Tag Archives: valuewalk

Buy-And-Holders Predict Future Returns Every Day, While Claiming That Predictions Don’t Work

By Rob Bennett Buy-and-holders don’t believe in return predictions . They say it is not possible to predict returns effectively. Their cardinal rule is that investors should never engage in market timing, and so they object strongly when valuation-informed indexers use return predictions to change their stock allocations. That’s market timing. It doesn’t work. It’s crazy. It’s a mistake. They believe this stuff. They are sincere in their repulsion for market timing and for return predictions. But the buy-and-holders make return predictions themselves! They don’t know it. They fool themselves into thinking they are not making return predictions. But it’s not possible to buy stocks without first forming some idea in your mind as to what return you expect to obtain. The buy-and-hold idea that it is not a good idea to make return predictions is not only strategically flawed, it is a logical impossibility. Say you were thinking of buying a car, and for some odd reason you vowed not to consider price when doing so. Could you do it? You could physically do it. But you couldn’t do it with a clear mind. Human reason demands of us that we consider price when trading money for something that we want to obtain. It works that way with stocks too. It’s not possible to buy stocks without the thought entering your head that you would like to obtain a return on your money that is greater than the return you could obtain from buying less risky asset classes. And it’s not possible to go ahead with the purchase without some notion of what return you expect to obtain entering your thought process. The buy-and-holders kid themselves about this. They need to believe that return predictions are not possible or they could not remain buy-and-holders (buy-and-holders who elect to become clear thinkers are transformed into valuation-informed indexers!). But they are not able to keep themselves entirely in the dark. Common sense intrudes. That’s why buy-and-holders become uncomfortable when people like me write on the internet about the implications of the last 35 years of peer-reviewed research in this field. Buy-and-holders believe they are going to obtain a return of 6.5 percent real on their stock investments. That’s the average return. So that’s their default. They compare the 6.5 percent return they expect to obtain from investing in stocks with whatever return they can obtain from less risky asset classes and elect stocks when the expected return from stocks is better. It always is. That’s why buy-and-holders invest most of the money that they do not expect to need within a few years in stocks. Buy-and-holders, of course, understand that they are not going to see that 6.5 percent return every year. There are some years in which stocks provide a return of 30 percent, and there are some years in which stocks provide a return of a negative 30 percent. But a positive 6.5 percent is the norm. That’s what buy-and-holders expect. That’s what buy-and-holders predict. Ask a buy-and-holder what he expects his stock return will be after the passage of 10 years. He will say that he expects something in the neighborhood of 6.5 percent. He doesn’t expect precisely that. Of course, valuation-informed indexers don’t expect their predictions to apply precisely either. He view the predictions we make by looking at the valuation level that applies on the day we make our stock purchases as in-the-neighborhood numbers. That’s how buy-and-holders view their prediction that the usual 6.5 percent return will establish itself once again. The reality, of course, is that there is a strong chance the 6.5 percent return will not re-establish itself. It’s reasonable to expect such a return for stocks purchased at fair value prices. But stocks are frequently sold either at inflated prices or at deflated prices. When stocks are sold at wildly inflated prices or at wildly deflated prices, it is not likely that the 6.5 percent return will apply in 10 years. The likelihood is that a return a good bit lower than 6.5 percent will apply (for stocks purchased at wildly inflated prices), or that a return a good bit higher than 6.5 percent will apply (for stocks purchased at wildly deflated prices). A poster at the Bogleheads Forum once stated this idea in compelling fashion: “I don’t go into a bank and say ‘I’d like to buy three certificates of deposit’ without first asking what rate of return applies – Why should it be different when I buy stocks?” It shouldn’t be any different. We cannot know the return we will obtain from stocks with precision. But then, we cannot know the return that we will obtain from certificates of deposit with precision either. The inflation rate is unknown at the time of purchase of certificates of deposit, and the inflation rate affects the real return obtained. With certificates of deposit, we all do the best we can. We look up the nominal return and form some reasonable expectation of what inflation rate might apply. We educate ourselves to the best of our ability. This is the step that buy-and-holders fail to take when they buy stocks. Why? Buy-and-holders want to know the return they will obtain from the certificates of deposit they purchase. Why don’t they want to know the return they will obtain from the stocks they purchase? They want to believe in bull markets. They want to believe that the 6.5 percent average return is a floor that applies even when prices are insanely high, but that returns that exceed the 6.5 average return are real and do not pull future returns down. They want to believe in a fantasy that makes it impossible for them to purchase stocks in as informed a manner as they purchase certificates of deposit. Disclosure: None.

