2012 Speaker Series: Dr. Jeremy Siegel
December 15, 2012
Market Summary – 3rd Quarter, 2012
“Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stock-picker.” – Peter Lynch (1994)
Our society appears to have developed a case of collective attention deficit disorder. Older generations trained their brains to find instant gratification through fast food, microwave meals, and television remote controls. Younger generations seem to conduct their lives moment-to-moment on smart phones and Facebook, where they can share and “tweet” even the most mundane of everyday activities to a cadre of followers in their pursuit of instant approval and validation. The media is obsessed with instant response to every event, trying to extrapolate dramatic short-term happenings into a long-term trend. Investors can be excused if they have a difficult time following the advice from Peter Lynch provided above. Too often, their instinct is to let emotions and short-term thinking cloud their better judgment.
One person who has avoided the obsessive focus with the here-and-now is Dr. Jeremy Siegel, Professor of Finance at the prestigious Wharton School of Business. Professor Siegel is one of the world’s most prominent authorities on economic and financial markets, and author of Stocks for the Long Run, named one of the ten best investment books of all time1. As the featured guest at this year’s recently held annual MPMG Speaker Series event, Dr. Siegel presented evidence as to why stocks, despite short-term periods of underperformance and high volatility, have been the greatest wealth creation vehicle in recorded history. In fact, equities have delivered almost twice the annual return of the next best asset class – bonds.
In addition, his data supported the thesis that stocks are undervalued based on historical metrics, particularly given today’s low interest rate environment. Finally, Dr. Siegel illustrated how the strength of emerging economies is changing the composition of world wealth and consumption, with developed economies like the United States and Europe becoming smaller components of a much larger global marketplace.
Buying when the price is right
Our value-based investment philosophy is predicated on the conviction that price is everything. The ability to buy the stock of a great business when it is trading at a low valuation is the best – and safest – path to generating long-term wealth. Dr. Siegel’s data supports this premise, as he demonstrated that stock returns are highest when valuation (as measured by price to earnings ratios, or P/E) is low (see chart below).
A limitation of this data is that it ignores the fact that investing in stocks is really investing in businesses, and as value investors we seek to buy great businesses at low prices, not all businesses at low prices.
The chart illustrates that equity returns are far below the historical trend line. Stock returns, as reflected by their current low price, make a compelling argument for the value opportunity that exists in equities. This comes on the heels of the go-go period of the late 1990s, when returns were markedly above the long-term trend line. Calculating an average necessitates that long periods of underperformance (our current market) must be followed by periods of above-average returns in order to revert to the real long-term average market return rate. Dr. Siegel’s data stretches back over 200 years and the reliability of returns reverting to this long-term trend line is undeniable. This 200 year period encompasses periods of tremendous fear and uncertainty, be it the Civil War, the Great Depression, two World Wars, the Cuban missile crisis, six U.S. Presidents being shot, terrorism attacks, oil shortages, and more recently the Great Recession. The data demonstrates quite clearly that while stock valuations and returns can fluctuate in the short- term, over the long-term they are very stable.
Stocks on sale
It should come as no surprise that valuations, or how much investors pay for a company’s earnings, are currently also below the long-term average. However, what is surprising is that equity valuations remain depressed even with strong growth in corporate earnings. Despite the dour mood of the market and pessimism regarding corporate growth prospects, earnings for companies in the S&P 500 Index are expected to grow by approximately 10% next year – greater than the average annual growth rate of the past five years and in line with the average annual growth rates of the past 10 and 20 years.
Yet valuations have not kept pace with earnings growth. The P/E ratio of the S&P 500 Index is approximately 14x the past 12 months earnings and only 12x next year’s projected earnings. This is below the 50 year average P/E ratio of 15x, but more importantly, considerably below the 19x average P/E ratio when interest rates are below 8%. When borrowing money is easy and inexpensive, it encourages businesses to borrow in order to fund their expansion. As a point of reference, the yield on the 10-Year U.S. Treasury bond is now approximately 1.6%. Based on the historical P/E averages, stocks could now be undervalued by more than 35%.
How do opportunities line up today?
