returns earned during a
year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last
year of 15 basis points (0.15%) for ordinary shares and only seven basis points
for Admiral shares, which are available to large
investors. Admiral shares are the ones 'bought' by Buffett in the bet.
"On top of the management fee, the hedge funds
typically collect 20% of any gains they make. That leaves 80% for the
investors. The fund of funds takes 5% (or more) of that 80% as its share of the
gains. The upshot is that only 76% (at most) of the annual return made on an
investor's money accrues to him, with the rest going to the 'helpers' that
Buffett has written about. Meanwhile, the investor is paying his inexorable
management fee of 2.5% on capital.
"The summation is pretty obvious. For Protégé to win
this bet, the five funds of funds it has picked must do much, much better than
the S&P."
True. But the growth of hedge funds and fund of funds
suggests that some think there is value there that is worth the fees. But let's
set aside that argument for now, and look at the prospects for the bet between
Protégé and Buffett.
It's All About Values
As I wrote in Bull's Eye Investing (Amazon.com) and occasionally stress in my writing, the
long-term returns you get from index fund investing are very highly correlated
with the P/E (price to earnings) ratio at the time you make your initial
investment. The P/E is price divided by earnings. If the ratio is 10, then
earnings are about 10% of the stock price. If the ratio is 20, they are about
5% of the stock price. The higher the price, the less
earnings you get for your invested dollar. However, a rising P/E ratio can be a
major boost to stock market returns.
If you make your investment when valuations are low, you
return is going to be much higher over time than if you make your investment
when valuations are high. Look at this graph from South African partner Prieur du Plessis of Plexus:
Prieur divided the S&P 500 into five groups based on the
initial P/E ratio and then calculated what the returns would be for the next 10
years, after inflation. He also used a 10-year average of the P/E ratio, to
take out the fluctuations caused by one-off events, recessions, etc.
As you can see, and long-time readers should expect, if you
invest when stocks are at their cheapest, you can make a remarkable 11% on
average for the next 10 years after inflation. As stocks get more expensive in
terms of their P/E, returns begin to fall. Real returns for the last group are
only 3.2% on average.
We are currently in the range of the highest valuations. If
you make the generous assumption that inflation will be 3% over the next
decade, you are talking about a 6% total return, based on historical averages.
Not bad, but not what a lot of investors are hoping for. Remember that 6%
number, as we will revisit it in a moment.
One of my basic premises is that we need to look at markets
in terms of valuation and not just price. Markets go from high valuations to
low valuations and back to high. The round trip can take the better part of
30-40 years. These are long-term secular markets, and they are mean-reverting.
By that I mean that markets will go both well above and well below the
long-term mean average over time.
To see how well correlated long-term
returns and P/E ratios are, you can go to www.frontlinethoughts.com
and click on the link where it says "get the stock market graphs
here" on the upper right-hand side. You can see what your returns
would have been in any period of time since 1900. Then check at
the top to see what the P/E ratio was at that time. If the return numbers are
white, then P/E ratios were falling and returns were either negative or low.
When the numbers are black, that means P/E ratios were rising, and returns are
also likely to be good.
Look at the following charts from Vitaliy
Katsenelson (author of the most excellent book Active
Value Investing, and one I recommend to anyone interested in value
investing. Amazon.com)
Again, these are 10-year trailing P/E ratios. Notice how the
P/Es always go back below the average? And we are a long way from the average
now. There are two ways that we can get back to low P/Es. Either the stock
market can go down or earnings can go up faster than prices (or some
combination thereof). The stock market bottomed in 1974 in terms of price, but
in terms of valuation the market took another eight years to get to its low.
Then in 1982, with valuations below 10, the stock market was a coiled spring
ready to explode.
Let's look at one more chart from Vitaliy.
This chart shows the one-year trailing P/Es. Today, if you go to the S&P
500 tables at Standard and Poor's, you find the current P/E ratio is a heady
22, with the long-term one-year average being 15.2. There is a long way to go
before we get to anything we can call mean reversion.
Hedging Your Bet
Now, let's look at how
(Note: these hedge fund indexes are representative of funds
of funds in general, but you cannot invest in them. They have problems like
survivor bias; they don't have all the fund of funds, just the ones that
report, etc. Past performance is not indicative of future results. Further, the
hedge fund climate is much different today than in 1990. But the indexes are
the best proxy we can find if we want to do a comparison.)
