By Geoff Gannon
The first quarter of 2006 is over. Now is a good time to
reflect on stock prices and the opportunities they present.
Bargains are scarce. Equities are expensive. In recent weeks,
Iíve heard several fund managers say valuations are still
attractive. I donít agree. Generally speaking, valuations are
unattractive. Returns on equity are higher than historical
levels. A market-wide return on equity of 15% is
Price-to-earnings ratios may not fully reflect how expensive
stocks are. Price-to-book ratios are more alarming.
There are two additional concerns. Most discussions of the
relative attractiveness of equities focus on the S&P 500 and
forward earnings. The S&P 500 is not the most representative
index. It may not be the best index to consider when looking
Forward earnings are (necessarily) estimates. Where current
returns on equity are unsustainable, projected earnings that
use similar returns on equity may overstate the earnings power
of equities in general. This can occur even where the
appear reasonable given current earnings. If you start with
unsustainable base earnings, you are likely to overestimate
future earnings even if you truly believe you are assuming
modest earnings growth.
Assets in general are pricey. Value investors have few places
to turn if they continue to insist upon a true margin of
Bonds are unattractive. Long-term inflation risks make U.S.
treasury, corporate, and municipal bonds a foolís bet. There
little to gain and much to lose. The know-nothing investor who
buys a top-quality bond today and holds it for decades may
well find his purchasing power diminished.
There may be some select opportunities in foreign equities.
But, these are difficult to evaluate. Foreign government
obligations are also difficult to evaluate, but that isnít
of a problem for value investors, because most foreign
government debt is priced to perfection. Youíll have to be
willing to take a lot of uncompensated risks if you want to
Of course, there are exceptions to every rule. There may be a
few bonds out there that are attractive. There certainly are a
few attractive stocks out there. But, even those stocks that
look very attractive relative to their peers donít look nearly
as attractive when compared to past bargains.
Value investors face a difficult choice. They can assume stock
prices will return to historical levels, and hold cash until
the correction comes. Or, they can accept the reality they
There is no logical reason stock prices must necessarily
to historical levels. During the twentieth century, real
after-tax returns in diversified groups of common stocks were
very high relative to other investment opportunities. There
have been various reasons given for why this occurred. Many
have said these returns were possible, because of the higher
risks involved in holding equities. Over the long-term, risks
were somewhat higher than todayís investors seem to remember,
but they were hardly severe enough to justify the kind of
performance spreads that existed during much of the twentieth
True, if you bought at inopportune times, it was possible to
remain in a fairly deep hole for a fairly long time. But, if
you gave no real consideration to the timing of your purchases
or the prospects of the underlying enterprises, you did better
than many bondholders who chose their investments with the
This is a disconcerting problem. It may be that most investors
are overly sensitive to the risk of an immediate ďpaperĒ loss
in nominal terms, and therefore overlook the much greater risk
of a gradual loss of purchasing power. Issuing fixed dollar
obligations may be the best bet for any business or government
that seeks to swindle investors.
For the sake of the common stockholders, I hope many of the
best businesses continue to issue such obligations when money
is cheap. Corporate debt gets a bad name, because it tends to
be overused by those who donít need it and shouldnít want it
(and, of course, by those businesses that do need it but won't
survive even if they get it). The businesses that would
the most from the use of debt usually appear to have more cash
than they could ever need. But, itís best to think ahead. For
truly high quality businesses, the cost of capital will
fluctuate far more wildly than the likely returns on capital.
If, during the last hundred years, stocks really were far
cheaper than they should have been, is there any reason to
believe stock prices will return to past levels? The past is
often a pretty good predictor of the future Ė but, not always.
Itís difficult to say whether, over the next few decades,
valuations will, on average, be higher or lower than they are
today. However, it isnít all that difficult to say whether, at
some point over the next few decades, valuations will be
or lower than they are today. The answer to that question is
almost certainly yes. They will be higher and they will be
lower. Maybe for a few years or a few months. Maybe for a full
decade. I donít know.
What I do know is that value investors will have opportunities
to make investments with a true margin of safety. But, should
Thatís the most difficult question. Today, I am not finding
opportunities that look particularly attractive when compared
to the best opportunities of past years. But, I am still able
to find a few (in fact, a very few) situations where the
expected annual rate of return is greater than 15%.
That will be more than enough to beat the market. It will also
likely be enough to provide a material increase in after-tax
purchasing power. Thatís not guaranteed, but it hardly seems
holding cash would offer the better odds in this regard.
So, is an expected annual rate of return of 15% good enough?
it reasonable to bet on the good opportunity that is currently
available instead of waiting for the great opportunity that
yet become available?
Iíll leave that for you to decide.
About The Author: Geoff Gannon writes a daily value investing
blog and produces a twice weekly (half hour) value investing
podcast at: www.gannononinvesting.com