Shiller Was Warned Not To Tell The Truth About The Stock Market – And We All Heard The Message

By Rob Bennett Robert Shiller says in his book Irrational Exuberance that: “On several occasions I have discovered firsthand the pressure on public prognosticators to deliver positive statements about the market. Once, just before going on national television, the anchor looked me squarely in the eye and told me that what I said could conceivably have an impact on the market, and that people can get upset if they perceive prognosticators as disrupting the market.” I’d like to know what Buy-and-Holders think of that statement. Buy-and-Hold is rooted in the belief that it is economic developments, not investor emotion, that determine stock prices. If that were so, nothing that Shiller said could affect the market. Do Buy-and-Holders think that the television anchor’s worries were foolish ones? I don’t think they were foolish so much as dangerous. What Shiller or anyone else says certainly can affect market prices. Buy-and-Holders agree even though they follow a strategy rooted in a belief that only economic developments matter. I know because it is Buy-and-Holders who have insisted that I be banned at the 20 investing sites at which I have gotten the boot. If what I said didn’t matter, why would the Buy-and-Holders want to see me banned? The Buy-and-Holders haven’t convinced even themselves that only economic developments matter. We all filter out information that disturbs us because it threatens our confidence in our world view. Conservatives filter out information advanced by liberals and liberals filter out information advanced by conservatives and it has ever been so. It’s a universal phenomenon. What possible reason could there be for believing that it doesn’t work that way with stocks? A man hears what he wants to hear and disregards the rest. I filter out information casting doubt on the merit of the Valuation-Informed Indexing strategy. I am not aware of doing so, and I understand that it’s a bad idea to do so. I need to know the drawbacks more than anyone else does. It is foolish for me to tune out the words of my critics. But it’s hard to imagine that I do not often do so. Humans always tune out stuff they don’t want to hear. Is that not so? And it always hurts us. That’s also so. That’s why I see such a huge opportunity in Shiller’s research. If we were to begin taking Shiller’s research seriously, we could overcome the force that has made stock investing risky since the beginning of time. That force is self-deception. Do away with self-deception and you change the game in a fundamental way. Many people think it can’t be done. Since we always have engaged in self-deception re stocks, they think we always will. I am more hopeful because Shiller’s P/E10 metric quantifies the effect of self-deception. Now that we can tell people the dollar-and-cents price of following Buy-and-Hold strategies, we can persuade them to ditch the self-deception. People like to make money. We now have the tool we need to motivate investors to demand that Shiller and lots of others tell them the straight story. Even Shiller does not tell the straight story today. It is not my intent to be critical with that statement but to point out how deep the problem goes. Shiller’s next words in the passage that I quoted above are: “He was right, of course, to give me such advice, and I shudder to think that I (or anyone else) could ever help cause a market event that would cost some people their fortunes.” Huh? The television anchor invited an expert onto his television show and then discouraged that expert from sharing his true beliefs with his listeners. How could that possibly be the right thing to do? The television anchor should be ashamed of himself. Shiller should be proud of himself for sharing this revealing anecdote and also a little ashamed as well for soft-peddling the danger of the practice (which is widespread) described. Everyone does what the television anchor did. The newspapers celebrate price jumps even though all they do is raise the price of stocks, a good that all of us who hope to be able to retire someday must buy. Investment advisors brag about the good advice they gave when prices rise even though all price increases greater than those justified by the economic realities (that is, all price increases greater than the 6.5 percent real price increase that has been the price increase that has applied in the U.S. market for as far back as we have records) are temporary cotton-candy gains fated to be blown away in the wind as time passes. Retirement calculators assume 6.5 percent gains on a going-forward basis even when prices are insanely inflated and it is obviously unrealistic to expect such gains. Everyone lies in the stock investing field. Because everyone demands lies. Those who don’t lie are silenced. Those who don’t lie make the ones who do lie look bad. A bull market cannot survive truth-telling. And we all like those pretend cotton-candy gains. For obvious reasons. Two paragraphs down from the passage cited above, Shiller tells a different anecdote: “One investment manager for a pension plan spoke to me about how difficult it was for him to suggest in his public statements that people should perhaps be concerned about overpricing of the stock market. Despite his considerable reputation and apparent sympathy with the views expressed in my book, he seemed to be saying that it was not within his authority to make bold and unprovable statements contrary to conventional wisdom. He seemed to view his charge as interpreting received doctrine and that it would be considered a dereliction of duty to voice contrary opinions that came only from his own judgment.” We expect doctors to express their own judgment. That’s why they get paid the big bucks. It’s the same with baseball umpires. And with accountants. And with lawyers. And with engineers. And with every other kind of professional. The person giving investing advice is the only exception to the otherwise universal rule. Because of what the television anchor said to Shiller. Question Pretend Gains and they might disappear. No one wants that. And so the Pretend Gains grow bigger and bigger and bigger until the cost associated with their disappearance (which is ultimately inevitable) becomes so large that it causes an economic crisis. It’s a problem. Disclosure : None

