Sunday, March 25, 2012

Burton Malkiel quote (and reading history)

Bob Rodriguez has often told the story about meeting Charlie Munger while at USC. He asked Munger what one thing he could do to become a better investment professional, and Munger replied "Read history! Read history! Read history!"

Our stated goal at Chanticleer Investment Partners is to grow our clients' capital and maintain their purchasing power over time by earning returns significantly better than the rate of inflation. Although we don't claim to have any predictive power as to when inflation may become a significant issue or if deflationary forces will once again rule the headlines first, we think it is a risk worth preparing for ahead of time. Besides reading more current books about the history of the market and inflationary times, we also find it interesting to go back and read things written as those events were happening (if you have any good recommendations, feel free to pass them along!).

One book written during an interesting time is Burton Malkiel's The Inflation-Beater's Investment Guide: Winning Strategies for the 1980s, which Malkiel finished writing in January 1980 (ironically, the same month gold reached its peak). He makes the case in the book that stocks would be the best investment (15%+ per year) for the years ahead and the best hedge for the inflation that may continue to be an issue. As a reference to valuations then compared to today, the Graham-Dodd-Shiller PE ratio (10-year trailing earnings) in January 1980 was just below 9, compared to about 23 today. And profit margins were about half in 1980 what they are today, so you had a low PE on low profits versus a high PE and record profit margins today.

So the valuation winds for the market as a whole are NOT at one's back today like they were in 1980. As Ed Easterling shows in his books, the main driver of overvalued markets getting re-rated to lower a lower PE ratio is a change from relatively stable inflation levels to either inflation or deflation. It may sound a little counter-intuitive to hold a lot of cash when one is concerned about the eventual erosion of the dollar's purchasing power, but in a period when inflation is still fairly stable and the risks to that changing--whether towards deflation or inflation--over the next few years may be nearly as high as they have ever been, I think a high level of cash, patience, and a diligent effort preparing to put that cash to work when the opportunities present themselves is the prudent course of action in today's market.

If the governments and central banks of the world are able handle the storms better than I expect, maybe high cash balances will just be awaiting opportunities that will never come. But if the opportunities we can find today perform as we hope and the main cost of holding a lot of cash is the cost of missed opportunity by having that cash yielding close to nothing, that is a cost I think is worth taking compared to being too fully invested as stocks get re-rated when price stability moves towards instability.

Below are the last few paragraphs of Chapter 1 of Malkiel's book that I thought were of interest and worth posting here.

"It is very difficult to be neutral about things so difficult to forecast as the future earnings prospects of corporations (or other investors' hopes and fears). Moreover, there are styles and fashions in investors' evaluations of securities. As I shall indicate in Chapter 5, this extreme overreaction to growth stocks following the collapse of the Nifty Fifty in the 1970s has created excellent opportunities for investors in the 1980s.

The Practical Theories for Investors

This chapter began with a description of the firm-foundation theory of stock values which indicated that "fundamental" considerations such as earnings and growth do influence the prices of common stocks. There is a yardstick for value, but we have seen that it is a most flexible and undependable instrument. To change the metaphor, stock prices are in a sense anchored to certain "fundamentals" but the anchor is easily pulled up and then dropped in another place. For the standards of value, we have found, are not the fixed and immutable standards that characterize the laws of physics, but rather the more flexible and fickle relationships that are consistent with a marketplace heavily influenced by mass psychology.

Not only does the market change the values it puts on the various fundamental determinants of stock prices, but the most important of these fundamentals are themselves liable to change depending on the state of market psychology. Stocks are bought on expectations--not on facts. Future earnings growth is not easily estimated, even by market professionals. In times of great optimism it is very easy for investors to convince themselves that their favorite corporations can enjoy substantial and persistent growth over an extended period of time. By raising his estimates of growth, even the most sober firm-foundation theorist can convince himself to pay any price whatever for a share.

During periods of extreme pessimism, many security analysts will not project any growth that is not "visible" to them over the very short run and hence will estimate only the most modest of growth rates for the corporations they follow. But if expected growth rates themselves and the price the market is willing to pay for this growth can both change rapidly on the basis of market psychology, then it is clear that the concept of a firm intrinsic value for shares must be an elusive will-o'-the-wisp. As an old Wall Street proverb runs: No price is too high for a bull or too low for a bear.

Dreams of castles in the air, of getting rich quick, do play a role--at times a dominant one--in determining actual stock prices. In this chapter I have documented several examples from both the distant and the recent past. Why are memories so short? Why do speculative crazes seem so isolated from the lessons of history? I have no apt answer to offer, but I am convinced that Bernard Baruch was correct in suggesting that a study of these events can help equip investors for survival. The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard, really, to make money in the market. What is hard is to avoid the alluring temptation to throw money away on short, get-rich-quick speculative binges.

And yet the melody lingers on. While common stocks are virtually ignored, gold has recently been advancing toward $1000 an ounce. At the end of the 1970s, eager real estate speculators in places like California were turning properties around with profits of 25 percent in a matter of days. The notion is always the same: there will always be some greater fool to pay an even greater price. Will the music stop again?

Markets, whether for common stocks, real properties, or precious metals, will not be a perpetual tulip-bulb craze. The existence of some generally accepted principles of valuation does serve as a kind of balance wheel. For the castle-in-the-air investor might well consider that if prices get too far out of line with normal valuation standards, the average opinion may soon expect that others will anticipate a reaction. There is, after all, a firm foundation of value, albeit a very loose and flexible one. Sooner or later, however, all skyrocketing investments must measure up to this basic foundation of value. The ability to avoid being swept up in some frenzy of speculative enthusiasm is probably the most important factor in preserving the real value of one's capital and allowing it to grow. The lesson is so obvious and yet so easy to ignore."