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Seth Klarman gave a (rare) interview on CNBC this morning.

He has edited a new edition of Security Analysis.

"We've been in an everything bubble."

Becky: "What's changed for you over time as the markets over the time? How has your style evolved?"

Klarman:"I think you almost have to run harder to stay in place."

https://www.cnbc.com/video/2023/06/27/legendary-in...

https://www.cnbc.com/video/2023/06/27/legendary-in...

Puts a pin in the bubble in "Margin of Safety" prices for investing book collectors.

Review of the 7th edition of Security Analysis which Seth Klarman edited:

News to me Todd Combs contributed to the new edition with a section entitled : "Finding Value in Common Stocks"
https://www.kingswell.io/p/security-analysis-7th-e...

Michael Mauboussin:"The new (7th) edition of Security Analysis is out, nearly 90 years after the original. Edited by Seth Klarman. A great blend of timeless wisdom and contemporary commentary. The contribution by Todd Combs, "Finding Value in Common Stocks," is my favorite"
https://twitter.com/mjmauboussin/status/1670777566...

Full audio version of CNBS interview of Klarman posted here:

https://player.fm/series/squawk-pod/the-investors-...

Jim Grant interview with Seth Klarman:

Klarman: "This is a market of stretched valuations once again after the down year of 2022. The market is once again over 20 times earnings. A number of stocks stand out for very extended valuations."

https://twitter.com/GrantsPub/status/1679149652724...

Klarman is complaining about stretched valuations using the market's P/E ratio as a metric. This is a backward-looking figure that is useless for predicting forward year returns and its particularly useless for valuing the growth stocks that dominate the index.

Why time the market? People in their wealth-building years should keep dollar cost averaging into an index fund every month. Especially if they have a 401K. People who are retired should have a majority allocation in an index fund plus an amount in cash or bonds that covers their living expenses for a few years.

"This is a backward-looking figure that is useless for predicting forward year returns
....
People in their wealth-building years should keep dollar cost averaging into an index fund every month. Especially if they have a 401K. People who
are retired should have a majority allocation in an index fund plus an amount in cash or bonds that covers their living expenses for a few years. "

Hmm, there is a potential issue here:
The extremely conventional advice at the end would have worked well in the past, but as the first part of the post notes, success in the rear view mirror is not by itself sufficient to ensure that something is sensible advice for the future.

Imagine a person doing DCA investment of savings of $200 into SPY at the end of each month, the monthly savings amount rising with inflation.
Imagine a second person who is saving the same amount as cash for a while with no real return (just enough interest to cover inflation), and only then puts it into SPY and starts DCA into SPY thereafter.
It has been 28.5 years. Based on the recent peak portfolio value, how did the two investors do?
The second person would have been 28% better off waiting for 14.2 years before investing and starting the DCA process, and they'd still be ahead of the first investor even if they'd waited 15.5 years before putting a penny into the S&P.
Or waiting 8 years before starting, or 14 years before starting.
I'm not suggesting that it's easy to decide when top stop saving and start buying.
But similarly DCA isn't a magical easy route to good returns. The biggest single determinant of forward returns is what price you pay.
If too many of the investments are made at poor valuation levels, there is no guarantee of a good end result, nor even a positive one.

Of course, this is distorted by including the last 1990s. The millennium megacap bubble was off the charts and is never to be repeated, right?
I note that the top 10 stocks made up 20.3% of the Wilshire 5000 market cap at the March 2000 peak, and the top 10 make up 25.9% now.
That's far from being the best metric of market valuation, but it's certainly a warning sign that it might be useful to look more closely at what you're getting for your money.
The S&P 500 will have only so much value 25 years from now.
If you pay twice the price for a share of that endpoint, you'll have half the wealth at the end.

Jim

The second person would have been 28% better off waiting for 14.2 years before investing and starting the DCA process...

Are you seriously telling young people in their wealth-building years to wait 14 years before adding to an index fund? I'm telling my kids (who are in their late 20s and early 30s) to keep adding to their 401Ks every month, allocated 100% to a Vanguard S&P 500 fund. It's the best way for them to accumulate wealth for the long term. I'm telling them not to get cute and try to time the market.

Suppose they had started dollar cost averaging into the Vanguard 500 Index Trust at the worst possible time. Which, as you say, was near the Nasdaq peak at the end of 1999. Here's a table showing how long it took for the dollars invested during the early 2000's to become profitable.

Dollars invested in     Became profitable after
===================     =======================
Jan. 2000               6 years and 10 months
Mar. 2001               1 year and 6 months
Sep. 2001               2 years and 1 month
Mar. 2002               1 year and 2 months
June 2002               6 months           

I know there are a lot of people who have Post Traumatic Stress Syndrome from the Nasdaq bubble aftermath, but they assume someone put in a big lump sum at the market peak in early 2000 and never invested again. That's just not realistic. What's more realistic is saving money from your paycheck, and investing that amount every month in the market. Put that on autopilot in your company 401K during your working years.

The timeframes in the above table are short for people who have decades to go before they retire. I would never, ever advise young people to wait 14 years before they invest in the market. That's almost half their working career.

