Tag Archives: seeking-alpha

Basic Maths – If An Industry Has A Longer Economic Cycle, Valuation Metrics Should Reflect This

By Kevin Murphy Why might an investor look at a business trading at the top of its historic price range and think it cheap yet, on a different date, look at the same business trading near its lows and think it expensive? It should not really be possible, but it can happen if the investor is using a one-year earnings number – be that forward-looking or historic – to arrive at their valuation metric for a business. The inherent problem with this approach is that a business’s earnings can vary very significantly from year to year. As such, a single year’s figures may be good, bad or indifferent and, unless you have studied the history of the business, you are not going to know which it is. Far better, we would argue, to use a valuation metric that better takes account of the economic cycle. Long-term visitors to The Value Perspective will by now have guessed we are warming up to an article on our preferred valuation metric, the cyclically adjusted price/earnings ratio. Known for short as the ‘CAPE’, this effectively smooths out the peaks and troughs of an economic cycle by dividing a business’s current share price by its average profits over a number of years, adjusted for inflation. The idea of the CAPE was originated in the 1930s by value gurus Ben Graham and David Dodd, who suggested that seven or, better still, 10 years was enough to reflect the earnings cycle of a business or market. We, however, are no longer sure that universally holds true and since that may sound close to sacrilege – especially coming from a site dedicated to value investing – we should quickly explain why. Over the last 12 months or so, basic materials businesses – in other words, mining shares – have been showing up as increasingly cheap on a CAPE basis. Until recently, however, we have held back from investing and the reason we have done so is because we do not believe that even 10 years comes close to encompassing a full economic cycle for a mining company. From the initial discovery of iron ore, copper or whatever it may be – through obtaining planning permission to develop the site as well the necessary permits to operate it to sorting the transportation network, buying plant and machinery, hiring workers and so on – it perhaps takes a mining company five years just to bring a mine up to speed. In short, these are long-cycle businesses. So while we could just set up our computers to screen the market for Graham and Dodd profits, we believe it makes more sense to get to the bottom of what the CAPE metric is aiming to do, which of course is to arrive at an average. And if we believe seven or 10 years is not a long enough time period to generate a meaningful valuation for this sector, the answer is obvious – use a longer period. The past 18 months notwithstanding, the last decade has broadly been a very good one for miners. Go back 20 years, however, and commodity prices were much lower than they are now – as, by extension, were mining company profits. Averaging out these two contrasting decades should thus offer a much more holistic view of the profitability of the basic materials sector – so that is what we have done. (click to enlarge) Source: Schroders Datastream, 2015 As you can see, the sector currently stands on a 20-year CAPE valuation of 10x, which is very close to every other trough over the period. What particularly catches our eye is the way the sector has tended to bounce each time it has approached those lows while the potential upside, should valuations revert towards their long-term mean of 16.2x, helps to explain why almost every stock we have been looking at over the course of the last month has been in this space.

Built For Action

We humans are doers. We want to move, to make, to accomplish, to act. We do not take kindly to sitting idly by. We do not enjoy being bored and most of us struggle to sit quietly alone. It is increasingly easy to distract ourselves, to push away the quiet. Unless I’m asleep I am within arm’s reach of my phone about 95% of the day. Why sit quietly when Twitter and Instagram await?! Last year I read 10% Happier: How I Tamed the Voice in my Head by Dan Harris (at the recommendation of this post by Shane Parrish at Farnam Street). It is a great reflection on the difficulty of our busy lives and our ability to focus and slow down. Harris, after having a panic attack on national television, explores a path towards meditation and trying to relieve his anxiety. In doing so, he finds that meditation is hard. It’s really hard. Sitting and trying to focus on a single thing (typically breathing) without being distracted by thoughts of work, family, hobbies, to-do lists, dentist appointments and everything else. We are just not very good at doing nothing. This is especially true as investors. And we really don’t like it when are portfolios do nothing. We’re sitting in the doldrums right now. Returns everywhere are nowhere. Here’s a quick rundown of 12-month returns through 9-15-15: S&P 500: 1.77% Russell 2000: 3.05% Barclays Aggregate Bond: 2.32% MSCI EAFE: -6.34% MSCI Emerging Markets: -23.58% US Real Estate: 1.89% Other than Emerging Markets being pretty painful, those are some pretty unexciting numbers. A weighted average of those for a balanced investor is probably going to put you in the -3%ish range for twelve months. A little painful, but probably not panic-inducing for most. And yet, it itches. You get your statement and look at the numbers and it just tickles your nerves a little bit. “Should I do something?” it asks. “What’s not working?” it wants to know. “Have I made a mistake?” “What should I do?” “How do I fix it?” They are quiet questions, but there they are, lingering in the back of our minds. We only get one chance at this investing thing, and we’re terrified that we’ll get it wrong. We’ll miss out on opportunities or hire the wrong advisor or buy at the wrong time or have to listen to our brother-in-law at Thanksgiving talk about how he nailed it AGAIN this year. Hopefully, we have the other voice too. The calm, rational one that reminds us that we have a plan. A pretty well-thought-out plan. A plan that involves boring years and periods where returns don’t meet our expectations. This voice should remind us that we knew about that going in. It doesn’t necessarily make it easier to remember that, but it ought to handcuff us. Even though we simply hate to do nothing, we should. We are not built for it. We are built for action! If it looks broken, fix it! The problem is that what “looks broken” to us is based on our desperate need for immediate gratification and split-second feedback about our decisions. But split-second feedback makes us absolutely terrible investors. In the moment, we can’t take the long view, so we need to listen to our past selves about why we made the plans we did and how we already know what to do in these situations. Generally: nothing.

