Home Value Investing More On Valuation: The Fed Model and Profit Margins

More On Valuation: The Fed Model and Profit Margins

Last week I’ve shared with you my  Institutional Investor article on some important but quite boring topics that include the Fed Model, the price-to-earnings ratio, and profit margins. I imagine for most civilians (people who don’t do investing for a living) reading about these topics is as exciting as watching a live debate between two paleontologists about how the size of tyrannosaurus’ front teeth relates to the length of spinosaurus’ tail. (I have no idea what I just wrote.)

I will have you know, however, that the Fed Model is extremely important, because I vividly remember how low interest rates and the Fed Model were used as propaganda tool in the late ’90s to justify the stock market’s “this time is different” sky-high valuafed-change-interest-rate-1tion. Low interest rates have been pushing investors into riskier assets and have thus resulted in higher valuations, but just as you would expect a finite boost of energy from 5-Hour Energy drink, low interest rates will not bring permanently higher valuations in stocks.

I see an army of experts on business TV – and non-experts in day-to-day dealings – justify holding otherwise overvalued stocks by comparing their yields of 2% or 3% to the yields of bonds. Stocks and bonds are competing assets, so a low yield in bonds in the short term (a key distinction) will drive higher P/Es (lower earnings yields) in stocks. But today, rather than a race to the top we have a race to the bottom. As bonds yields rise (or not – if they don’t it means we’re in deflation, which is even worse) stock valuations will return to their rightful place – lower. Of course there is a caveat: they may go a lot higher before they do that. But that’s investing for you.

I have written the topic of profit margins half to death; I even penned a scribble for Barron’s, discussing them back in 2008. All you have to do is look at the historical charts (see this chart) – profits always mean-revert. Mean reversion of profits is so banal it should be taught in finance classes just as Newton’s law of gravitation is taught in physics. Earnings have never grown at a faster rate than GDP (sales of the economy) for a substantial period of time. This time is not different. I’d buy an argument that the long-term mean of profit margins may have shifted upwards over the last two decades as we have become more of a service and less of a manufacturing economy. So instead of being at 8% – or maybe it should be closer to 9% – we are in the mid-teens.

Via: contrarianedge

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I was born and raised in Murmansk, Russia (the home for Russia’s northern navy fleet, think Tom Clancy’s Red October). I immigrated to the US from Russia in 1991 with all my family – my three brothers, my father, and my stepmother. (Here is a link to a more detailed story of how my family emigrated from Russia.) My professional career is easily described in one sentence: I invest, I educate, I write, and I could not dream of doing anything else. Here is a slightly more detailed curriculum vitae: I am Chief Investment Officer at Investment Management Associates, Inc (IMA), a value investment firm based in Denver, Colorado. After I received my graduate and undergraduate degrees in finance (cum laude, but who cares) from the University of Colorado at Denver, and finished my CFA designation (three years of my life that are a vague recollection at this point), I wanted to keep learning. I figured the best way to learn is to teach. At first I taught an undergraduate class at the University of Colorado at Denver and later a graduate investment class at the same university that I designed based on my day job. Currently I am on sabbatical from teaching for a while. I found that the university classroom was not big enough for me, so I started writing and, let’s be honest, I needed to let my genetically embedded Russian sarcasm out. I’ve written articles for the Financial Times, Barron’s, BusinessWeek, Christian Science Monitor, New York Post, Institutional Investor … and the list goes on. I was profiled in Barron’s, and have been interviewed by Value Investor Insight, [email protected], BusinessWeek, BNN, CNBC, and countless radio shows. Finally, my biggest achievement – well actually second biggest; I count quitting smoking in 1992 as the biggest – I’ve authored the Little Book of Sideways Markets (Wiley, 2010) and Active Value Investing (Wiley, 2007).