The second person would have been 28% better off waiting for 14.2 years before investing and starting the DCA process...
...
Are you seriously telling young people in their wealth-building years to wait 14 years before adding to an index fund?

I'm seriously suggesting that EVERYONE should look at the price of what they're buying, investments or hamburgers.
If they're going to go ahead and buy anyway, which is fine by me, they should have appropriately modest expectations of what they're getting in return.
And modest expectations for investment systems which look good in long bull markets.

Markets are very high. Each time that happens, all discussions of checking the price are dismissed as a waste of time, because it's obvious that markets can only go up.
DCA seems like a brilliant can't-lose strategy once again.
Then markets go down, and people change their views for a few years, then it all repeats. It was ever thus.

Humans always have the tendency of seeing the current situation as the normal or typical situation.
The S&P 500 is at 4505 at the moment.
Yet if valuation levels were the same as in summer of '82, the S&P would be at 887 right now adjusted for inflation.
That's definitely not a prediction of what will happen and not my expectation, but it's a nice reminder of what CAN happen.
Sometimes things are very cheap. Sometimes they are very expensive.
If the valuation level today were the same as at the 2007 credit bubble peak, the S&P would be at 4064 right now adjusted for inflation, 10% lower.

Today's S&P 500 valuation level is very similar to that of mid 1997, six months after the famous "irrational exuberance" speech, which an optimist could see as bullish if looking forward three years.
Though a pessimist might view it more darkly, as there was zero net real total return from the S&P 500 in the next 12 years.

So what's a not-crazy expectation?
Since 1995, a purchase of the S&P 500 at this valuation level has been consistent with a seven-year-forward real total return of about inflation + 1.9%/year.
(for comparison the 7 year TIPS yield is inflation + 1.638%, which is entirely certain to the extent that the US dollar doesn't tank)

This valuation level is based on the current level of smoothed real earnings, which is based on the large upsweep of earnings as net margins have soared in the last few years.
If net profit margins slide back towards their prior normal or high levels, the current value estimate would turn out to have been an overestimate and the likely forward returns correspondingly lower.
Phrased another way, US corporate profits have gone up way more than sales lately, so a sales-based value metric would give a very much lower expectation of forward returns.

Invested in     Became profitable
===========     =========
Jan. 2000       6 years 10m
Mar. 2001       1 year 6m
Sep. 2001       2 years 1m
Mar. 2002       1 year 2m
June 2002       6m 

FWIW, dollars invested in the S&P 500 at the March 2000 peak had a negative real total return until May 8 2013, 13.13 years later.
Half a typical investing career, give or take.
For comparison, ten year TIPS yields in March 2000 were roughly inflation + 3.9%.

One can buy the broad market all the time, but one should then also be aware that at times of high valuation there is no particular prospect for an increase in wealth from the current purchase.

My point is merely that the DCA strategy can give very good results or very poor results, depending on the era it is started.
Somebody starting in (say) 1962 would have been better off with zero-real-return cash savings even 20 years later.
Though the world has changed a lot, based on earning power the broad US market is 85% more expensive today than it was in 1962.

And the times that DCA seems like the smartest idea are often the worst times to actually do it, as they are the times that markets have had a very strong recent stretch.
Never mistake the cycle for the trend.

Valuations do matter.
In November 1999 Mr Buffett wrote that famous Fortune article about how the next 17 years wouldn't be anything like the prior 17.
His guess of real total returns for the next 17 years was around 4%/year (first paragraph on final page).
The actual result was 2.5%/year. It was less than 4.0%/year for all ending dates till roughly the 20th anniversary in late 2019.
(the real result for Berkshire stock for the 17 years starting from that article was 6.42%/year)
On the lighter side, the broad US market isn't quite as expensive as it as when that article was written in 1999.
And Berkshire stock isn't expensive at all.

Jim

"And Berkshire stock isn't expensive at all."

With regard to the S&P overall valuation relative to Berkshire, the current market value of our equities (not counting some foreign stuff)
is $375 billion against a market cap of about $744 billion. Call it 50%. Significant to say the least.

If the S&P takes a hit and returns to a more modest valuation, so will Berkshire.

https://www.cnbc.com/berkshire-hathaway-portfolio/

If the S&P takes a hit and returns to a more modest valuation, so will Berkshire.

Sure, in terms of a price dip.

But one shouldn't make the assumption that Berkshire's equity portfolio is exactly as richly valued as the broad market is. It usually isn't.
Price dips which don't start from overvaluation are transient.

When looking at Berkshire's stock portfolio, it naturally breaks down into Apple and the rest.
For Apple, I personally value the business based on the trend of its look-through earnings, not the market value. Seen that way, the current market valuation level of Apple stock doesn't matter to the value of a share of Berkshire.

For the rest of the stocks, last time I checked it looked like the weighted average earnings yield of Berkshire's portfolio was about 7.17%, equating to a P/E of about 13.9.
It's just one possible yardstick, but that certainly doesn't seem dangerously stretched.
The simple average earnings yield among the S&P 500 stocks equates to a P/E of 17.6, superficially 26% more expensive than Berkshire's portfolio ex-Apple.
On a cap weight basis it's 21.4, superficially 53% more expensive.