Buy DVY Ahead Of The Fed Announcement

Regardless of Thursday’s announcement, rates will be low for a while. Utility stocks have taken a beating, and seem poised for a rebound. Dividend funds are a long-term trend that is not going away. The purpose of this article is to determine the attractiveness of the iShares Select Dividend ETF (NYSEARCA: DVY ) as an investment option. To do so, I will review DVY’s recent performance, current holdings and weightings, and trends in the market to attempt to determine where DVY may be headed for the rest of 2015, and in to the new year. With the Fed’s meeting tomorrow regarding interest rates, investors may want to initiate positions ahead of their announcement. First, a little about DVY. The Fund seeks investment results that correspond with the price and yield performance of the Dow Jones U.S. Select Dividend Index . The Index is generally made up of companies with relatively high dividend yields and that have maintained these yields for a long stretch of time, the minimum being 5 years. Because of its diversity and inclusion of only high dividend payers, DVY is not representative of the general market and or the DOW as a whole, but is weighted towards certain sectors specifically. DVY is currently trading at $73.87/share and pays a quarterly dividend of $.65/share, which translates to an annual yield of 3.52%. The fund has struggled in 2015, heading lower with the market as a whole. Year to date, DVY is down about 7%, excluding dividends. This compares to a drop of about 6.5% in the Dow Jones Index (NYSE: DOW ), a popular benchmark. Given its yield, DVY has slightly outperformed the DOW, but it is important to consider the Fed’s influence on the market before deciding to invest in DVY going forward. There are a few reasons why I like DVY, regardless of what the Fed decides to do, as I see the fund performing strongly in either scenario. First, if the Fed decides to not raise rates after tomorrow’s meeting, high-yielding safe sectors like utilities should outperform, as investors will scramble back into those stocks to earn that higher yield. This is important for DVY because the fund has a weighting of almost 33% towards the utilities sector . Over the past few years this sector has rallied each time the rate increase is delayed, or when there is speculation that it will be delayed. And this type of delay is precisely what most traders are betting on this time around, as most traders are betting the central bank will not increase rates at its Sept. 16-17 meeting. Traders are pricing in a 28 percent chance of action on Thursday. Odds of a move at the December gathering are about 59 percent, according to data compiled by Bloomberg. Given the very real possibility of a September delay announcement by the Fed, investors could profit by getting in to DVY ahead of time. Second, I also believe DVY should perform well even if the Fed does decide to raise rates. I believe this is the case because the increase is sure to be modest, and will likely not be followed by another increase this year. Because of this, investors will continue to be subject to ultra-low rates by historical standards, and will continue to look at dividend-focused exchange traded funds, as has been the long-term trend for years now. While most investors are increasingly conflicted about whether or not the Fed will raise rates, the amount of the increase, if it happens, seems to have a consensus that the rise will be to .25%, with a small possibility of .50%. Given that DVY is currently yielding 3.50%, and has the potential of price appreciation through stock gains, the potential return of this fund will still beat investing in U.S. Treasuries. Of course, investing in DVY is not without risks. As the past few months have shown, the Fed’s action (or lack thereof) on interest rates can heavily influence the markets. If the Fed decides to raise rates more aggressively than anticipated, funds like DVY will fall, and fall sharply, given that most traders are betting on the Fed being more dovish. Additionally, dividend funds have been falling out of favor with investors over the course of 2015, as some investors are predicting the years-long bull run for these funds to be ending. Data compiled by Bloomberg has shown outflows for popular dividend funds like DVY, and others, over the course of 2015. However, these are not scenarios I expect to occur. The Fed has been very straightforward about their intentions, and I do not believe they have any desire to “spook” the market with a large increase. I also expect, for reasons I outlined in the above paragraph, for the trend towards dividend ETF’s to continue to be profitable going in to the new year, as rates stay historically low for at least another six months. Bottomline: The market has undergone some volatility over the last few months and trended lower, and DVY has not been immune to this trend. However, the drop in stock price has pushed DVY’s yield above 3.50%, and offers a reasonable value while trading at 12.5 times earnings. The fund has suffered disproportionately as investors fret over a coming rate hike, but the rate hike will be small and could very well be delayed. If so, investors will look to get back in to DVY and similar funds as safe, high-yield alternatives will continue to be scarce. With a above-average yield and a beta of only .69 (indicating it is less volatile than the market as a whole), DVY provides investors with a relatively safe play to ride out any forthcoming volatility. I would encourage investors to take a serious look into this fund, regardless of the Fed’s decision this week. Disclosure: I am/we are long DVY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.