“Assets decline in value until they reach the hands of their true owners.” — Anon.
Quick, answer this question: If you buy a share of a stock for $1 and sell it a year later for $1.20, what is your percentage gain?
If you said “Duh, it’s 20%” you are right. A tad ill-mannered, but right. Now, the same stock is available for 80 cents a share. You jump on it and then sell it soon after for $1. What’s your gain now?
A: Duh, the same 20%
D. Let me get a calculator out…
The answer here is B, More. Your gain on the move from 80 cents to a dollar is 25%. Strange, but logical. What is 25% of 80? Well, divide 80 by four and you will find that it’s 20 cents.
So, the important thing here is, buy cheap stocks! No, just kidding. Cheap stocks can lose value very easily. Penny stocks are absolutely silly and a quick way to the bread line, if that’s your aim.
The point of this mini math lesson is to show you something important about stock market logic, which is that investing because stocks have gone up is a crucial error, one that investors fall for over and over, seemingly inexhaustibly in their quest to ride the good times to even better times.
There is a school of thought that says investors should buy stocks that have risen quickly (known as “momentum” investing). Similarly, there is an investing style which says to buy stocks that have fallen rapidly, on the presumption that fast-declining stocks will bounce back soon enough.
Both strategies require very quick trading skills and, too often, rely on tricks such as leverage to amplify the results. It’s a high-wire act, that’s for sure.
Inevitably, such “fair weather investing” ends badly for those involved. As markets correct, and they do with frequency, many of those same, gutsy investors sell out near the bottom. Having gotten in too high, they can’t stand the vertiginous decline and panic when things look the worst. They lock in the losses, never to recover.
This fundamental error was obvious after the dot-com crash, when investors were chasing stock at triple-digit multiples in hopes that they would fly even higher — only to bail out in the subsequent crash.
Naturally, we get excited when things are going great and despondent when they go poorly, always with one finger to the wind, the other on the sell trigger. With no margin of safety, fear takes over.
So, how can an investor know if the stock is relatively expensive or, perhaps, relatively cheap? One way is the price-to-earnings (PE) ratio.
Mathematically, that’s the stock’s current price per share divided by earnings per share. Here’s a simple example: A stock you like earned, on average, $4 of profit (earnings) per share over the last 12 months. It’s trading at $20. Twenty divided by four is five. The PE ratio is five.
So what? Well, if you know the PE ratio, which is listed along the stock’s price on most online financial tickers, you have a pretty good idea if the stock is cheaper (or more expensive) than a similar stock, or the Dow 30, or the S&P 500.
The median, or average, PE for the S&P 500 Index, for instance, is 14.45 at this writing, based on data going back to 1871. (Check the current number here.)
Individual stocks trading below that level might be deemed cheap, and higher deemed expensive, if you consider the last, or “trailing” 12-months (shorthanded as “ttm” in finance-speak) PE ratio the best valuation measure. There are many other statistics you could consider, but PE is a commonly used and widely accepted starting point.
Foolproof? Of course not. Robert Shiller, the respected Yale economist who predicted the tech crash in his book,” Irrational Exuberance”, makes the case that using the most recent 12-month period (not the last full year, mind you, but literally 12 months counting backward) is not long enough.
Instead, Shiller prefers a 10-year average, which smooths out wild swings in earnings (for instance, the 2009 credit crisis) by using a longer time period. It’s known officially as the cyclically adjusted PE (CAPE) ratio and unofficially as the Shiller PE. It works like this: Take annual earnings over 10 years, adjust for inflation, then divide by the current share price.
How do they compare? Well, the “normal” 12-month PE suggests that stocks, as represented by the S&P 500, are on average close to a reasonable price, just above 15 compared to a long-term average of 14.45. (Individual stocks will vary, of course.)
Margin of Safety
Interestingly, the Shiller PE provides an alternate opinion; it suggests waiting. It’s above 21 at this writing. Compared to the Shiller PE median of 15.84, that’s a gap (and a potential decline in value) of 28.48 percent! If Shiller is right and stocks revert to the long-term average (it goes back to 1881), that gap represents the size of the possible risk of loss.
Waiting until the market — or an individual stock, if that’s your target — drops well below the Shiller PE median should give you a better “margin of safety,” to use Ben Graham’s term. It’s not protection against a decline per se, but protection against the urge to sell when those declines occur, as they always do.