Are Stocks Cheaper or More Expensive Today?: An Exclusive Guest Post from Bruce Greenwald and Judd Kahn, Authors of Value Investing: From Graham to Buffet and Beyond

In an interview with Bloomberg in mid-January 2022, Jeremy Grantham described what he considered to be the fourth super bubble in U.S. history. He predicted that a crash was imminent and advised investors to liquidate all their U.S. equities. He forecast a drop of almost 50% in the S&P 500 and said no amount of Federal Reserve intervention could prevent it.

It is now mid-April, and the floral tapestry of the Masters Tournament is in full bloom. The S&P 500 is close to what it was when Grantham issued his warning three months ago. Was he correct but only a little premature? Rephrased another way: if you buy a stock or portfolio of stocks today, will you earn a decent return? And how expensive is the stock market per dollar of earnings? These questions are perennials, not to be saved only for times when valuations look stretched. We believe that intelligent valuation, appropriate to the economic structures of the time, is a key to successful investing.

There are some basic ways of looking at the expensive vs. cheap question. For many investors, the Schiller CAPE P/E ratio, which compares price to average earnings over the last 10 years, is an important gauge. Currently, the Shiller PE index is trading at 36 times earnings, substantially above the historical average level is 19.5-20 times. By that measure, the market looks expensive.

But hold that thought.

The simpler version of that P/E ratio is to look at price relative to the last 12 months of earnings. The S&P 500 is trading at about 25 times the last 12 months earnings, compared to the historical average of 15 times—again suggesting the stock market is expensive. But again, hold that thought.

We argue in the updated edition of Value Investing: From Graham to Buffett and Beyond, the world has changed for those of us who live in Graham and Doddsville. P/E ratios, whether the simple price to trailing 12 months earnings or the more complex CAPE ratios, may no longer have the power they once did as indicators of value investments. 

Companies that grow faster than average, such as technology companies, typically have had higher P/Es. The high multiple indicates that investors expect higher growth from the company compared to the overall market. But a high P/E, in and of itself, does not necessarily mean a stock is overvalued. 

Any P/E ratio needs to be considered against the backdrop of the P/E for the industry and the prospects for the specific company. What we think of as modern Graham and Dodd value investing puts more emphasis on the competitive conditions facing the industry and the company than on hard assets. It depends on specific knowledge about particular industries and markets, and growth in earnings above the cost of capital, rather than growth in revenues or earnings that require major investments. This is the discipline of value investing in the Graham and Dodd tradition recast to deal with companies that can retain competitive advantages over longer periods – franchise businesses. The investments in question are quite different from short-term investments with well-defined returns for which a Discounted Cash Flow approach is appropriate. The larger lesson here is that valuation approaches must be tailored to investment specifics. One-size-fits-all valuation approaches are a bad idea, particularly when globalization increases competition in some markets more than others. 

The trend toward franchise-based value is evident in the high profitability and sustained trillion-dollar valuations of companies such as Microsoft, Google, and Apple. It is also clear from the way in which Walmart and McDonald’s have created hundreds of billions in market value for traditionally atomized service industries. Health care, now a major sector, was formerly represented in securities markets almost exclusively by major pharmaceutical companies. Today significant health investment opportunities include health insurers, prescription drug fulfillment companies, hospital chains, specialized treatment businesses, and a multitude of high-tech equipment companies and biotech companies. 

At the same time, historically dominant businesses —General Electric, IBM, General Motors—and whole industries such as newspapers have seen their values diminish or even disappear. The ability to value growth accurately is essential and challenges the skills required of modern Graham and Dodd investors.

Our view is that the world has changed in ways that make growth – and the careful analysis of it – a crucial factor in analysis for modern value investors. The only growth that creates value — a return above the cost of capital — is in markets where the firm enjoys an actual competitive advantage or has the potential to create one, typically in markets it can dominate.

Historically, even outstanding companies had limited and declining barriers to entry, meaning revenue growth added little or no value. Cost reductions and production innovation may have added to returns in the short run, but because these improvements were ultimately available to  others, competition drove down returns and the benefits ultimately were passed on to consumers in the long run.  Under those conditions, a 15 P/E ratio meant that the real return on the market was approximately 6.5% (1/15). At a 1.5% inflation rate, the nominal return to an investor was 8% (6.5% + 1.5%). 

Current conditions are different. Organic output growth (GDP growth and productivity growth) of 1.5% plus 0.7% Labor Force Growth creates 2.2% in incremental returns. Margin Growth (corporate profits) were 8.5% in 1990, but are 13.5% in in 2020, which adds 1.5% per annum to returns. All in, organic growth on earnings of 3.7% with limited investment required to support growth of 0.7% generates an organic growth return of 3.0% per year. A PE of 25 (1/25) suggests a 4% return but adding organic growth of 3.0% equates to 7% real return. With 1.5% inflation rate, the nominal return is 8.5%. Thus, the current earnings return, even with the elevated PE, is above the historical average by a small amount. 

Given outsize impact of Tesla, Amazon, Google and Apple with extremely high multiples, our view is that properly focused value investment opportunities are better than historical average at present, keeping in mind the cost of capital is also lower today for publicly traded companies than in the past. Historical bond returns of 4% at 1.5% inflation translated to a real return of 2.5% versus historical equity returns of 6.5% real return for equities. This equates to a 4% equity premium. Today, nominal bond returns are 2.5% at 1.5% inflation, versus a current real return of the stock market of 7%, or a 6% equity premium.

Our view: Don’t bet against the stock market.