April 2014: Valuations Matter

Valuation:       The estimated value of something — Merriam-Webster
                        An estimation of something’s worth — Oxford Dictionary

Introduction:  When making an investment, its valuation at the time of purchase matters!  This pertains to purchases of all types of investments including real estate, private businesses, bonds and stocks.  The single largest determinant of how much (or little) your future profits will be when making an investment is whether you bought it at a low valuation (bargain level) or a high valuation (richly priced).  Most investors comprehend this when it comes to buying income property.  But, somehow, when it comes to evaluating potential stock returns, they seem to struggle to grasp the same concept. Yet, in both cases they are buying a future stream of profits. 

Why This Is Important:  Investments are acquired with the expectation that the investment will provide a profit.  The attractiveness of an investment – how profitable it will be, that is, the percentage return—is largely based on how much or how little you pay for the investment.

How it Works:  Let’s consider this concept using a simple example.  Suppose you have a chance to buy a machine that generates $1 of cash to you each year.  How much would you pay for that machine?  Furthermore, what difference would it make to you if you bought it for a song or if you paid a high price?

Let’s say you were able to buy this machine for $10.  That would mean your profit (cash generated to you), expressed as a percentage return, would be 10% per year [$1 of income divided by a $10 purchase price = 10%].   However, if you paid $20 for the same machine, your percentage return would be only 5%, even though it would still generate the same cash income of $1 per year [$1 of income divided by a $20 purchase price = 5%].

Valuations matter when making an investment.  Clearly, paying less for the investment provides for a more attractive return from that investment.  Conversely, paying more for the investment makes for a less attractive return.

Real Estate:  Investors know that buying a rental property that provides a high percentage cash return is superior to buying the same property but with a lower percentage cash return.  For example, if a property could provide you with $2,000 per month ($24,000 per year) of rental income, would you rather pay $200,000 or $400,000 to acquire that investment property?  Obviously, you would rather pay the lower price of $200,000.  If you make $24,000 per year on a $200,000 investment, that’s an annual cash return of 12%.  But, if you pay $400,000 for the same property and receive the same $24,000 of annual income, that’s only a 6% cash return.  Valuations at the time of purchase matter when it comes to the profitability of an investment.

Stocks:  Current valuations and future profits are linked; they are inversely correlated.  Buying stocks at high valuations is similar to buying real estate at a high price—expected future returns, expressed as a percentage, will be lower than if buying at cheaper prices.  Conversely, buying stocks at low valuations means expected future returns will be relatively higher.  

Of course, the attractiveness of an individual stock has many other factors to consider in addition to its current price. But, when viewing the overall stock market—a composite of parallels with our earlier examples hold true.  A key determinant in how high or how low future profits are likely to be is the overall valuation of the stock market.

The guidance we’re looking for is: How do we know if today’s stock market is cheap or expensive and, based on that answer, what can we reasonably expect about how much or how little forthcoming profits will be from stock market investments?

Historical Evidence:  Stock market history shows that low valuations (cheap prices) correlate to higher future returns, and high valuations (expensive prices) correlate to lower returns. Let’s look at this concept using a method called the Cyclically Adjusted Price Earnings ratio (CAPE), a tool created by Professor Robert Shiller.  [See sidebar for explanation of CAPE.]

Historically, this indicator has been useful in sizing up returns three, five, and ten years out.  It does not provide a definitive forecast with a calendar attached.  However, based on 140 years of stock market history, this tool offers useful insights of whether we should expect coming stock market returns to be average, above average, or below average.   Prudent investors will take heed.  Still, investors operating under the influence of speculative juices will likely choose to ignore more than a century of data.


How to Use This Information:
  This data covers many, many stock market cycles, including the best of times and the worst of times.  The question today is, “Where do we stand now and, based on history, what can we reasonably expect stock market returns to be in the coming years?” The Shiller CAPE ratio is currently at 25.5. It is in the very top strata of expensive valuations observed over 140 years of stock market history.  When the Shiller CAPE ratio exceeds 21, like now, annual stock market returns for the subsequent ten years have ranged from a high of +7.5% to a low of -5.9% with an average of +1.3%. 

It is important to note this data does not provide a precise prediction of future returns.  Instead, it provides an estimated range of prospective returns based on historical outcomes. Furthermore, it is not a timing mechanism; it does not mark whether or when to be in or out of stocks.

According to Professor Shiller, CAPE ratios provide guidance on the general attractiveness or unattractiveness of the stock market-- that is, how cheap or how expensive the stock market is based on historical precedents.  Using this input, he advocates gradually increasing the percentage of stocks in your portfolio as prices become cheaper (declining Shiller CAPE ratio) and gradually reducing the percentage of stocks in your portfolio as valuations reach increasingly higher, more expensive valuations (increasing Shiller CAPE ratio), like now.

Current Portfolio Allocation and Why: The Shiller CAPE ratio is currently very high, meaning stock market valuations are high ( i.e., stocks are expensive).  That warrants a lower than normal portfolio allocation to stocks. 

Asset Allocation Advisors’ managed portfolios are in sync with this conclusion.  Our moderate allocation accounts normally target a 50-70% stock allocation; we currently have a 45% stock allocation, a cautious level of stock market exposure.  We will never be 100% invested in stocks (or any other single asset category) nor will we ever be completely out of stocks.  When valuations become more attractive—and we firmly believe this is a matter of “when,” not “if”—our plan is to increase the allocation of stocks in our clients’ accounts.  We anticipate today’s patience will be well worth the advantages it will provide when the time to buy arrives.

As the guardians of your capital, our job is to vigilantly protect your capital and prudently make money for you.  We remain committed to this endeavor.  ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2014