by Rob Bennett
Valuation-Informed Indexing is obviously a strategy for indexers, not stock pickers. Those who can pick stocks effectively can avoid the risks of overvaluation. There are always some stocks that do well. Pick those even at times of insanely high overvaluations and you will not suffer the fate of indexers following Buy-and-Hold strategies. Indexers obtain market returns both when that is a good thing and when it is not. Effective stock pickers can realistically expect to earn better than market returns and that’s an important distinction at times when high valuations virtually insure poor long-term returns for indexers.
All that said, stock pickers may want to take the P/E10 level into consideration when setting their stock allocations. They don’t absolutely need to, as indexers do (in my opinion). But a good case can be made that it would be a plus for them to do so.
P/E10 (the current price over the average of the last 10 years of earnings) cannot be applied directly by stock pickers seeking to determine the intrinsic value of their stock purchases as it can be to determine the intrinsic value of the purchase of shares of an index fund. It can be used as a valuation metric in assessment of a company being considered, of course (perhaps in place of P/E1, the more commonly used metric). But P/E10 offers only vague guidance in the assessment of an individual stock compared to the powerful insight it offers on the question of whether an index fund is worth buying at a particular time or not.
The difference is that the valuation level that applies for a particular stock is one of dozens of factors that need to be taken into consideration. An individual stock with a low valuation can easily prove to be a poor investment if the underlying company has poor management or fails to bring new products to market in a timely manner or is in a dying industry. In the index fund context, all factors other than valuation are all but insignificant. An indexer will be buying some companies with good management and some companies with poor management and the effect of those in the first category will cancel out the effect of those in the second category. This is so for all factors except valuations. So the valuation factor is of critical importance to the investor considering an index fund purchase.
This is a huge benefit of indexing. Index funds are predictable for those who take valuations into account. Individual stock returns are predictable only to the extent that the research done by the stock picker provides him an edge over his fellow investors. Stock pickers can of course obtain far higher returns than indexers; that’s the stock picking edge. But that edge comes at a cost. Stock picking is riskier because success depends on the efficacy of the research effort. Returns for individual stocks are sometimes somewhat predictable for those who possess good insight. Index returns are always highly (but not precisely) predictable for all willing to take price into consideration when setting their stock allocation percentage.
However, stock pickers can put the predictive power of P/E10 to use in an indirect way. They can go with higher stock allocations at times of low valuations and with lower stock allocations at times of high valuations.
There are always some good stocks available. But how many? The number of good stocks available cannot possibly be the same at times of high valuations as as times of low valuations. And it is obviously easier to find a small number of outstanding stocks at a time when overall prices are so low that lots of stocks are available at good prices than it is when overall prices are so high that few stocks are available at good prices.
Stock pickers do not believe in market efficiency; effective stock picking is impossible in an efficient market. But presuming that there might be some efficiency to the market, it is likely that there is a greater measure of efficiency on the micro side (how individual stocks are priced) than on the macro side (how the overall market is priced). Stock pickers are better informed than most indexers. So the market is probably better able to price stocks well relative to each other than it is to price the overall market properly.
Market inefficiencies present opportunities to stock pickers. They seek to take advantage of micro inefficiencies by picking stocks. It may be that even greater opportunities are available to them in the form of macro inefficiencies. Stock picking is all about gaining an edge. Lots of people are studying annual reports of all the companies in an effort to find profitable edges. How many are giving thought to how much of a change in their overall stock allocation is appropriate at various valuation levels? It may be that it is on the macro side that the low-hanging fruit is to be found.
The best opportunities present themselves at times of extreme valuations. A regression analysis of the historical data showed in January 2000 that the most likely 10-year annualized return going forward was a negative 1 percent real. It’s easy to imagine that moving some money to TIPS paying 4 percent real for a time would have permitted a stock picker to put his money to better use a few years later. Yale Economics Professor Robert Shiller has said that he will be putting his money back into stocks when the P/E10 level again drops below 10. It’s hard to imagine that it will not be easier to find appealing individual stocks to invest in after we see a price drop of more than 50 percent from today’s prices.
One of the most important distinctions between the Buy-and-Hold and Valuation-Informed Indexing models is that the former posits that stocks are always the best place to put one’s long-term money while the latter posits that there are times when super-safe asset classes offer a more appealing long-term value proposition. If that’s so, it’s probably also so that there are times when even the best stock pickers should be taking a little something off the table if only to be able to put a little something extra on the table at times when once again lots of individual stocks offer an appealing value proposition.