This weekend I replaced some wooden planks in our backyard deck. This is only noteworthy if one understands my aptitude with tools and wood. I majored in finance for good reasons. To complete the job, I needed to use a crowbar, reciprocating saw, tape measure, hammer and about 20 nails. On these rare occasions when I work with wood and saws, I can’t help but remember the old carpenter’s saw (!), “Measure twice, cut once.”
As I reflected on this saying, I was struck with the idea that so many activities require precise measurement and exact execution. Whether you are a surgeon or a chef, an airplane pilot or a pharmacist, you must follow certain procedures and recipes with exactness, or dire consequences may follow (like a fallen soufflé!).
Then there are other professions, such as being a professional investor, where such exactness is much harder to come by. We all would like some kind of formula or recipe that would guarantee positive returns. I constantly see ads from people claiming that they have discovered the “secret” of investing. Listen, if there was one way to assure positive returns, we would all be doing it. Take my word on this one; there is no “magic secret” to investing.
That said, there are some things that investors can measure with precision that may help them achieve attractive returns. I spend a lot of my research effort measuring such things.
Book Value. The book value of a company is what’s left over after you subtract its liabilities from its assets. I like this number because it does not change rapidly for most companies, and it usually grows over time. I can measure how a stock is trading using the price/book value ratio. Knowing the historical relationship between the share price and the company’s book value can tell me something about the stock. In general, stocks trading at the low end of their price/book value range may be considered “cheap” or “inexpensive” and may have more upside than downside. I do not look exclusively at this ratio, but it is one I can measure with precision, and one that tells me a lot about a stock’s value.
Earnings. The price/earnings ratio (P/E) is one of the most widely used valuation ratios around. Although we can know with precision past earnings (barring those pesky revisions), I think the market usually cares more about future earnings. I use simple consensus estimates for future earnings to calculate P/Es. Earnings estimates are generally much more volatile than book values and are vulnerable to company-specific surprises and the overall quality of equity analysts. That said, many companies will trade in a well-defined P/E range, and understanding the current P/E can give us a good idea about how the market feels about the stock.
Sentiment. How investors feel about the market can be measured via sentiment surveys. Our favorite is one conducted and published weekly by The American Association of Individual Investors (AAII). This organization asks individual investors how they view the market: bullish, bearish or neutral. This survey has been a pretty good predictor of future market moves. As the reader may recall, sentiment is a contra-indicator, that is, the more bearish the survey, the more likely the market is to move up. Although sentiment is not a perfect indicator of the future (there are none, in my opinion), it is a pretty good one, and one that I watch constantly. The latest AAII survey shows 30.2% bullish, 35.0% neutral and 34.7% bearish. One could interpret these figures as generally bullish for the stock market.
There are many other things that I measure and monitor on a regular basis. I don’t spend much time trying to predict “big” things like GDP, currency exchange rates, politics or the likelihood of the next “black swan.” The great complexity and volatility of these metrics make them very hard to predict with the level of precision I would need to use them as guideposts for investing.
Will Rogers offered good advice about stock investing, “Don’t gamble; take all your money and buy some good stock, and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.” I would amend this slightly, “Don’t gamble; take some of your money and buy well-diversified portfolio filled with inexpensive stocks, and actively measure the value of each stock in the portfolio. If a stock doesn’t go up, don’t worry, if it’s cheap enough, it probably will go up over time.”
Okay, so I’m no Will Rogers, but I think I know how to invest without gambling. That may actually be worth more than crafting catchy phrases.