Jim

Are you seriously telling young people in their wealth-building years to wait 14 years before adding to an index fund?
'''-
I'm seriously suggesting that EVERYONE should look at the price of what they're buying, investments or hamburgers.


I see validity in both, depending on where the individual is on their investing learning path. I look at this with respect to my own path.

I was born in 1978 and for as early as I can remember I had a red passbook savings account and US savings bonds my grandmother gave to me for every birthday and Christmas. I'm sure there were many dates along those early years where my meager balance could have been more optimally deployed but it was the educational experience of saving and delayed gratification that was valuable at a young age.

My grandparents were 'dirt poor' farmers but they were determined to provide the opportunity for each of their grandchildren to learn the value of investing (as they had learned from one of my grandfather's uncles). At the age of 13 every grandchild was setup with an IRA of which they funded half of the yearly maximum until the age of 21. My account was opened in 1991 and I believe it was originally with Invesco in the American Fund with an insane 5.0% front end load. I mowed lawns and did other jobs around the farm to fund my other half to the max. Once again the educational experience, being exposed to investing, was the value because it led me to reading and learning. I wasn't ready for the deeper exploration into valuation but habits were forming.

By the time of the dot com crash in 2000/2001 I was graduating from college, lurking around the Fool and Yahoo boards, and experiencing a loss in my investments that equaled 2-3x my initial yearly starting salary out of college (I recall owning a Putnam tech fund that was the highest return mutual fund in 1999 that subsequently lost over 95% of it's value). Far from optimal, a major setback, but WOW what an education. I wasn't ready to learn about valuing my investments before, but I was now! It still took me over a decade to really grasp the core concepts, and I still have much to learn, but the foundations were set early even with suboptimal guidance.

My oldest will be 13 this year and I plan to carry on the tradition of opening a ROTH IRA for him. I will probably control how the funds are invested (likely BRK to begin with if it's trading at or under median Price to IV, ha!) because, unlike my grandparents, I have a better understanding of what price and value mean but regular contributions from him will be a requirement to begin building the habits. When he's ready to listen to the concepts of valuation (sooner than I was hopefully) we can have that discussion. Even if he wants to invest in meme stocks or crypto at some point I don't think I will stop him. Some lessons in life have to be learned the hard way, but I will do my best to make them as cheap as possible.


Jeff

On the lighter side, the broad US market isn't quite as expensive as it as when that article was written in 1999.
And Berkshire stock isn't expensive at all.

Berkshire isn't expensive. But is it ever?

I consider $359.52 intrinsic value. Peak book to date of $231.95 x last four quarters peak P/B of 1.55.

The price while I'm typing this is $345.03. I'm more likely to be a seller in the near future than a buyer.

Although if I was being forced to invest money today Berkshire would get it.

And maybe that's the point.

A lot of stuff is expensive. Berkshire is reasonable.

Berkshire isn't expensive. But is it ever?
I consider $359.52 intrinsic value. Peak book to date of $231.95 x last four quarters peak P/B of 1.55...

Fair question. I'd say so.

I personally define a "fair price" for any investment as the price that gets you inflation + 6.5%/year from your purchase date.
That's basically Siegel's constant, the historical average real total return from the average US stock in the average year.
You can choose different time horizons for the investment, but I prefer to pick the average price over a fairly long stretch as the end date, so it isn't dependent on any one lucky or unlucky exit price.
So, for example, if you take a purchase on a given date, and compare that to the average real price 4-10 years later, that's like a super-smoothed endpoint on a 7 year hold.
You can annualize that as a 7 year rate of return.
If that's more than inflation + 6.5%, Berkshire wasn't overvalued when you bought.

On that measure, Berkshire hasn't been overvalued very much of the time, at least not since the late 1990s bubble pricing ended, but sometimes.

There was a fairly long stretch March-August 2007 that P/peak-book values were below 1.55 but you still got lower than average inflation + 6.5%/year in the next 4-7 years.
The lowest P/peak-book in that stretch that led to a lower average return was 1.47.

Quite a few stretches in 2005-2006 as well.
The lowest P/peak-book that got you under inflation + 6.5% was 1.432.

So, based on history, and using my dubious definition, sometimes valuations below 1.55 times peak known book turn out to have been "overpaying".

Historically, since 1997:
a purchase on a day with P/peak-book under 1.55 (50% of all days) had about a 32% chance of not hitting my real return hurdle.
a purchase on a day with P/peak-book under 1.50 (42% of all days) had about a 20% chance of not hitting my real return hurdle.
a purchase on a day with P/peak-book under 1.45 (34% of all days) had about an 8% chance of not hitting my real return hurdle.

So, at least with the very modest valuation multiples we have seen in recent years, and my dubious definition of "Fair price", one could make a case that Berkshire is sometimes "overvalued" even at P/peak-book in the 1.45 to 1.50 range.

The good news:
The average ending price method I used to calculate the returns assumes you have no discretion about which day you sell: you don't consider valuation levels.
Surely in any given 6 year "endpoint" stretch there are some good valuation days which would get you a return better than selling the average day.

Jim

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