Is Value Investing a Safe Bet?

Dow Jones Earnings-Book Value 1937-1982

QUESTION: What do you think of value investing?


ANSWER: As with everything, a cycle that you have to understand will unfold. Everything will move to extremes on both sides and you must understand the driving forces. Look at the PE Ratio. People write in and say I am wrong and the market must crash because of the PE Ratio. Everybody is wrong at some point in life. That is how we learn from our mistakes, which we call “experience.” If you assume such stagnant relationships are always fixed, well, you have a lot to learn.

Value investing works for the majority of the trend in general. However, that view typically looks just at earnings. As illustrated at the top, I used these charts during the 1980s and was blamed for creating the takeover boom. Why? Forget earnings. The book value of assets were ignored after the Great Depression so the low in the Dow Jones Industrial shares was 1977. You could buy a company, sell its assets, and triple your money. So looking just at earnings did not identify the takeover boom when the Dow rose from 1,000 to 6,000.

PE Ratio 2007-2016

Now look at the PE Ratio. Here a second cyclical trend emerges. Note that the high in the PE Ratio exceeded 120:1 during the panic into 2009. Why? For the very same reason that interest rates are NEGATIVE on 10-year German bunds. People are uncertain about the future so they are willing to park money with ZERO return. This proves that “value investing” is just like everything else. Sometimes it works, and sometimes it does not. EVERYTHING is cyclical. There is a time to buy and a time to sell.

S&P500 Trading Volume 1982-2016The trend where people hoard cash can be seen in the trading volume of the S&P 500 where the peak remains 1996. When confidence shifts and people wake up and say, “Oh shit!” you will see things go crazy like never before. There is no panacea for value investing based upon PE Ratios and “value,” for there comes a time when people are scared of the future and want to park.

Anyone suggesting differently is either fooling themselves or trying to fool you. Piling into the assets to preserve capital will become the name of the game.

This is not some wild theory that is isolated to a single event such as the German hyperinflation. This is a major shift in confidence that is historically consistent.