How Share Repurchases Boost Earnings Without Improving Returns

By Obi Ezekoye, Tim Koller, and Ankit Mittal – McKinsey & Co Some actions that boost earnings per share don’t create value for shareholders. Share repurchases are generally a wash. Of all the measures of a company’s performance, its earnings per share (EPS) may be the most visible. It’s quite literally the “bottom line” on a company’s income statement. It’s the number that business journalists focus on more often than any other, and it’s usually the first or second item in any company press release about quarterly or annual performance. It’s also often a key factor in executive compensation. But for all the attention EPS receives, it is highly overrated as a barometer of value creation. In fact, over the past ten years, 36 percent of large companies with higher-than-average EPS underperformed on average total return to shareholders (TRS). And while it’s true that EPS growth and shareholder returns are strongly correlated, executives and naïve investors sometimes take that relationship too seriously. If improving EPS is good, they assume, then companies should increase it by any means possible. The fallacy is believing that anything that improves EPS will have the same effect on value creation and TRS. On the contrary, the factors that most influence EPS – revenue growth, margin improvement, and share repurchases – actually affect value creation differently. Revenue growth, for example, can increase TRS as long as the organic investments or acquisitions behind it earn more than their cost of capital. Margin improvements, by cutting costs, for instance, can increase TRS as long as they don’t impede future growth by cutting essential investments in research and development or marketing. For example, to improve EPS, managers at one company committed to an aggressive share buyback program after several years of disappointing growth in net income. Five years later, managers had retired about a fifth of the company’s outstanding shares, increasing its EPS by more than 8 percent. Yet the company was merely retiring shares faster than net income was falling. Investors could see that the company’s underlying performance hadn’t changed, and the company’s share price dropped by 40 percent relative to the market index. Share repurchases seldom have any lasting effect on TRS – and that often comes as a surprise to managers and investors alike. Given how often we hear executives advocate share repurchases because of their effect on EPS – and make the occasional argument for taking on debt to execute them – it is worth exploring the relationship between buybacks, EPS, and shareholder returns. We’ll begin by examining the empirical evidence and then look at the logic behind so many decisions to repurchase shares. Misguided math Companies that repurchase shares when prices are low can create value for those shareholders who don’t sell if the share price rises as a result. As our prior research has found, however, most companies don’t time these purchases well. 1 Rather, we find that many executives have come to believe that share repurchases create value just by increasing EPS. The logic seems to be that earnings across a smaller number of shares mathematically increases EPS, and if EPS increases and the price-to-earnings (P/E) ratio stays constant, then a company’s share price must increase. The empirical evidence disproves this. For while there appears to be a correlation between TRS and EPS growth, little of that is due to share repurchases. Much of it can be attributed to revenue and total earnings growth – and especially to return on invested capital (ROIC), which determines how much cash flow a company generates for a given dollar of income. All else being equal, a company with higher ROIC will generate more cash flow than a similar company with lower ROIC. But without the contribution of growth and ROIC to TRS, there is no relationship between TRS and the intensity of a company’s share repurchases (Exhibit 1). 2 Click to enlarge That’s because it’s the generation of cash flow that creates value, regardless of how that cash is distributed to shareholders. So share repurchases are just a reflection of how much cash flow a company generates. The greater the cash flow, the more of it a company will eventually need to return to shareholders as dividends and share repurchases. The error in valuing share repurchases in isolation The idea that share repurchases create value by increasing EPS also errs in its failure to consider other possible uses of the cash, such as paying dividends, repaying debt, increasing cash balances, or investing in new growth opportunities. What matters is the effect of a share repurchase relative to those other actions, not the effect of the repurchase on its own. Repurchase versus dividend Consider the effect of a hypothetical company