The S&P 500 rather handily beat the hedge funds. The
S&P 500 went from 353 to 1469 in those 10 years, for an average total
return (including dividends) of 433%, or an average 18.2% a year. The hedge
fund index returned 14% a year for a total return of 271%, net of fees. The
standard deviation for the S&P 500 was 13.38% and for the hedge funds was a
lower 7.87%, so the hedge funds were a lot less volatile. Still, buy-and-hold
index investors were rewarded for the risk. The chart below shows how $1,000
invested might have grown over the 10 years.
Now, let's look at the last 10 years, from May 1998 to May
2008. Here we use a fund of funds index from Barclayhedge.com. Now, we find a
different story. The market returned 4.21% on average, or a total of 51%, with
a standard deviation of 14.7%. The hedge fund index returned 7.7%, with a
standard deviation of 5.1%. So, you got a lot less return with a lot more
volatility, if you stayed with the S&P 500.
Of course, there was a nasty bear market in 2000-2002, and a
roaring bull market in the 1990s. But let me make one observation. In 1990 the
P/E ratio was 15 and had been below 12 just a few quarters earlier. In 1998 the
P/E ratio was 27.8, almost double what it was eight years earlier. A lot of the
difference came from the starting point of stock market valuations.
Where are we today? The P/E ratio is 23.2. Earnings are
dropping as we work our way through a very tough economy. As I have written
elsewhere, I think the recovery, such as it is, will take at least two years
before we can get back to 3% growth, because the twin bubbles of the housing
market and the credit crisis will take at least two years to work themselves
out. 1-2% growth in GDP for the next two years is not an environment for
significant earnings growth. It is also not an environment in which stock
markets are likely to thrive.
Roughly 20% of the S&P is financial stocks. Do you think
they are likely as a group to start reporting robust earnings growth over the
next two years? They are deleveraging, which will not help earnings growth.
There are more write-offs to come. A significant portion of the S&P is tied
to US consumers, who are pulling back. On the other hand, there are some very
large multinational corporations that are benefiting from a weak dollar, as
both their exports rise and their foreign subsidiaries profit.
But the climate is not favorable to robust earnings growth
for the next few years. That will make it tougher for the stock market to keep
up with the funds of hedge funds.
Mean Reversion of National Wealth
One more thought pointed out to me by Woody Brock: National
wealth is a mean-reversion machine. That is a fundamental basic truth in
economics. Over very long periods of time (multiple decades), growth in
national wealth will equal growth in nominal GDP. And by national wealth, I am
referring to our homes, stocks, bonds, real estate, etc.
Now, nominal GDP has been running about 5.5% for a long
time. But between 1981 and 2006,
Graham taught us that in the short run the stock market is a
voting machine, but in the long run it is a weighing machine. And what it
weighs are earnings.
I have little doubt that earnings will rise at 6-8% on
average over the next 10 years. The 1990s saw earnings more than double over 10
years, and the back of my napkin says that is around 8% annualized growth,
although earnings dropped by 50% over the next three years. Over the very long
run, earnings are going to grow at the level of nominal GDP, or around 5.5-6%.
For the stock market to do more than 6%, P/E levels would
have to rise to even loftier levels than at present. Can it happen? Sure, it
did in the late '90s; but we saw how that ended.
Let's go back to the graphs from Katsenelson.
If P/E ratios continue the process of mean reversion and continue to fall, that
will be a serious headwind for stock market growth. And we have no example in
history where valuations did not revert to the mean. That doesn't mean that
this time it couldn't be different. But that is not usually the way to bet.
If it was 1990 and a lower P/E, or 2002 and low P/Es (on a
normalized basis), when the stock market outperformed the hedge funds, then I
would not want to bet against
In
the end, it will depend on how good the funds of funds are that Protégé picked,
but these are savvy managers. They want to win, and I bet they picked the best they
could find. We will find out each year at the annual
But the real winners will be the charities they have picked.
And that is a good thing, not matter who wins the bet.
Now, if Buffett bet that
New
York Las Vegas Sweden
I will go to
Last October I agreed to go to
The wedding shower for Tiffani last Saturday was fun. I got
to see a lot of old friends I had not seen for years. Where does the time go?
And it was good to have the kids under one roof again, if only for a few days.
This weekend I am going to relax and catch up on some fun
reading, and play with my new Apple MacBook Air. It is
so light. I think I am really going to enjoy it.
Have a great week.
Your not believing he would bet against
John Mauldin
John@FrontLineThoughts.com
Copyright 2008 John Mauldin. All Rights
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