Be fearful when others are greedy and be greedy when others are fearful
Or, contrarian investing pays.
Bill Gross of Pimco, the bond man himself, writes in his monthly market analysis that the "cult of equity" is over, and the consistent long term returns for stocks since 1912 will be viewed as a historical freak.
Gross follows David Rosenberg from Gluskin Sheff who declared yesterday that the equity cult is over.
These pronouncements come as equity funds suffered their biggest outflows in the last two years. For the week ended July 25, investors pulled $11.5 B net from equity funds (mutual funds and etfs) and $3.5 B in taxable bond funds, according to Lipper.
Clearly, investors are hesitant about stocks and more comfortable with bonds, despite historically low bond yields and a guaranteed loss of capital in bonds as interest rates pick up. Therefore, it is quite likely that Gross’ and Rosenberg’s predictions would be received in sympathy.
But they are wrong.
Gross’ arguments to support his prediction are profound on the surface but completely misleading and erroneous. He questions how one part of the over all economy (stock appreciation) can consistently outpace the GDP. Clearly, as he says, this can’t continue, otherwise the stock owners will end up owning the world! Henry Blodget picks apart his arguments writing for Yahoo Finance, when he points out the difference between appreciation and returns. Blodget also points to the fact that the bulk of long term returns in equities have come from dividends.
There are structural reasons why equities return more than bonds, and these haven’t changed
Anyone who has an elementary knowledge of how businesses are organized knows that the capital structure is essentially made up of debt and equity. The company produces value, or a return, on this total capital. Return on the debt is essentially limited by two factors – the agreed upon cost of debt, as in the coupon on the bonds, and the limitation of the risk of default given to the debt holders by giving them preferential ownership of the company assets over the stock holders.
Bond holders are more likely to collect on their investment in the event the company goes bankrupt as they are first in line to take over the assets. Stock holders may be left with very little, or nothing. Since they bear unlimited risk of total capital loss, they demand higher returns then the bond holders.
In most cases, the risk of default for a company is low, therefore stocks have value.
In fact, the higher the debt a company carries, more default risk is priced into the stock, and the potential rewards or returns from owning the equity is higher. The capital structure of a company gives leverage to the stock holders.
Other way to say this is for a company that has both debt and equity holders, if the total capitalized value of the company rises in direct proportion to the GDP, the value of the debt component will rise less than the GDP rate, while the equity component will rise at a greater rate. This is assuming the capital structure remains constant.
Gross will be right in his estimate that the overall stock market returns (assuming he is talking about real returns after inflation) will be lower than the past, only if the overall capital structure of US businesses tilt more heavily to equity and reduce their use of debt financing.
But debt is and has been a cheaper way to finance a business. Unless this changes (let’s say the interest rates go up a lot and the inflation remains low), companies will continue to use debt.
If Gross is Right, Index funds’ days are numbered
Eventually, you can’t get outstanding returns by doing the same thing that every one else is doing. If there is indeed a structural change in the economy going forward that reduces equity returns for many decades to come, investors will continue to pull their money out of equity funds, which are in most cases closet index funds.
However, no one is suggesting that the overall business growth will be negative or some sectors will not see a growth while others decline. In fact, it is very likely that some good companies will continue to do better then the competition and gain market share, while similar companies that are not well managed might lose market share and go out of business.
Being selective and picky about your investments will serve you well and will beat picking random stocks or not caring at all about where you invest (i.e. buying the whole market through an index).
Find the best stock website for value investors
But of course, Bill Gross is wrong as stated above.
Be greedy when others are fearful
This is the whole thesis of value investing. The idea that "this time it is different" keeps rearing its head every few years or decades, and every time it gets shown up as bunk. Details may change, but the very basic principles of good business and solid stock selection remain true as ever. Forget history and you are doomed to repeat it. Going beyond the clichés, I do want to point out to you that you are weighing two things as you decide to invest in stocks today
- On one hand, the historically validated and time-tested fact that buying undervalued stocks outperform the market, and
- On the other hand, another historically validated and time-tested observation that most economic predictions are wrong
Ironically, the Fact #1 works better when majority of the investors (the herd) ignores the Fact #2 and makes their investment decisions based on short term emotional triggers.
What will you do?
Is the market cheap today or is it expensive?
I get asked this question a lot and I find it an interesting question on many different levels
- First, if you are investing in individual stocks, you should be more concerned with whether the stock you are buying is cheap or expensive
- Even in expensive markets, there are always sectors/industries/companies that are cheaper than they ought to be
- Well picked stocks will stand up well in ALL market conditions, because they have much more than the overall market driving their performance. For example, a good solid growing business, some identifiable macro economic trends, etc. Before you protest that economic trends are unreliable, I would submit that some trends are more reliable then others. For example, I have not yet found anyone disputing that the proportion of retirees in US is set to grow in coming years, or that a growing Chinese population will consume more food and other resources.
You need to ignore the market and focus on the business. This will help you find stocks that continue to generate outstanding returns in the future and help you make confident investment decisions.