Bonds have enjoyed a tremendous run dating back to the double-digit interest rate days of the early 1980s when Federal Reserve Chairman Paul Volcker became determined to break a spell of rampant inflation. Since that time, interest rates have trended lower. As interest rates decline, the price of bonds already in the market that pay higher interest goes up. This explains why bonds have generated such an attractive total return in recent years. However, this trend is poised to reverse. With interest rates at historic lows, and the 10-Year U.S. Treasury bond yielding less than inflation, it would appear that interest rates have little room to fall further. Therefore, existing bonds will be worth less as interest rates rise.
Dr. Siegel’s historical data shows that the annual returns generated by bonds in the past 30 years have been well in excess of their long-term averages over any meaningful period of time. If bonds and stocks continue to return to their long-term averages, bonds will revert to lower returns, while stocks are poised to begin a strong recovery.
Markets are turned on their head – maybe conventional wisdom should be too
Those giving serious consideration to the challenges that await them in retirement know that increasing their purchasing power is the primary objective. The most desirable asset is one that can generate the highest real returns and offer the best opportunity to keep pace with rising living costs over a potentially decades-long retirement. This would seem to augur well for equities.
At the same time, investors have long bought into the conventional wisdom that suggests that they scale back their stock holdings as they grow older in order to protect themselves from volatile markets. We maintain that safety is not achieved by acquiring a specific asset class, but rather by buying assets that are priced at fair or even bargain prices.
Not all stocks are created equal, but as Dr. Siegel has pointed out, stocks in general offer solid value today – laying the foundation for a generational wealth building opportunity.
The next generation of profit creators
Investors shouldn’t be convinced alone by expectations that are based on the historical record. More important is what the future holds. Will there be the kind of growth over the coming decades that fueled the dramatic wealth creation we experienced in the past? Are there unappreciated and inexpensive companies with critical products that will solve tomorrow’s problems? Or are developed markets such as the U.S., Japan and prominent European countries growing old together and seeing an end to their economic glory days?
Let’s acknowledge that the U.S., Japan and Europe are growing older. By 2035, the ratio of retired Americans will be equivalent to 45% of the workforce that must support them. It’s worse elsewhere – a full 50% in Europe and 80% in Japan (meaning 5 workers support every 4 retirees).
This leads to the question of where will the workers come from in order to support all of these retirees? Just as important, as retirees begin to sell stocks within their portfolio in order to pay for living expenses, will there be buyers to keep the stock market growing as it has in the past?
Dr. Siegel points out that the good news for the U.S. and other aging countries is that the rest of the world is much younger, with a far larger percentage of workers. China is growing the oldest of the major developing countries, but at worst in 2035 will still have a 3-to-1 ratio of workers to retirees, comparable to where the U.S. stands today. India’s ratio will be about 6-to-1, and in emerging markets worldwide the average will be around 5-to-1. In other words, there will be no shortage of workers globally to fuel economic growth.
The revised world order
In positioning our portfolio to benefit from the world’s long-term investment opportunities, it is important to appreciate how the world economy is developing. In the coming years the United States will no longer dwarf other economies in size, but will instead become a smaller piece of a bigger economic pie. It is estimated that over the next 20 years the emerging economies in Asia, led by India and China, are forecast to become bigger than the developed economies of the United States, Europe, and Japan.
With this economic expansion comes a growing middle class – and tremendous opportunity. Middle-class spending is expected to grow significantly, particularly in the Asia Pacific region. By 2025, annual consumption in emerging markets will reach $30 trillion – the biggest growth opportunity in the history of capitalism.
We are positioning our portfolio with an eye on this long-term trend and the ripple effects that it will have not only on consumer discretionary spending in those regions, but on businesses that create products and services to meet the necessities of life.
The opportunity to capitalize on economic development opportunities across the world presents itself at a time when stocks remain undervalued. This intersection of historically favorable market trends and new economic and technological developments stands out as a most exciting opportunity that investors can find in today’s market. In order to fully benefit from this opportunity, one must still identify the right companies. This is the time for investors to use foresight and long-term vision, and overcome the short-term fears that are fanned almost daily by the media. Wealth building opportunities abound for those who can see through the fog of the daily noise machine.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.