using cash to repurchase shares relative to using it to pay an equivalent dividend. The company earns $100, has a P/E ratio of 15, and makes no investments, so managers can distribute the earnings as dividends or as share repurchases (Exhibit 2). Click to enlarge If the company pays out its earnings as dividends, its value will be $1,500. Shareholders will also have received $100, so the total value to the shareholders is $1,600. On a per-share basis, the share price will be $15. Since each share will also have received $1 in dividends, the total value and cash per share will be $16. If the company pays out its earnings by repurchasing shares, its total value will remain the same, $1,500, and shareholders as a whole will have received the same amount of cash, $100. On a per-share basis, for those shareholders who don’t sell, each remaining share will increase in value to $16 because the earnings are now divided by a smaller number of shares. For an individual share, this is economically equivalent to having a share worth $15 plus cash of $1 from a dividend. The mechanical effect on EPS is irrelevant. If the company pays a dividend, shareholders retain their shares and receive cash. If the company repurchases shares, the selling shareholders receive cash and the remaining shareholders have shares with higher value (but they don’t receive any cash). Overall, there is no change in value, just a change in the mix of shareholders. Repurchase versus debt reduction Comparing the effect of using cash to repurchase shares with using it to pay down debt is more complex. The reason is that when the company pays down debt, its capital structure, cost of capital, and P/E ratio change. Yet, because the enterprise value of the company stays the same, so does the value to shareholders. In this comparison, suppose our hypothetical company has $200 of debt in the base year (Exhibit 3). In that base year, the company’s enterprise value is $1,500 and its equity value is $1,300. Note that the enterprise value divided by after-tax operating profits is now different from the P/E ratio, at 15.0 and 13.8 times, respectively. The P/E ratio is lower because the higher leverage increases the riskiness of the equity, leading to a higher cost of equity. Click to enlarge Click to enlarge If the company repurchases shares, the enterprise value and equity remain the same as in the base year. In addition, shareholders receive $100 in share repurchases, so collectively, the shareholders will have $1,300 in equity value plus $100 of cash, for a total of $1,400. The remaining shares outstanding will be worth $14 per share. If the company pays down debt instead, the enterprise value remains the same, but the equity value increases by $100. Note that the enterprise value doesn’t change because the operating cash flows of the company have not changed. However, the value of the equity increases by the amount of cash retained and used to pay down debt. The value of the company to all the shareholders is the same as the sum of equity value and cash distributed in the share repurchase, or $1,400. A better way to understand internal rate of return – read this article . The equity value of $1,400 divided by a net income of $97 produces a P/E ratio of 14.4. Note that the P/E ratio in the base year, as well as in the share repurchase scenario, was lower, at 13.8. The increase in the P/E ratio is due to the declining leverage, leading to less risky equity and a lower cost of equity. On a per-share basis, repurchasing shares increases EPS, in this case from $0.94 to $1.01, but the increase in EPS is offset by the lower P/E ratio relative to the scenario of paying down debt. On the off chance that a company might borrow cash to repurchase shares, for example, it would increase a company’s EPS because the effect of reducing the share count is larger than the reduction in net income due to additional interest expense. However, with its increased debt, the company’s equity would be riskier and, all else being equal, its P/E ratio would decline-offsetting the increase in EPS. Repurchase versus investing Finally, consider what happens when, instead of repurchasing shares, our hypothetical company invests that same amount of cash, $100, back in the business. Assuming it earns a return of 15 percent, which exceeds its cost of capital, its income would increase by $15 (Exhibit 4). 3 Click to enlarge Assuming the enterprise-value multiple remains constant at 15 times, the enterprise value and equity value will increase to $1,725 – which is more than the sum of the equity value and the cash paid out in the share repurchase case. The EPS is also higher in the investment case. Investing at an attractive return on capital will always create more value than repurchasing shares, but it doesn’t always do so as quickly. In this simple example, we’ve assumed that the company earned an immediate 15 percent return on its investment. That’s often not realistic, since there will be a lag between when a company invests and when it realizes a return. For example, if the company didn’t earn a return until year three, its EPS for the first two years would be higher from share repurchases than it would be from investing. This explains the temptation to repurchase shares instead of investing. With a share repurchase, the effect on EPS is immediate, and with investing, it is delayed. Disciplined managers won’t fall for the short-term benefit at the expense of long-term value creation. Improving a company’s earnings per share can improve its return to shareholders. But the contribution of share repurchases is virtually nil. Disclosure: None.