Klarman: “Value Investing Is Simple To understand But difficult to implement” And The Reach For Yield

“Value investing is simple to understand but difficult to implement.”

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

— Seth Klarman, The Baupost Group

Also see

Seth Klarman On Value Investing In A Turbulent Market

Klarman "Catching Knives" Experiences Rare Yearly Loss, Looks ...

Seth Klarman: Now's Not The Time To Give Up On Value

Today, let’s take a look at the most recent market valuations.  Hint and not a surprise: both stocks and bonds remain expensively priced.  Value?  Not today.  Especially in the bond market.

[drizzle]What’s important for you, me and our clients to understand is that current valuations can tell us a great deal about what coming 10-year returns are likely to be.  When should we play more defense than offense or more offense than defense?  We’ll look at the numbers today.

Former head of the endowment at the University of North Carolina, Mark Yusko, wrote an outstanding client letter called The Value of Value.  It is a great piece about value and a reminder about the investment discipline required to be successful.  Mark shares some great quotes from value investor Seth Klarman.  Here are just a few:

  • There’s no such thing as a value company. Price is all that matters.  At some price, an asset is a buy, at another it’s a hold and at another it’s a sell.
  • There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate and invest with a margin of safety.
  • It is precisely because we do not, and cannot, know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.
  • A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility in a complex, unpredictable and rapidly changing world. (SB here – you will find most recent equity market valuations below in this week’s OMR.)
  • While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology. (Emphasis mine.)
  • Roy Neuberger said it first that there were three rules to managing money and Klarman reminds us that Warren Buffet paraphrased Roy saying,
    • “The first rule of investing is ‘Don’t lose money,’ and the second rule is, ‘Never forget the first rule.’”
  • An important clarification, however, is that “this does not mean that investors should never incur the risk of any loss at all.”
    • Rather ‘Don’t lose money’ means that over several years, an investment portfolio should not be exposed to appreciable loss of principal. (Emphasis mine.)

What you’ll find this week, both for the equity and the fixed income markets, is that valuations remain significantly overvalued.  In my view, the bond market resembles the tech bubble of 1999.  There is little “value” today.  60/40 is in trouble – big trouble and unlike any period in time in my 32 years in the business.  Just saying.

However, you’ll also see, in the Trade Signals section below, that the weight of trend evidence continues to point bullish for both stocks and bonds.  To that end, I believe trend following can help us minimize loss and preserve principal.  The preserving principal part will play the most important role in our ability to buy the bargains when the getting gets good again.

I favor trend following processes, especially given where valuations sit today.  OK, grab a coffee and jump in.  You’ll find a number of charts below (click on the orange link below) and today’s OMR should be a quick read.

Included in this week’s On My Radar:

  • October 1, 2016 Equity Market Valuations & Probable Forward Returns
  • Bond Market Valuations (High Grade and High Yield)
  • Trade Signals – The Weight of Trend Evidence is Bullish for Equities and Bonds; Extreme Bearish Sentiment is S/T Bullish for Stocks (10-5-2016)

October 1, 2016 Equity Market Valuations & Probable Forward Returns

S&P 500 Median Price-to-Earnings Ratio = 23.3 (current level = 2,168.27 on 9-30-2016)

  • 1,576.33 = Current Fair Value (this number is based on a 52.6-year median P/E of 16.9)
  • 2,057.69 = Overvalued (the S&P 500 was at 2,168.27 on 9-30-2016, so it is at a level of more than 5% above what is considered overvalued)
  • 1,092.81 = Undervalued is at 1,092.81 (a crisis event might get us there)

Source:  Ned Davis Research (NDR)


Source: NDR

Shiller P/E = 26.8 as of 9-30-2016.  The above chart uses 6-30-2016 quarter-end Shiller P/E of 25.9.


Source: dshort.com

What does this tell us about returns over the coming 10 years?

The next chart shows the “Average 10-year S&P 500 Annualized Real Total Return Based on Price/Average 10-Year Earnings”

  • Probable returns of just 2.2% per year over coming 10 years


Source: NDR

Crestmont Research – Ed Easterling

The 2011 article “P/E: Future On The Horizon” by Advisor Perspectives contributor Ed Easterling provided an overview of Ed’s method for determining where the market is headed.  His analysis was quite compelling.  Accordingly, we include the Crestmont Research data to our monthly market valuation updates.

The first chart is the Crestmont equivalent of the Cyclical P/E10 ratio chart we’ve been sharing on a monthly basis for the past few years.


Source: dshort.com; Crestmont Research (crestmontresearch.com)

The Crestmont P/E of 27.1 is 93% above its average (arithmetic mean) and at the 98th percentile of this 14-plus-decade series.


Source: dshort.com; Crestmont Research (crestmontresearch.com)

From Doug Short:

  • The inflation “sweet spot,” the range that has supported the highest valuations, is approximately between 1.4% and 3%. See, for example, the highlighted extreme valuations associated with the Tech Bubble arbitrarily as a P/E10 of 30 and higher.
  • The chronology of the orange “bubble” on the chart is a clockwise loop of 56 months starting at the 6 o’clock position.
  • The P/E10 was 31.3 and the annual inflation rate for that month (June 1997) was 2.30%.
  • The average inflation rate for the loop was 2.41%. The P/E10 peak of 44.2 in December 1999 was accompanied by a 2.68% annual inflation rate.  Two months later the inflation rate topped 3% at 3.22%.  The right side of the loop shows what happened thereafter.
  • The ratio slipped below 30 for two months (the tail at the bottom of the loop) before its final three-month swan song in the 30+ range.
  • The latest P/E10 valuation is 26.8 at a 1.31% year-over-year inflation rate, which is below the sweet spot mentioned above.
  • And speaking of that 30 threshold for the P/E10, prior to the Tech Bubble, only two months in history had a ratio above 30: They were 31.5 and 32.6 in August and September of 1929, respectively, just before the Crash of 1929.
  • Research estimates put the annual inflation rate during
    1, 23  - View Full Page