The Enterprising Investor’s Guide 6-22-2009

The price-to-peak earnings multiple has declined to 10.3 times as of Friday’s close. The S&P 500 closed down 2.6% last week as the market’s impressive three month rally appears to be exhausted. The S&P 500 was able to regain about one-third of its decline from the 2007 peak and we now stand generally in-line with October 2008 levels when Warren Buffet wrote his now famous New York Times op ed “Buy American. I Am”. We have great respect for Mr. Buffet, but the way he buys stock is very different from the way individuals invest. Through Berkshire Hathaway, Warren Buffet has billions of dollars to literally “bail out” companies and his investments tend to come with better terms than those available to smaller investors. Many investments that Mr. Buffet has made over the past few months have come in the form of preferred stock or debt with a healthy quarterly dividend (see his fixed-income equivalent investments in Goldman Sachs (GS), General Electric (GE), and Harley-Davidson (HOG)). Furthermore, because of the wealth he has built over the course of a lifetime of wise investments, he has the ability to take a bit more risk with his personal investments (if so desired) than an individual managing his or her own retirement funds for example.

To be fair, Buffet’s advice was based on his look at asset class valuations and their prospects for the coming decade. He reached the conclusion that equities will almost certainly outperform cash equivalents primarily because of the inflationary policies being enacted in order to alleviate the current financial mess. We cannot disagree with this overarching thesis, but I wonder if Buffet would offer the same advice today, with equities up rapidly from their March low. One tenet of his investing philosophy is: “be fearful when others are greedy and be greedy when others are fearful.” In our opinion, this merits different advice now than was relevant nine months ago (please look at the sentiment chart).

The percentage of NYSE stocks selling above their 30-week moving average is just over 80% this week. Sentiment is still remarkably high, although it is starting to show signs of weakness. It is clear that the market’s upside recently has been fueled by better than expected (but still bleak) economic data and hopes of “green shoots” appearing in the economic rubble. This market condition can not perpetuate itself indefinitely and investors will begin to require more tangible signs that an economic and earnings recovery are really underway. We believe that the market is due for a re-tracement unless further upside earnings surprises are seen. The trailing twelve month earnings on the S&P 500 are abysmal causing a trailing twelve month price/earnings ratio of 127x, according to Barron’s. Of course, these results look back at a period of unprecedented economic upheaval, but they also underscore the fact that this market is trading on sentiment rather than fundamentals. Over the longer term, this should be reversed as the market’s “weighing machine” beings to overrule its “voting machine”.

As we stated previously, it is hard to understand how the stock market will retain its gains and advance further in the absence of a real earnings rebound. While anything is possible over the short-term, the risk/return tradeoff in this situation warrants caution. For example, on Monday morning the World Bank issued an updated outlook for the global economy, predicting a contraction of 2.9% (42% worse than its previous estimates). If this prediction holds true, it will spell trouble for equities and as well as commodities markets, which have rallied even more than equity indices based on hopes of a rapid resumption in global economic growth.

The Enterprising Investor’s Guide 6/22/2009

About Ockham Research 645 Articles

Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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