I am a little bit wary of when there is a large rise in capital flying into the markets because it suggests the possibility that assets could be trading at an inflated mark. Often enough, “good days” are not recognized until they are followed by days that are decidedly not good days and then held up as comparison between the two.
In the most recent Allianz Report on Wealth Trends in 2018, it was noted that each dollar generated in the U.S. economy results in 17 cents flowing into stocks and bonds as investments, whereas in 2010, it could only be said that 10 cents were doing the same. During the last time U.S. investment per dollar earned was this high (1999, 1989, 1969, must be a year that ends in “9” thing), it did coincide with moments that seemed to be identified as market highs in hindsight.
The million-dollar question, it always follows, is: What should be done about this information?
My view is that, knowing that such a data point is at an all-time high, should serve as a basis for refocusing on what matters most in investing–getting the most future earnings at the lowest possible price. In 1974, Walter Schloss was up over 52% while everyone else was down over 25%. While I don’t ever expect that kind of relative outperformance, it is a reminder that the “margin of safety” principle never goes out of style. If you pay less than something is worth, you will do well eventually.
The problem with “good times” is that they often coincide with valuations that will be difficult to defend with the benefit of hindsight. For instance, McCormick & Company is one of my favorite businesses in the entire world. It is one of the best buy-and-hold forever stocks out there, and is one of the best that is not generally known among the investing public at large. It sells salt, pepper, and spices, controls 40% market share or more in most countries in which it operates, has a vast distribution network, never goes out of style, and delivers 11-14% returns to shareholders without missing a beat.
The problem is that it is a business trading at 32x earnings that has almost always traded at 18-20x earnings. It’s still growing at the same 8-10% rate it always has. The valuation is a function of low interest rates and frothy economic conditions. Over the next ten years, it will probably deliver dividends and earnings per share growth of 10-11%, and total returns of 7-9%. That’s why I would hold it if I owned it, but the current valuation is the most excessive ever even while the business is doing the same thing it has always done, so I acknowledge the times and move it down a spot on my list.
Other businesses remain attractively valued. For instance, the business I profiled on Patreon yesterday, is trading at 10x earnings (an unusual P/E ratio low) while I also expect it will grow by high single digits with a reasonable chance of double-digits over the long haul. You won’t go wrong acquiring businesses that are trading at prices you’d find attractive even if interest rates were higher and/or economic conditions were worse. That’s the whole point of the margin of safety principle. You draw up bad conditions where you will still do all right, and if those bad conditions don’t materialize, you do well. Solid upside, limited downside. As Charlie Munger pithily put it at the 2019 Berkshire Hathaway shareholder meeting, “That’s what I call being an adult.”
Investing, and even financial management in general, is a lot easier when you break it down into individual parts. It’s a lot easier to figure out of Coca-Cola, Exxon, Nestle, Johnson & Johnson, Hershey, Disney, or Procter & Gamble offer good risk-adjusted returns on the individual basis of studying the company, rather than making some grand pronouncement about the economy as a whole and projecting that onto stocks as a class. The latter is an abstraction that gets you nowhere, the former the identification of the path to wealth.
Originally posted 2019-05-27 13:30:41.
