Valuations are Normalizing

OK, I admit the title looks deceptively simple but I am not going to go into a discourse on valuations because it is a dry and boring topic and one is probably better off reading “Security Analysis” by Benjamin Graham and David Dodd. This post serves as a sort of warning and wake-up call that valuations, in time, will always revert to the mean and that “cheap” valuations will not stay for the long-term. Just as irrational exuberance was expounded as a leading cause of high and unsustainable valuations, irrational pessimism is the exact opposite and leads to the converse.

Of course, one may argue that just 9 months ago, economists and many educated individuals were pronouncing that global growth would be negative and that the stock market may stay at depressed valuations for 10 years at least. The doomsayers and prophets foretold of a dark period where wages struggled to remain at current levels and economic growth was all but non-existent. On hindsight, everyone (including myself) believed them because the situation back then seemed so bleak, so hopeless, that one could not have imagined otherwise. There is a certain limit to human imagination and certain events are of such a huge magnitude that it literally blows one’s mind away, leaving it to struggle to absorb new realities among the vestiges of the broken financial system. Such an event occurred one year ago in September 2008 with the collapse of Lehman Brothers; which propelled the world on the brink of financial disaster akin to the effects of an atomic bomb spreading out like a mushroom cloud across the world. That single event was cataclysmic in its effects and a huge destructive ripple spread across all financial institutions, threatening to shut down the global finance system and wreck chaos. In disaster movie jargon, we would have called it “Financial Armageddon”, or so it seemed.

If we fast-forward to the present moment, governments all over the world have pledged to boost their respective economies with massive fiscal spending, of which the USA is a frontrunner under President Obama. This concerted effort has created “green shoots” since May 2009 when previously all one could see was dead soil and brown weeds. Therefore, valuations were rightly beaten down when prospects of corporate revenues and profit growth were muted; and many companies traded then at trough valuations as yet unseen, which create another wave of shock across the globe as stock markets plunged to levels not seen for the last 10-15 years, effectively wiping out the economic growth for the last 10 years. The discerning investor should then sift through the rubble and debris to look for shining gems in the stock market, which at the time resembled a blasted wasteland full of writhing corpses. Those who had the fortitude and foresight to pick stocks at trough valuations, and who believed in the long-term prospects of economic growth and the eventual easing of the recession, were in turn handsomely rewarded when news of these green shoots was announced. To buy on uncertainty is no doubt difficult, for it resembles the intrepid adventurer heading down a dark, unknown tunnel (fear of the unknown); yet this is when the investor gets valuations which are so attractive that they remain a talking point for years to come, as well as dividend yields so high that they exceed inflation over an extended period of time. This is in essence the embodiment of the slogan “you pay a high price for a cheery consensus”, uttered by Mr. Warren Buffett.

Once news broke on the possible early recovery of the financial system and that global growth would be restored by 2010, coupled with record low interest rates to boost liquidity; people then began to view companies in a whole different light. Companies are the backbone of a society and their products and services are the ones which support and move the economy along, like oil on cogs turning the huge machines of industries. So the process began to look for quality companies which could continue to survive and grow amidst the carnage, and valuations have thus risen in tandem to this expectation. Even analysts are now keenly using the average PER valuation for the last 5-years as a gauge of the “cheapness” of a company, when previously all the reports only featured trough valuations and price-to-book ratios (it was assumed earnings were non-existent).

As a result of these factors, we have seen stocks becoming less than cheap, and definitely less attractive as the huge margin of safety present during the period of October 2008 through to March 2009 has all but disappeared into the ether. Even with our Finance Minister Mr. Shanmugaratnam warning of a possible double-dip recession, it is unlikely that valuations will scrape trough levels as expectations of growth are already being priced in, and people are now willing to pay more to own the same companies. The process of methodically selecting good companies must now be applied once again.

In other words, the days of “easy money” are probably gone, swept away very suddenly in the first 2 weeks of May 2009 as valuations increased sharply. Only on hindsight could we have seen that the “smart money” was actually quietly but actively buying up shares of solid companies; without much fanfare and in a creepily discreet manner. This is what we, as astute investors, should have been doing as well – staking our future on the innovativeness and creativity of the human race to overcome adversity and adapt to changes; instead of blindly believing the false prophets singing their hymns of doom and proclaiming, with almost divine fervour, that they indeed know more than us. In reality, no one knows the future, but we must still strive to invest; for only through proper investing can we achieve the eventual goal of a comfortable retirement and a steady increase in the value of our wealth.