No. of Recommendations: 35
I agree that it's not different this time. The fact that P/E ratios, by themselves, are useless for valuing high-growth companies was known back in
the 1ate 1970s. That was when Peter Lynch took over the reins at Fidelity Magellan and delivered an astounding 29.1% annualized return for his
investors from 1977 through 1990. A $10,000 investment in the Magellan Fund would have grown to $280,000 during the 13 years Lynch ran the fund. As
he explains in his classic book One Up on Wall Street (which I recommend you read), Lynch decided long ago that P/E ratios were not useful for
deciding when to buy growth stocks. He used the PEG ratio ratio instead, but his most important criteria was to "buy what you know".
So you are correct that it's not different this time. P/E ratios were useless for valuing growth stocks in the 1970's and they are still useless for valuing growth stocks 50 years later.I am asserting that the ratio of FUTURE earnings to CURRENT price is important. More than anything else.
An "expensive" current P/E ratio for a specific firm isn't bad, especially if it is youngish or smallish, provided the future earnings eventually arrive and are plentiful enough to make it all worthwhile.
The 7 largest firms in the US do not fall into either of those categories, and even less so taken as a group, but the same thing is true: it's the future profits that matter, and how much you pay today to get them.
The main thing we
learn from a low or negative current P/E is to identify the firms that investors are optimistic about. They expect a rosy future so they aren't requiring current earnings--fair enough.
Future growth is expected. It might happen or might not, but it's clear that people are expecting it and paying extra for it.
And the most useful
observation of that group is that they are, on average, poor investments.
This confirms your assertion that low P/E is not useful to predict a good investment, but a high or undefined P/E is even worse as a predictor of a good investment.
You have to look at something else to find the exceptions among high P/E firms that will do well, because as as group, you'll do badly.
(Among low P/E firms you're somewhat less likely to do badly because the average is not as bad*)
Among those firms with high valuations a decade ago (low or negative current earnings yields) among the 1700 covered by Value Line,
there is almost no difference in return between the set with low earnings (P/E over 33, say) and those with negative earnings.
The first group returned inflation + 3.0%/year in the last decade, and the second group returned inflation + 2.4%/year.
(those are error-prone figures: more than half of the firms in that group could not be easily matched by ticker now,
generally because they were bought out or delisted or changed tickers, so I averaged only those that matched. Some of the matches will be wrong, too.
I suspect, but am unwilling to go to the work to prove, that the numbers would be even worse if we found the fates of the missing tickers and included them in the average)
The point here is that both of those returns are really terrible: on average across the group, a low earnings yield (high P/E) was a successful predictor of a poor outcome.
The S&P 500 returned inflation + 9.6%/year in the same ten years.
The reason is simple: On average over the centuries, the typical stock with a low earnings yield (high P/E, if there is a P/E) is overvalued.
Some definitely aren't, but the average one is.
They generally do have high growth, and high growth is definitely worth more.
But the typical situation is that people get excited and overpay for that bright future they anticipate.
A firm might be worth a lot more because it is going to grow a lot--nobody would dispute that--but people tend to pay 3 or 4 times as much for something that's ultimately worth only twice as much, and end up with poor returns.
In this particular case, we can even put a number on it: if we assume for the sake of argument that the return from the S&P 500 is what they "should" have got,
the optimism a decade ago cause people to pay 97% more than they should have, on average.
The numbers will vary depending on the time frame you look at, this is a pretty typical result. People usually overpay for growth prospects.
It isn't useful to find some exceptions and declare high valuation levels to be the sign of rapid growers or good investments.
Some are, but most aren't as good as their current prices assume.
The ones that turn out well are either (a) distant future profits turned out to be sufficient relative to the price originally paid, or (b) the investor got lucky enough to sell to a future optimist.
I do like investing in super-high-growth firms, with no profits or low profits. But I won't overpay for them.
If I'm putting $10 at risk, I want to see that achieving honest profits on that of $1/year 7-10 years down the road doesn't require any absurd assumptions.
The only other alternative is to rely on luck, which isn't much of a plan.
If you pay today over 15 times what the earnings turn out to be a decade later, you'll have a poor return with very high probability. ... The valuations will fall to earth with 100% certainty; the only question is the time frame.
...
100% certainty? Really? What would you say if I told you that in the 26 years that Amazon has been publicly traded that it has never traded at a multiple lower than 20 times earnings? I haven't checked the precise lowest figure for Amazon's multiples, but sure. What's your point?
They will trade at a multiple in the teens as a norm, as does every firm sooner or later. As mentioned, the only question is when. For them, unusually, it's "not yet".
The poor ten year outcome I mention is stated quite clearly as "very high probability"---Amazon is simply an outlier in that high valuation period is much longer than typical.
They aren't enough to change measurably the average outcome of stocks bought at high multiples of distant future profits, which is dismal.
As an aside:
Interestingly, in any year of your choice, forecasts for Amazon's profits ten years later were very much higher than what ultimately occurred.
At any individual date of high valuation, people were quite sensibly expecting a lot of profits within a reasonable time frame, much as I suggest is prudent.
So Amazon investors in 2000 weren't willing to wait 20 years: they expected lots of profits in 10 years.
They then morphed into Amazon 2005 investors willing to wait 10 years, then they into Amazon 2010 investors willing to wait 10 years, and so on.
That's not a problem for them--Amazon has built some formidable businesses and there is still an expectation of future profits--but it's an interesting phenomenon of investors rewriting their memories.
I presume that if you told the Amazon investors of 2000 (or whenever) what the total profits per share would be 10-20 years later (but not the share price) they mostly wouldn't have been buyers.
Annualized return
5 yrs 10 yrs 15 yrs
------------------------------------
S&P 500 12.3% 12.8% 10.9%
BRK.B 12.8% 11.8% 10.1%
If index funds were "overvalued" relative to Berkshire 10 years and 15 years ago, why has the index beaten BRK.B over those time periods? Well, since you ask, it's because of the endpoint effect of the date you chose (now).
In the specific interval you cite, the S&P 500 has become more expensive and Berkshire hasn't.
Berkshire's business results have been moderately superior, by an amount about the same as the amount by which the relative valuation levels changed.
Based on smooth trend earnings yield, the S&P is 32% more expensive than it was 10 years ago, and 55% more expensive than it was 15 years ago, and 32% more than 20 years ago.
That's based on smoothed recent profits, so it's on top of the upswing in profits from the tax cuts and recent net margin expansion.
By comparison Berkshire's valuation is relatively unchanged in the last 10 or 15 years based on price-to-peak-book or other methods.
Maybe the S&P 500 will continue to get ever more expensive. I personally wouldn't bet on it.
FWIW, a wild guess as to a plausible outlook for the S&P 500:
Starting from valuations similar to this on starting dates since 1995, if the future rhymes in terms of value growth and valuation levels and ongoing multiple expansion,
you'd expect a real total return from the S&P of around inflation + 1.9%/year in the next 7 years.
That's defined as the average of the annualized rates of return, across all possible holding periods starting now and ending in the stretch 4-10 years later.
Maybe more, maybe less, but higher or lower outcomes are probably a 50/50 shot.
Jim
*
Among the ~1700 firms covered by Value Line, last 37 years, total return CAGR among the ~250 firms with highest current P/E at purchase: 6.81%/year
Among the ~1700 firms covered by Value Line, last 37 years, total return CAGR among the ~250 firms with lowest current P/E at purchase: 14.55%/year
S&P 500 same period: 10.58%/year, between the two.
