Ser Jing is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In investing, one of the most heard of maxims with long term buy-and-hold (LTBH) investing is that market timing does not work. Investing legends like Peter Lynch, John Neff and Warren Buffett have repeatedly stated in various interviews, books and articles that they do not pick out stock market peaks and bottoms but rather, study the merits of individual companies and buy and sell based on their strengths and weaknesses.
Generally, it is true that most of The Motley Fool’s favorite high-profile investors do not look at market timing, in the sense that they are not concerned with how the general market indices are going to perform in the future. But yet, Warren Buffett famously avoided the tech-bubble of 1999-2000 by not deploying any capital during that timeframe because he could not find any bargains. In that regard, can there be any valuation timing signals that investors could use to detect the presence of bubbles or perhaps, cheapness in equities or bonds?
Market timing, as I understand, is the buying and selling of financial assets based on the outlook provided by macroeconomic and technical analysis. When the signals say sell, market timers would offload most of the financial assets they possess. Most of the criticisms against market timing argue that macroeconomic analysis is notoriously hard to get right, so too, are predictions of short-term market movements. I agree with most of the criticisms. Various studies done in the realm of behavioral finance and analysis of forecasting results have led to the conclusion that market forecasting, even by ‘experts,’ is notoriously inconsistent with reality. Benjamin Graham saw through the futility of market forecasting and wrote a particularly poignant phrase in his book, ‘Security Analysis,’ which goes like this: “In market analysis, there are no margins of safety; you are either right or wrong, and if you are wrong, you lose money’.’
Valuation timing, on the other hand, is the buying and partial selling of financial assets based on fundamental analysis of market indices as well as individual stocks. Investors sometimes lighten positions in individual stocks after a great run-up in market prices such that the relationship between value and price have worsened since the initial purchase. There is also the possibility for investors to study the value-to-price relationship for market indices and depending on the valuation outlook, to start accumulating cash in anticipation of market pull backs. In Bruce Greenwald’s book ‘Value Investing: From Graham to Buffett And Beyond,’ he wrote about a lecture that value investor Glenn Greenberg gave to students at Columbia Business School. Greenberg, who is the Co-founder and Managing Director of Chieftain Capital Management, asked the students about the attractiveness of investing in a certain company. The company’s details were given as:
Earnings Per Share: $50
Dividend Per Share: $20
Growth Rate: 6%-8% per year
Business: Diversified and Cyclical
Options: Many, but not considered as diluting earnings until they are vested
Given this backdrop, most investors would not want to invest much in a company that is growing at 8% but trading at a P/E ratio of 26.8 with a dividend yield of 1.5%. As it turns out, this is not a company, but the fundamentals of the S&P500 index during November 1999. Most readers would recognize that 1999 was part of the infamous Dotcom bubble. Looking at the S&P500 index in November 1999, without the benefit of hindsight, it would still be hard to argue that bargains were aplenty during those times. In such a situation, would it not be prudent to start setting aside some cash to take advantage of any potential market correction by selling some shares in companies that have begun to attain absurdly high valuations, even while maintaining positions in companies which still displayed solid fundamentals and a value-to-price relationship that does not alarm our common sense?
There have also been companies with great fundamentals that had valuations that got ahead of themselves even in general market conditions that would not be normally considered overly frothy. A case in point? Take the most recent earnings results for Chipotle Mexican Grill (NYSE: CMG). Prior to their earnings release on 20 July 2012, CMG was trading at a TTM P/E ratio of approximately 55. CMG’s earnings have grown at a Compounded Annual Growth Rate (CAGR) of 39% over the past 5 years. Given a P/E ratio that was much higher than CMG’s historical earnings CAGR, only a slight earnings miss would have the potential to cause a massive decline in CMG’s share price and that is exactly what happened after CMG released their earnings results. The share price tumbled 21.5% in a single day even though CMG posted stellar earnings growth of 61% year-over-year (Y-o-Y) but fell short of analyst estimates. The current TTM P/E ratio for CMG stands at a more manageable 36. By all accounts, CMG is a well-run company with a rock solid balance sheet and good earnings growth prospects. Individual investors who happen to have a cash cushion could use this drop in share price to accumulate a position and benefit from its future business performance. Companies like Starbucks, Buffalo Wild Wings and even Facebook have also suffered similar fates after reporting good earnings results with double digit growth rates because they did not ‘grow enough.’
Now, what about companies that have great fundamentals whose growth has gotten way ahead of its valuation? Let us take a quick peek at Apple (NASDAQ: AAPL). Prior to their earnings release on 24 July 2012, AAPL was trading at a TTM P/E ratio of approximately 14.7. AAPL’s earnings grew at a CAGR of 67% over the past 5 years. With such explosive growth coupled with an anaemic P/E ratio, one can certainly make a strong case for AAPL being severely undervalued. As it turns out, after the release of its earnings, AAPL’s share price fell by 4.2% after missing analyst estimates even though earnings grew by 19.6% Y-o-Y. The magnitude of the share price drop was miniscule compared to the likes of CMG because of the huge buffer AAPL had between its P/E ratio and growth rate. As it stands currently, AAPL’s share price has more than made up its post-earnings losses, possibly due to the huge discrepancy between its historical growth rate and P/E ratio.
Fund managers have the luxury of asking for cash infusions from their investors when bargains appear (their success in getting those funds is another story), but individual investors do not. Thus, having a cash cushion for bargain hunting would be nice in the event of a recession or steep market correction. In such situations, babies are often thrown out with the bathwater and fundamentally sound companies will suffer price declines that are incoherent with their long-term business prospects. Besides market corrections, sometimes, fundamentally sound companies can also suffer major price declines when they face temporary business growth obstacles. These are the times when the cash cushion can be deployed for maximum benefit. There is a caveat though: Markets and individual stocks can persist with dangerously high over-valuations or severe under-valuations over an extended period of time and the cash sitting in the bank will not earn any inflation-beating returns for the individual investor. That is why, Valuation Timing of market indices and individual stocks can only serve as a compliment for the Bottoms-Up approach to stock picking, where the purchase of stocks in companies with solid fundamentals and good long-term prospects still ultimately holds the key to long-term investing success.
Fool Blogger Ser Jing does not own any positions in S&P500 index ETFs or any other market index ETF. Ser Jing owns shares in Apple and does not own any positions in Starbucks, Buffalo Wild Wings, Facebook and Chipotle Mexican Grill. The Motley Fool owns shares of Apple, Buffalo Wild Wings, Chipotle Mexican Grill, Facebook, and Starbucks. Motley Fool newsletter services recommend Apple, Buffalo Wild Wings, Chipotle Mexican Grill, Facebook, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.