Valuation Check - The Weighing Machine

October 5, 2015

Is the stock market in a bubble? Is it headed for a fall? Predicting the stock market over the short term is hard, some would say impossible, because the stock market is subject to the fear and greed of the day. Benjamin Graham, the father of value investing and Warren Buffet’s mentor, famously described the stock market like this: “in the short run, the market is like a voting machine—tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine—assessing the substance of a company.”

 

We believe that staying focused on the substance of our investments, the fundamentals of the investments we have made, help cut through the noise of the news cycle to give us a clearer picture of what is happening in the market despite the daily ups and downs. To be sure, focusing on fundamentals is more complex than looking at a single chart or statistic because we live in a complex world. Nonetheless, we remain convinced that decisions made based on data are better than those made based on the news, fear, greed, or a gut feeling.

 

Investing in a stock is, in a very real sense, investing in the future earnings of that company and, over the long term, it is those earnings that matter most. One way to look at the price of a company compared to its earnings is through the Price Earnings Ratio or P/E ratio. The P/E Ratio answers the question “how much am I paying for every dollar of earnings” and therefore is one indicator of whether a stock is cheap or expensive. P/E ratios are not a predictor of stock performance, but a low P/E ratio is an indication that a stock is relatively cheap and a high P/E ratio is an indication that a stock is relatively expensive - something buyers should be wary of.

 

Similarly, if we look at the overall P/E Ratio for the S&P500 we can get an indication of whether the market is in bubble territory.

As you can see in the chart, historically, the P/E Ratio for the S&P500 has averaged 17.1x trailing earnings. In September the market was trading closer to 16.1x earnings, making the market relatively cheap compared to this historical average. Again, this does not perfectly predict the stock market, but it is a positive indicator that the recent sell-off is due to fear rather than worsening fundamentals.

 

As we navigate today’s volatile markets we believe that this type of analysis is critical to understanding what is really happening. We cannot predict the future, but we can be data-driven, thoughtful, and wise in our decision process. In the long run, good companies will continue to grow earnings, creating a good return for the long-term investor.

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