In his latest piece, Francois Sicart, Founder and Chairman of Tocqueville Asset Management, explores how a “good enough” understanding of a security’s value, in conjunction with discipline and common sense, can result in investment success.
“The plain truth is that in the practice of investment, “good enough,” combined with a solid dose of common sense, usually beats precision and faith in mathematical models. So, if a careful analysis has given us a “good enough” idea of a company’s worth, we can assume that its market-traded shares will fluctuate – sometimes wildly – around that fundamental value. And that may be the value investor’s salvation.”
The piece goes into detail on the value of the P/E ratio versus the “human factor” when valuing securities, mean regression, the “value of value” and the importance of being contrarian.
He concludes by noting: “that this seems like an ideal time to exercise what Howard Marks calls “patient opportunism”: to wait for bargain levels in the general markets while we opportunistically seize investment opportunities in out-of-favor and attractively priced individual stocks.”
Secular Market Cycles: Three Steps To "Good Enough" In Praise Of Simplicity, Common Sense, And Stubbornness
When we discuss stock investments, we usually talk about companies’ sales, earnings, and growth trends. Yet perhaps the main factor moving stock prices in bull and bear markets is not the fluctuation of earnings per se, but the rise or decline in price/earnings (P/E) ratios.
P/E ratios are not an impartial measure of value; they really reflect the investing crowd’s opinion of a price worth paying for current and future earnings. The influence of P/E ratios on stock prices is clearly illustrated by the following chart from Crestmont Research, which uses a 10-year smoothed P/E ratio to reduce the impact of earnings cycles. As can be seen in the lower part of the chart, bull and bear markets (as defined by Crestmont) correspond to periods of expansion or contraction of the S&P 500 index’s P/E ratio.
Since there are different ways to determine the beginning and end of secular market phases, I used the raw database (without adjustments) maintained by Robert Shiller at Yale University to pick the major highs and lows of the S&P 500 index since 1920 and the index’s P/E ratio on the same dates. As the resulting table (below) illustrates, it cannot be argued that fluctuations in the P/E ratio have been solely or entirely responsible for market behavior; but there is little doubt that they have been a significant contributing factor to secular bull and bear markets.
Note: In 1966-1980 and 2000-2014, the markets did show modest gains rather than outright losses; but over such long periods (14 years each), it can be deemed that prices were mostly flat. Students of secular market cycles often classify long periods of sideways prices as bear markets, since the lack of net price movement in the face of continuing earnings progress is largely due to a steady downward adjustment in P/E ratios.
Overall, as can be seen, the real money has been made when there was a significant expansion of the P/E ratio, which, as previously mentioned, is really a matter of opinion. The preponderance of the human factor in driving P/E ratios guarantees that stock prices will always be far more volatile than can be accounted for by economic forces alone. As Howard Marks puts it, “The extremes of greed and fear, and worry over missing out, will never be banished” (The Most Important Thing, Columbia University Press, 2011).
The Importance of Being Contrarian
Thus, investment markets are situated at the confluence of two sets of forces, both cyclical: economic growth and profitability on the one hand, and crowd psychology on the other. These two influences do not necessarily move in concert. Over the very long term, it is hard to argue that the stock market could make progress without the support of higher earnings. But over shorter periods, even ones lasting many years, it is the influence of crowd psychology that prevails, by causing P/E ratios to shrink or expand.
This is why it is important, in my view, to maintain a contrarian bias: If crowd psychology causes the ups and downs of P/E ratios, which in turn are a major influence on stock prices, the more pessimistic investors become about a company or a market, the closer one must be to a bottom – and, of course, vice versa.
This being said, the majority is not always wrong. If most people say that it is raining, for example, even contrarians would be well advised to take an umbrella before going out. In fact, it could even be argued that the momentum-following majority is right most of the time by assuming that what has been going up will continue to go up, and vice versa.
However, with the tendency of both optimism and pessimism to feed upon themselves to reach unreasonable extremes, a contrarian approach is most rewarding around major trend reversals, when momentum followers, at the opposite, are often caught badly unprepared. As University of California mathematician Tom Murphy reminds us in his blog Do the Math, “In almost every case, extrapolation works until it doesn’t.” More graphically, Warren Buffet reminds us that you only discover who has been swimming naked when the tide goes out.
But how do we know when we are approaching a major turning point? The fact that bull markets usually run too high and too long while bear markets usually decline more than reason would justify makes it very hard to time buy and sell decisions precisely under a contrarian approach.
Sell decisions, for example, are challenging because it is very difficult to tell at what level of a rising market people are becoming a little bit crazy, totally nuts, or raving mad.
Acknowledging the futility of trying to time the end of speculative excesses, both Bernard Baruch and Baron de Rothschild, iconic market fortune-makers, claimed that they became rich by selling too early.
On the buy side, Jim Rogers, the famous “Investment Biker” who co-founded the Quantum Fund with George Soros, wrote in Adventure Capitalist (Random House, 2004):
If I do have a strength, it is the ability to look at Industry X or Country Y, on which everybody is really down, and exercise the courage, the sense, the stupidity, whatever it is, to buy it, even though everybody is telling me I am nuts to do so. If people become hostile when you say you are buying, it’s probably the right thing to do. Hostility is a great indicator. Everybody has lost so much money that they have sold the disgusting thing, and as a consequence it is really cheap.
What makes real contrarians successful is not necessarily that they dare to be different or to be wrong, but that they dare to look wrong, sometimes for quite some time. And that not only requires skill; it requires character.
The Value of Value
A contrarian bias is useful in order to be prepared for the reversal of excesses and to identify out-of-favor investment opportunities or dangerously over-loved market favorites, but it is of little help in fine-tuning the timing of long-term investors’ buy and sell