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Equity Risk and Return June 15, 2011
Concerns over the outlook for the global economy have preoccupied investors over the last six weeks. Stocks are down 6% from the April high and demand for bonds has pushed prices up and brought yields down to the lowest level for the year. After a 100% advance in stock prices since March 2009, this is a minor draw down and within the normal range of market volatility and the S&P 500 is still up slightly in 2011 for the year-to-date.
Macroeconomic forecasting is not an essential component to successful equity investing. If we knew today what the state of the economy would be over the next year or two, would that change the way we would invest? No, probably not. We believe successful equity investing can be achieved through developing an understanding of companies and their ability to generate sustainable profits, whatever the economic climate. What matters most is not whether the market is being supported by news of stronger economic activity, but whether companies are capable of producing profits that are not reflected in current valuations.
Risk-taking should be proportional to expected return. There are two parts of the risk equation that need to be understood – business risk and valuation risk. It’s critical that investors have a basis for evaluating the level of risk involved in running the business. The prospect of a good outcome for the investor is based on the valuation priced into the equation. Investors have to do their homework to avoid paying too high a price for what looks like an attractive investment opportunity.
We’re not talking about volatility. Over the short term, price changes have little to do with changes in inherent intrinsic value. Prices of stocks fluctuate a lot more widely than company fundamentals. What matters is not relative prices, but relative values. Valuations are not fixed, but moving targets that have to be adjusted to reflect shifts in cyclical economic and sector trends, revenue growth and margins. Since investor sentiment affects prices, we also need to understand what stages we are in economic and market cycles.
Valuation is a key component of the equity investment process. The valuation metrics may vary, but the most basic approach is to determine the present intrinsic value of projected cash flows over the life of the investment, assuming that over time the real value will be reflected in the market price. There are always risks of which we are aware and unknown risks. An investor will do well to analyze the most likely risks for a given investment. Otherwise it’s a price speculation, not an investment.
Dips in the market and moderate corrections of 5% - 10% can occur at any time for any reason. Nevertheless, in the past severe corrections or bear markets have not begun from a time when investors are cautious like they are at the present and when valuations are below the historical average. Despite the recent mania for some new-offered IPOs, and the recovery in stock prices, in general investors seem to be overly preoccupied with the recent slow-down in the economy.
Investors who are more risk-averse might be inclined to turn to bonds as possible safer havens than equities. As investors have become more cautious, buying demand for bonds has bid prices up to a point where they provide low current returns and are exposed to interest rate and inflation risks for which they will not be rewarded. Investors who can take a longer view in the current world of low returns can find equities, especially the largest companies, wherever domiciled, that are selling at valuation levels that are attractive, and so it is our perspective that equities should be over-weighted as the core position in most investment portfolios.