When Benjamin Graham was writing “The Intelligent Investor”, the market edge that American investors possessed was information asymmetry. Because there were few sources of comprehensive data–maybe there was a data chart from Moody’s here or there–the buyers and sellers of corporate stock had wildly different amounts of information at their ready access. Ty Cobb could see Coca-Cola stock rolling out across the southeastern United States and use his paychecks from playing baseball for the Detroit Tigers and endorsements from promoting Chesterfield cigarettes to build a million-dollar fortune. His regional access and insight to the product allowed him to see 20% growth in real time in a way that a Texas doctor could never imagine.
The proliferation of the internet and finance sites means that, outside of the world of micro-cap companies, it is extremely difficult to gain a competitive advantage that is the result of having knowledge that the other guy lacks.
But while information asymmetry is no longer a competitive advantage, the ability to process and weigh information correctly is the next step in the evolution of the successful investor. Rather than knowing data points that the other guy doesn’t, the successful stock-picker of today will have access to the same bits of information but will be more discerning about what to weigh of high importance and what information to disregard or accord little value.
I was thinking about this today after I came across the Wall Street Journal article titled: “The Dying Business of Picking Stocks” which offers the following data point that chronicles the rise of index funds:
“Although 66% of mutual-fund and exchange-traded-fund assets are still actively invested, Morningstar says, those numbers are down from 84% 10 years ago and are shrinking fast.”
It has been a while since I have quoted Warren Buffett, so I will remind you of this old bromide: “What the wise do in the beginning, fools do in the end.”
There is a reason why stocks like ExxonMobil haven’t fallen the way that you would expect during the 2014-2016 rollercoaster ride in oil prices. It is because people pouring into index funds are buying it indiscriminately. Every time you contribute a dollar to an index fund, you are putting three cents in ExxonMobil stock alone. Market-cap based indices have an element of a self-fulfilling prophecy to them. As people invest more and more into index funds, they will keep bidding up and up the shares of the names that are auto-assigned for purchase. If the fundamentals at a company like Exxon deteriorate–and I am emphatically NOT making that argument–it will be up to an active investor hedge fund to act as a market maker and adjust the price downward as it deserves.
You can continue to believe in a rational market hypothesis while you also acknowledge the rise of formulaic auto-pilot investing such as index funds. The two notions are incompatible. A rational stock price involves an assessment of a company’s prospects in determining the price to offer for the stock; meanwhile, regularly investing in index funds just means that you are buying more, more, and more if what is big regardless of the fundamentals.
The reason why index fund investing worked so well in the 1980s, 1990s, and early 2000s is because it was a niche art. When only ten cents on the dollar are dedicated to auto-purchasing, the values being assigned by the active investing community still dominate. But as we get within five years of witnessing an even split between active and passive management strategies, the historical edge of index funds is starting to disappear. In a sentence, it is because index fund investors will keep on buying shares of a stock with a pre-existing high market cap even as its future prospects begin to dim because the formula calls for the purchase.
Right now, the S&P 500 is trading at 24x earnings. That is a very unforgiving starting point if your goal is to reap the historical 10% returns that the Ibottson data suggests that the stock market produced from 1927 through 2012. The historical P/E ratio of the S&P 500 is around 15x earnings.
I am open to arguments that suggest we have entered a new era of higher deserved valuations for the largest American multinational companies because of technical improvements/productivity gains, an influx of international investing in the American markets, and higher earnings quality when companies earn profits across 50 countries instead of just 1.
But these argument might militate in favor of moving the average valuation of the S&P 500 up to the 18-20x earnings range. This is obviously a value judgment, but to argue that the S&P 500 is fairly valued right now means that you have to hold the belief that each dollar of profits generated by America, Inc. is worth 60% more than it was worth for the past century. That is an especially difficult argument to make when you consider that the earnings per share growth of the S&P 500 is only around 6%.
If my estimate is correct, and the true value of the S&P 500 has been lifted from 15x earnings to the 18-20x earnings range, then the current valuation of 24x earnings means that what we collectively call “the stock market” is 20% to 33% overvalued. What happens when you combine that kind of overvaluation with expected 6% earnings growth and 2% dividends? You’re probably looking at a decade’s worth of returns around 5-6% annualized pre-tax.
This is a good time to be a bit countercultural. Index investing has become quite fashionable, and the indiscriminate buying has bid up shares of America, Inc. to valuations that are a bit frothy / moderately overvalued. As a result, the hurdle for defining success for active investors has just gotten lower. If you’re capable of putting together a collection of assets that earns at least 7% for the decade, then there is a high probability that you will end up beating the performance of the S&P 500 Index over this time frame. At a minimum, I encourage all of you to think about the implications of buying something at 24x earnings that is attached to a 6% growth rate and a 2% dividend rate.