Print-friendly version
Send this to a friend
Posted 3/10/2003
Contrarian Chronicles
About Contrarian Chronicles
Learn the Contrarian Chronicles lingo
Visit RealMoney.com
Related Articles
Are world stock funds worth it?
4 warning signs of funny numbers
Related Resources
Keep abreast of the market with Market Dispatches
See how StockScouter rates your favorite stocks
Check our top 10 stocks lists
Look up key economic indicators
Check your portfolio on MSN Money
Related Sites
Welling@Weeden
Warren Buffett's letter to shareholders (PDF, go to Page 3)
Contrarian Chronicles
Recent articles:
• Why Alan Greenspan is a menace, 3/3/2003
• 3 reasons to expect a war rally, 2/24/2003
• 3 investing myths you shouldn't buy into, 2/17/2003
More...
| | Contrarian Chronicles
In the long run, the price you pay is what counts
Warren Buffett tells shareholders he believes stock prices are still too high. Investing legend Peter Bernstein agrees. That's why simple buy-and-hold no longer makes sense.
By Bill Fleckenstein
Some folks just don't want to be confused with the facts. Lets take the "fact" of buy-and-hold as an example. That one wins the contest for most beloved investing strategy. Well, this post-bubble world has turned strategy to myth. Cruise control is fine for the highway, not the portfolio.
For anyone who finds it hard to say so long to what worked for so long, a couple of guys who've been around the Wall Street block, Warren Buffett and Peter Bernstein, offer facts to make the separation easier.
The point both men are making -- and the point Ive been making for the last several years -- is that stocks are still so high that you can't assume youll make money in the long run. In fact, you could lose money.
Buffett on house (of cards) cleaning
By now, I'm sure many people know that last week, Fortune.com published an excerpt of Warren Buffett's annual letter to Berkshire Hathaway (BRK.B, news, msgs) shareholders, which was released in its entirety last weekend (after this column had been put to bed). But for any readers who may not have seen this preview, I would like to share some of Buffett's comments on derivatives and their associated trading activities.
"Time bombs" is how he describes them, "both for the parties that deal in them and the economic system." Then he goes on to point out counterparty risk: "Unless derivative contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties in them." Of course, that's the rub. Sometimes it is not possible to ferret out creditworthiness in advance. Anybody who had counted on Enron (ENRNQ, news, msgs) as a counterparty, for instance, has a problem on his hands.
To show the complex layers that separate investors from a company's true credit picture, Buffett points out that General Re Securities (which his General Re tried unsuccessfully to divest) still had 14,384 contracts outstanding, involving 672 counterparties, after 10 months of his attempt to wind down its operations. This was his account of how unwieldy the situation had become: "Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity." If it's mind-bogglingly complex for Warren Buffett, you can be sure that it's complicated.
So, there is what the world's greatest investor had to say about the eighth wonder of the world -- this massive derivatives mess. Thus far, it has avoided blowing up, and its lasted long enough to have lulled people into a false sense of security. But for Buffett to take an up-close and personal look at derivatives and conclude that this is a time bomb should serve as an alert to people when they examine their own investments. (Editor's note: For more on derivatives, see Jim Jubaks column, Why J.P. Morgan Chase has the market panicked.")
As for stocks in general, Buffett said, "We still find very few (stocks) that even mildly interest us." He continued: "That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge." My sentiments exactly.
Q&A the Welling way
Along the same vein of wisdom, and since we are in the quiet period and awaiting more war news, I thought I would reprise one of the single most spectacular interviews I have seen Kate Welling conduct (and believe me, she has done a few). Kate used to run the interviews at Barron's. For some time now, she has had her own publication, Welling@Weedon (see link at left under 'Related Sites'), a fee-based institutional product. In the current issue, her subject is Peter Bernstein, the New York financial expert who has forgotten more about investing than most people will ever learn.
What struck me about the interview was his view (which happens to be mine, but he is Peter Bernstein and I am not) that the post-bubble period will be entirely different from what has come before and entirely different from what people expect. A longtime hobbyhorse of mine, as longtime readers know, is that you can sort people into two camps: those who understand we had a bubble and what it means, and those who don't. Peter has given a lot of thought to his position, and I would like to share some of his comments here.
Bernstein hollows out hallowed truths
First of all, he believes, people need to say to themselves, "The basic investment structure that I have been using, which served me pretty well, is no longer appropriate." He explains: "My point is that we've reached a funny position, where the long run doesn't work, where long-run evidence doesn't fit circumstances as they are today." He ascribes that in part to the bubble: "I am suggesting we have to begin by focusing on the meaning of the long term think about it differently in the post-bubble world."
To help people understand that "the old long run, she ain't what she used to be," Bernstein cites powerful data. (He has made this point before, and some of the data may appear dry, but people may now be in a more receptive frame of mind to accept his compelling analysis.)
First, he takes up the theory articulated by University of Pennsylvania finance professor Jeremy Siegel that you will be just fine as an investor if you just shut your eyes and hang on. The foundation for that idea comes from Siegel's research showing that in the long run (in 20-year periods), real annual rate of return on equities in U.S. history has been a remarkably consistent 7%. "Ever since 1880. It's a very powerful story, Bernstein says. There's no way you can match that anywhere."
Data points prick illusions
The folly in that thinking, however, lies in how that 7% real (or after inflation) return is built. The average dividend yield during all those 20-year periods that Siegel studied was well over 4%, Bernstein points out. Real price appreciation contributed only 2.1% of the total return. All the rest was dividends, received and reinvested. By contrast, today's dividend yield is in the neighborhood of 2%. Thus, to achieve 7% real growth over the next 20 years, the stock market would need 5% real growth in both earnings and dividends. That's not exactly a reasonable expectation over the long run. Impossible, in fact," he says.
Okay, you say, 5% real growth doesn't sound so hard. Wrong, Bernstein argues. The question is the difference between what investors expect and what's rational to expect. Remember, he continues, "Its an important but little-known fact that real growth in earnings and dividends consistently lags long-run growth rates in real GDP -- and in many cases even in per capita GDP growth -- not just in the United States, but in all other developed economies. Between 1900 and 2001, U.S. GDP growth averaged 3.3% a year in real terms vs. 1.9% growth in GDP per capita, 1.5% earnings growth and just 1.1% dividend growth."
And, he added, the U.S. economy was the most successful on the planet." So there is some of the sobering data behind the view that people's long-run expectations are not liable to be met.
Of 'long run' and long runny noses
Furthering the disappointment is another problem that I have talked about frequently: valuations. If stock prices were far cheaper, dividend yields would be higher and therefore prospective rates of return would be higher. I believe that someday we will see much lower stock prices, which will then enable people who have cash reserves to realize their long-run expectations. But in the meantime, as Peter notes: "The underlying message in all of them (recent studies about valuation levels and prospective rates of return) is that until these valuation issues adjust themselves, equities are not necessarily going to be the best place in the long run."
The bottom line, he says: Research shows that starting price matters. The objectively feasible long-run equity return is the sum of the dividend yield and the long-run earnings growth. And when it's high, that's bullish for equities." As I have stated many times, the difference between a good company and a good investment is the price you pay for it.
Of course, all of this doesn't mean we can't have rallies from time to time, and big ones to boot, as this bear market winds its way along. We've had 10 of the biggest upside days in Nasdaq history since the bear market began. Tokyo has experienced many mini-bull markets during its 13-year bear market. So, there will be big rallies. But Peter's point, and one I heartily agree with, is that people who think they're going to make big money in the "long run" from these starting prices are more likely basing their faith on arm-waving than on facts.
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. William Fleckenstein's investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
|
