Another "Milestone" Approaches…

23 Apr

I posted comments when the Dow Jones Industrial Average (DJIA) was reaching new highs last year and so now feel compelled to comment on its recent rise to near 13,000.

The goal of active management is to, on a risk-adjusted basis, beat the return that could be earned by passively investing in a broad-market index fund or ETF. So long-term performance of indexes is relevant for comparison purposes. But over short-periods there is little relevance. Nevertheless, the financial press is hailing this is a “new bull run,” mostly based on an arbitrary number that has little real significance.

Let me start by saying the Dow will reach 13,000. The question is just a matter of when, and it looks like it could be soon. But what does Dow 13,000 mean? Not a whole lot. To me, it means the sum of 30 stock prices divided by 0.12482483 equal 13,000. It’s just a number whose absolute value is really meaningless to an individual’s portfolio, though technical analysts might say it is a “key psychological barrier” or a “technical breakthrough.” And of course CNBC is once again devoting some of its ticker real estate to a new graphic – “Dow is xx.xx points from 13,000 milestone.” I can’t blame them, CNBC is a financial news network and they have to report the financial news. But just because its being reported doesn’t mean it’s important. While we’re on the subject, the S&P 500 is still down 4.3% from its all-time high (1,553.11) set in March of 2000.

What is important is the individual makeup of each investor’s portfolio. Were the individual companies you own purchased at good prices? Are they currently trading at a cheap-to-fair price in relation to their normal earnings power? Do they have a competitive advantage that allows them to control their own destiny? Questions such as these are much more relevant than what an index or average value is doing. This is especially true if there is little overlap between your portfolio and “the Dow.” Day-to-day (even month-to-month) stock price fluctuations can have little to do with fundamentals and more to do with emotional reactions and to changing perceptions of those fundamentals. Over the long-term, as companies earn money and reinvest profitably in their businesses, their stock prices are going to follow. Finding good companies that can be purchased at reasonable prices should treat an investor well over longer time periods.

So what are some aggregate statistics of the broader market as of today? The S&P 500 Index is trading an earnings yield on a forward basis of just over 6.0%, versus a 10-year Treasury yield of 4.7%. Given these numbers, stocks seem relatively attractive to me, but I wouldn’t say they’re cheap. The S&P over the past year has generated returns on equity in the 18% range. Earnings have grown 15% year-over-year, and on a sustainable growth rate basis can probably grow 12% for the next year, assuming incremental reinvestment rates remain stable. However, analysts have predicted slowing growth – earnings are predicted to grow close to trend (~6%) for this quarter – a prediction that is being exceeded by several companies who have reported earnings thus far.

While buying “the market” at current levels is likely to result in reasonable but not spectacular returns, an investor’s best bet, as usual, is to find companies trading at more attractive valuations than the market as a whole. Pay attention to your “basket” of stocks, not those of “the market.” Find stocks with low debt and growing free cash flow that are returning cash to shareholders and generating solid returns on capital over a full economic cycle.

Where to look? The worst performing sector in the S&P 500 this year is “Financials,” up just 0.85% compared with the Index return of 5.21%, with an overall sector P/E of less than 15 and an above-market dividend yield of 2.5%. On an individual company basis, many stocks here are likely to be relatively more attractive, with a few yielding 4-5% along with solid growth prospects.

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