Monday, March 9, 2009

Graham Shows S&P 500 Still Too High as Buffett Loses

By Alexis Xydias and Michael Tsang (Bloomberg)

Benjamin Graham, the father of value investing and mentor of Warren Buffett, would find most U.S. stocks expensive even after the Standard & Poor’s 500 Index dropped 56 percent in 17 months.

Graham measured equities against a decade of profits to smooth out distortions, a method that shows the S&P 500 trading at 13.2 times earnings, according to data compiled by Yale University Professor Robert Shiller. At the bottom of the three worst recessions since 1929, the average ratio fell below 10. To reach that level, the S&P 500 would sink another 27 percent.

The rout set off by the subprime-mortgage collapse in August 2007 has fooled investors from Legg Mason Inc. money manager Bill Miller to Traxis Partners LP’s Barton Biggs, who said shares were cheap as they continued to fall. Even Buffett, the billionaire chief executive officer of Omaha, Nebraska-based Berkshire Hathaway Inc., who worked for Graham in the 1950s, was taken by surprise. He said he was buying on Oct. 17. The S&P 500 lost 28 percent since then, ending March 6 at 683.38.

“We are in a depression, therefore I would expect Graham’s and Shiller’s earnings ratios to get down to a single figure,” said Robin Griffiths, who first studied Graham in 1966 and helps oversee $15.5 billion at Cazenove Capital Management in London. “If it is a bad depression, it could take the S&P 500 to 400 or 500. It is clearly becoming better value as the market comes down, but it is nowhere as cheap as it can get.”

Futures on the S&P 500 slid 1.7 percent at 6:53 a.m. in London after the World Bank said the global economy will likely shrink for the first time since World War II.

Value Investing

Graham, who died in 1976 at 82, and David L. Dodd laid out the principles of value investing in “Security Analysis,” the 1934 textbook used by Buffett to help transform his Omaha, Nebraska-based company into an investment firm with a market value of $112 billion. Dodd died 21 years ago at 93.

Value investors seek out companies priced below their forecast of future earnings to compensate for the possibility of losses. The discount represents the so-called margin of safety that Graham’s followers demand before buying a stock. Graham avoided calculating values according to a single year of profits, instead urging investors to examine periods as long as a decade to erase anomalies.

During the worst bear markets, stocks don’t reach “bargain basement prices” until they fall to 10 times profit or less using Graham’s method, according to James Montier, Societe Generale SA’s London-based global equity strategist. That translates to a price of about 500 for the S&P 500, based on combined per-share earnings of at least $50.

Graham’s Disciple

Buffett, 78, who attended Graham’s Columbia University classes and worked for him at New York-based Graham-Newman Corp. in the 1950s, misjudged the severity of the credit market freeze, which spurred the first simultaneous recessions in the U.S., Europe and Japan since World War II. Berkshire’s market value decreased $119 billion since its peak in December 2007, according to data compiled by Bloomberg.

On Oct. 17, Buffett wrote in the New York Times that he was buying U.S. shares. The 263-point slump since then extended the index’s decline. Buffett said in his annual letter to shareholders on Feb. 28 that he made a “major mistake” buying shares in Houston-based ConocoPhillips when oil prices were near a peak last year. Berkshire’s net income fell 96 percent in the fourth quarter.

Buffett told CNBC today that the economy “has fallen off a cliff” and that efforts to stimulate a recovery may lead to inflation higher than the 1970s. While he stood by his Times column, he said, "I just wish I wrote it a few months later."

‘Quite Suspect’

Investors who valued companies based on earnings or forecasts covering just one year have been burned as equities kept dropping. The S&P 500 fetched 16.2 times its companies’ 12- month profits on Jan. 7, the lowest since at least 1998, according to data compiled by Bloomberg. The index has since plunged as much as 25 percent to a 12-year low.

“A lot of earnings estimates on which the market valuations are based are quite suspect,” said John Carey, who oversees $8 billion at Pioneer Investment Management in Boston. “You have to adjust what you see out there for reality. I remember thinking that a stock selling at 10 times earnings was expensive” in the 1970s and 1980s, he said.

Wall Street strategists are confident the U.S. market has tumbled enough to start a rally.

The S&P 500 will rise to 1,007 by year-end, according to the average estimate of 11 equity strategists tracked by Bloomberg. The projection represents a rise of 47 percent from last week’s closing price and an increase of the price-earnings ratio to 18.88 times operating profit, based on the strategists’ average per-share earnings estimate.

Time to Buy?

Some measures suggest U.S. stocks are cheap. Profits as a percentage of the index’s value climbed to 6.96 percentage points above the yield on 10-year Treasuries, the biggest advantage since at least 1962, monthly data compiled by Bloomberg show.

The S&P 500 also fell below its price trend dating back to 1900 in the past month to levels not seen since 1995, adjusting for inflation, according to Jim Reid and Nick Burns, credit strategists at Deutsche Bank AG in London. They’re still not convinced that’s low enough to ensure equities will gain.

“We are now entering the ‘cheap’ side of historical valuations,” Reid and Burns wrote in a report dated March 3. “Cheap is helpful but not a reason to suggest an imminent sustainable bounce.”

‘Very, Very Cheap’

Biggs, co-founder of New York-based hedge fund Traxis and formerly chief global strategist for Morgan Stanley, said in February last year that U.S. stocks were “very, very cheap” and the market was “at or very close to an important bottom.” The S&P 500 subsequently fell 49 percent.

Legg Mason’s Miller posted the worst performance of his 27- year career in 2008 as his $3.28 billion Value Trust trailed 99 percent of competing mutual funds. Miller, who guided his fund to a better performance than the S&P 500 for a record 15 years ending in 2005, said in December that U.S. stocks could rise as much as 20 percent this year. The S&P 500 instead is off to the worst start in its 81-year history.

In the previous three economic contractions since 1929 that lasted as long as the current one -- the Great Depression, the oil shock in 1973-1975 and the 1981-1982 recession -- the S&P 500 bottomed only after the index fell to 8.74 times profit on average, based on data compiled by Yale’s Shiller.

To match those levels, the S&P 500 would have to fall 21 percent to 537.95, based on analysts’ profit estimates for 2009 that strip out the impact of non-operating charges such as investment losses and writedowns.

“Our view on valuations is yes, they are cheap,” said Joost van Leenders, an Amsterdam-based strategist at Fortis Investments, which oversees $243 billion, and uses Graham’s method as one way to measure stocks against earnings. “But they can become cheaper.”

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