At What Price?

There was a terrific interview of Howard Marks, CFA, cofounder and chairman of Oaktree Capital Management, in the most recent issue of CFA Institute Magazine.  Marks shares insights into Oaktree’s corporate culture and leadership lessons learned over the years.  His thoughts on incentives and pay structures in the industry are also consistent with our own.

“We don’t use numerical, quantitative evaluation systems to determine people’s pay. We don’t have a formula to use for calculating pay based on so many upgrades or so many downgrades, and we don’t compute each analyst’s P&L . . . Of course, the people who work on funds that produce incentive fees for us, which is most of our business, get a share of the incentive fees. To distinguish us from other types of organizations, however, the important thing is that our managers don’t get paid for what they contributed to the incentive fees. In other words, they don’t get paid for the profits on their own deals. Everybody gets paid on the profits of the whole fund . . . I think every person should have the goal that the fund succeeds, and our system encourages teamwork. If they have that goal, they have a greater incentive to help their teammates do better . . . I think that creates a very wholesome incentive system. People are concerned whether they do well, whether their teammates do well, and whether all the funds in the company do well. It also tends to make people concerned with the long run and not the short run.”

Marks precisely portrays the essence of investment management in explaining that the number-one job of a money manager is not making a lot of money; it’s not beating the market. It is risk management.

“I believe strongly that girding for bad times, and thereby ensuring margin for error, is more essential than preparing for good times. If you prepare for and count on good times, their failure to materialize can knock you out. There’s a downside to this, however. Having a margin for safety in your portfolio means you can’t always maximize returns. The people who are sure what’s going to happen and turn out to be right—due to skill or luck— are the ones who’ll maximize. Those who aren’t sure what is going to happen and build in a margin of safety are unlikely to maximize under any single scenario. As investors, we all have to choose whether we’re going to play mostly offense or mostly defense.”

We choose defense.  Like Marks, we are worriers.  And there is no shortage of potential risks to keep us up at night.  But unlike Marks, we are not particularly excited about the prospects for long-term equity returns today.  A recent letter to Oaktree clients, titled Hemlines & Investment Styles, reviews recurring patterns, the history of stocks and bonds, and the old adage, “What the wise man does in the beginning, the fool does in the end.”  The letter is well worth a read and provides an excellent overview of the cycles of fear and greed in the stock market over the past century.  Perhaps the most important point is that investors consistently seize upon above average returns and extrapolate them, and the 17.6% compound return on the S&P 500 from 1979 through 1999 was certainly a case in point.  But rarely do they ask what gave rise to those good returns, or what it implies for the future.  Marks warns that:

“Investors consistently rail to recognize that past above average returns don’t imply future above average returns; rather they’ve probably borrowed from the future and thus imply below average returns ahead, or even losses . . . The right question to ask in the late 1990s wasn’t, ‘What has been the normal performance of stocks?’ but rather, ‘What has been the normal performance of stocks if purchased when average P/E ratio is 33?’”

Marks goes on to explain that price-earnings multiples are lower than usual today and 13% below the post-war average, while the “cash flow yield” is roughly capable of being compared against the yield on bonds.  This is where we respectively disagree.  Investors are being irresponsibly misled by countless talking heads, and quite a few respectable managers, who claim that stocks are cheap because their “earnings yield” or dividend yield is higher than the yield available on bonds, which hasn’t occurred in a number of decades.  Lots of things haven’t happened in decades.  That doesn’t necessarily mean there is anything special about them.  If these folks bothered to look more closely at history, they would see that dividend yields were higher than long-term bond yields for virtually the entire period from 1927 to 1958.  So what does that tell us?  Not a whole lot, except that this relationship was primarily driven by falling bond yields due to deflationary pressures and the extended effects of a lengthy deleveraging process. Coincidentally, these same forces are driving yields lower today and are likely to continue to do for some time.  So comparing the “earnings yield” or the dividend yield on stocks to “low” long-term bond yields, has almost zero predictive ability.  If anything, it is more helpful to look at the absolute dividend yield of the market, which still sits around 2% today, versus a historic average of 3.7% (coincidentally, around the same level seen at the market low in March 2009), and previous “bargain” levels of 5.6% or greater.

Andrew Smithers, best characterizes our frustrations, in Wall Street Revalued:

“Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth.  The more they achieve their aim the greater is their success at creating confusion rather than helping our understanding . . . The reason why current PEs provide no guide to value is that profits are highly volatile and rotate around their equilibrium level.  If profits are at their equilibrium level, and only if they are, then the ratio of the current to average PE will provide a valid estimate of the market’s value.”

Laymen’s interpretation: PEs calculated on one year of earnings are virtually meaningless.  It is absurd to value the stock market on current or predicted PEs when profits and margins are near peak levels.  It is equally absurd to undervalue the market when profits are depressed.  For example, at the end of 1932, after a near 90% fall in stock prices, the market PE was about 25% above average.  Anyone care to argue that stocks were expensive at this level?

There are two issues with Marks’ claim that multiples are lower today then the post-war average.  The first is a mistake commonly made by the street – the use of post-war data.  Limiting your dataset has important consequences, especially when today’s experience is likely “out of sample.”  The second is the price-earnings multiple used.  While Marks does not detail his definition of earnings, rest assured that they are not normalized.  Any attempt to normalize earnings, results in dramatically different results.  For example, a Cyclically Adjusted Price Earnings multiple, or CAPE, can be calculated by averaging the earnings per share of the stock market for each of the past ten years.  CAPE is a simple way to calculate the equilibrium rather than the current level of earnings.  The crucial assumption is that this averaging will provide a good guide to the current equilibrium level.  See the chart below for the results through Friday.

“There’s no such thing as a good idea . . . or a bad idea.  Anything can be a good idea at one price and time, and a bad one at another.  That question – at what price? – isn’t just the right question to ask about bonds versus stocks today.  It’s the right question regarding every investment at every point in time.”

To answer Marks’ question, we examine average ten-year returns based on various normalized earnings multiples.  When stocks have been priced in the most expensive quintile of CAPE ratios, as they are today, the average real return has been 2.5%.  Not exactly performance to write home about.  Sure, there are small segments of the market that are fairly priced (i.e. high quality franchises), but just because something is cheaper than the general market does not mean it won’t go down.  During abroad downward movements in the market, this segment may very well fall with the broader indices.  In our view, broad equity markets have already fully priced an economic recovery.  Consequently, downside risks should be fast and furious should the notorious double dip emerge.  Under such a scenario, government bonds would still provide a useful hedge to risk assets, as yields are likely to plunge further once economic expectations fall back to reality.  We’ll have more to say on our bullish bond call in coming weeks.  Until then, investors can revisit Ten Reasons to Buy Bonds.

We have a tremendous amount of respect for Mr. Marks and Oaktree.  But better buying opportunities lie ahead for equity investors.