Lynn Carpenter

This chat with you makes a nice break in the day and the business of paginating a long report on the market outlook.

Every year I do an extensive review of sectors, industries, and market conditions for my Rising Tide subscribers to spot what opportunities are on the cusp.  This is something that started a few years ago as an exercise in taking value investing to a higher level.  It’s up to 40 pages, and that’s why I’m glad to have a break from the final proof to talk about some of the things I’ve learned from the research.

Value investors want today’s stock at a steep discount to the company’s future earnings stream.  The most convenient way to do that is to look for stocks with certain traits such as low price-to-earnings ratios.  I’m a fan of using P/E ratios, but I’m not a fan of much of the public advice I see on what’s cheap.

For instance, financial writers seem to have caught a virus they keep passing around.  It is marked by the strange belief that the stock market’s historic P/E ratio is 15.  That’s suspect in its own right. 

But the accompanying notion that trails behind is a lulu.  If you’ve been around the investment block, I’ll bet you’ve heard it a few dozen times: “the market reverts to its historic mean.”  So when the S&P is sporting a P/E ratio of 22, it’s bound to fall back to 15.  When it’s at a P/E of 12, it’s going to turn upward to that 15 level as surely as iron filings cling to magnets.  Supposedly.

This statement is a real trifecta of goofiness.  One, the historic mean is not 15.  It’s closer to 16 for the very, very long term.  Two, stocks tend to revert to their own sector and industry means, not to a magical 15 level.  And three, if there is any value that the market hardly ever rests at, it is … you guessed, didn’t you? … 15.  Far from reverting to 15, the market seems to have an aversion to 15.

This is the kind of conventional wisdom that turns out to be dangerous.  It leads investors to think they should sell when things are perfectly normal, and it sometimes leads them to buy stocks they consider cheap that a savvier investor would recognize as expensive.

As to the level of the stock market, Ned Davis Research - an excellent but expensive source of market data - has the facts.  They have  calculated the same thing that I have by looking at charts myself.  The historical P/E for the S&P 500 is closer to 16.  Ned Davis says the exact value is 15.9 for the 81-year period from 1926 through this past January.

The more recent level is higher, though.  The 50-year mean is 17.6.  I think most of us would consider five decades respectably long term.  OK, conservatives might not be ready to embrace the 25-year mean because that is high - 20.7.

Further, consider the level of 15.  If this were the mean, then a stock selling at a P/E of 14 is considered to be a value, and one at 12 a deep value.  But that’s not correct.  Suppose you find a cigarette stock at 14.  Well, bad news for the bargain hunter, as that happens to be at the top end of the normal range for cigarette stocks.  For a copper mine, homebuilder, or oil and gas refinery, 14 is high.

But more damage is done when investors mistakenly think stocks are expensive when they creep above 15, or even 18 for the value liberals.  Candy stocks are constantly above those levels, ditto drug wholesalers, restaurants, waste management, insurance brokers, office REITs, business software, and a plethora of other industries that would be cheap at 20 because they are normally higher.  The deep value hunt has kept investors out of a lot of good stocks, and all because the people who wrote so convincingly about value never checked their facts in the marketplace.

That’s why I do an in-depth review of sectors each year.  I’ve just finished it - 149 industry groups, plus overall market outlook.  This includes finding the current average P/E for each group as well as their historical comfortable levels over the past 13 years for comparison.

Every year, surprises turn up.  Who would have thought that at the end of 2005, Vale (then called Companhia Vale do Rio Doce) was a big value?  The stock was already up 44 percent for the year.  But it was still trading for half the industry’s usual P/E value.  This is a stock I would have passed by if I had not done all that sector research.

So how do you find this stuff out?  Three ways: two are good and one bad.  You can do the work.  Start with pulling some S&P reports for the top five companies in an industry to see how their P/E levels have trended.  This is good, but take my word for it, it’s a lot of work.  Second, you can look on a quote site like Yahoo for the industry level, but this is a bad way because those averages include tiny, unimportant, barely traded companies as well as stocks with outlandish valuations.  The average is often far from reality. 

The third?  Well, Rising Tide subscribers got their sector outlook with the latest P/E levels yesterday.

Lynn Carpenter

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