Invest Wisdom

Fidelity and Vanguard have long been the leaders in offering index funds with paltry fees. Vanguard’s S&P 500 fund has an expense ratio of 0.15%. Fidelity’s Spartan 500 index fund has only 0.10% in annual expenses. If you asked me yesterday what fund company I thought was going to take the axe to fees next, I would have probably guessed Vanguard, as the two fund giants continued to outdo each other.

But no, ladies and gentleman, we have a completely different company throwing down the gauntlet in the low fee battle. Charles Schwab, whose S&P 500 and Total Stock Market index funds had expenses ranging from 0.19% to 0.53% yesterday, now will offer both its S&P 500 Index fund and its Total Stock Market Index Fund at an expense ratio of only 0.09%, making it the new market leader. There will be only one, no-load share class for both funds (that is, there will be no upfront or backend fees for buying or selling), and the minimum investment for the mutual funds will only be $100.

The Schwab International Index Fund and Small-Cap Index Fund also had their fees reduced—-to 0.19%.

The guys representing Schwab at a press conference this morning said that the change is immediate and permanent, and that there are no catches. Even if you had only $100 to invest, $100 could go into the S&P 500 fund, and you’d only pay about 9 cents per year in expenses. No upfront fee, no backend fee, no nothing.

Schwab made the announcement today and is letting their advisors know about the change as I type. I wonder if Vanguard and Fidelity knew it was coming and are preparing similar moves. I’m not sure of the regulatory requirements in changing fees. So there’s a chance there was some sort of public indication that this was happening, and I missed it.

For investors, if there really is no catch, this is great news. In fact, in recent weeks, more of a focus has been on expense ratios going up as mutual funds lose assets. If you’re looking to simply track a stock index (there doesn’t appear to be any news on the bond front, unfortunately), Schwab has the most cost efficient way of doing it. In fact, its expense ratio is the same as that of the most popular market-tracking ETF (SPY). But whereas you’d have to pay a broker commission every time you bought the ETF, buying Schwab’s mutual fund has no fee associated with it.

Just how much does a 0.01% smaller fee help you? If you invested $100,000 in the Schwab fund and $100,000 in the Fidelity fund, the Schwab fund would be worth about $850 more after 20 years (A difference so small that I couldn’t even draw an effective chart). Not a huge amount. And probably not enough of a difference to get fee-conscious investors to change mutual fund companies. But it’s nothing to sniff at either. Let’s hope Vanguard and Fidelity don’t take this lying down. It’d be great to have a low fee battle on our hands.

This is where I typically offer a “but…”, and I don’t want to sound like a Schwab advertisement. They said a lot of other stuff at the meeting, like how they think their active mutual funds are going to outperform and how the recession might already be over that I’m extremely skeptical about (more on that later). On first take, though, I’m having trouble finding a bad angle on lower mutual fund fees. Let me know if you see something I don’t.

- Joe Light

After writing my summary of Berkshire Hathaway’s annual meeting, I realized that I didn’t really explain what Treasury Inflation-Protected Securities and Series I Bonds were, let alone which one is the better pick to battle inflation.

Both TIPS and I-Bonds are designed to do the same thing, though through different means.

When you buy TIPS:
– The principal (that is, the face value) of the bond is adjusted up with inflation or down with deflation.
– You receive a stated coupon rate, just like any other bond, but the interest payment is based on the adjusted principal, which means your payments can vary.

When you buy I-Bonds:
– The principal stays the same.
– The interest is a combination of the stated fixed rate and the inflation adjustment. In a deflationary period, the adjusted rate can go to 0%.

As luck would have it, the Treasury announced on Friday that Series I Bonds bought between now and Oct. 30 would return 0% — the first time a six-month period has had no return since the bonds were created in 1998.

That doesn’t mean the bonds aren’t working. It just means that right now, in the short term, we’re experience deflation. The Consumer Price Index, the government’s main measure of inflation, dropped at an annualized rate of 5.6% in the last six months.

If you’re deciding right now between I-Bonds and TIPS, and if you’re investing in a tax-deferred account, it’s best to go with TIPS. The easy reason is that TIPS are providing a real return (that is, a return after inflation) of 1.1% to 2.3% depending on the bond’s maturity date versus the 0% real return for I-Bonds. While the principal might get adjusted down in the shortterm, in the longterm, most investors and economists expect inflation to return with a vengeance, as the government pays for the stimulus program.

But if you’re investing in a taxable account, depending on tax considerations, you might want to stick with I-Bonds in the hope that their interest rate is adjusted up in November. As one of my colleagues at Money points out, while I-Bond interest is deferred for the life of the bond, the interest and principal growth of TIPS bonds are subject to federal tax, even if the bond hasn’t matured yet!

- Joe Light

If you’re not a regular at the Carnival of Personal Finance already, check it out. It’s a collection of some really great personal finance posts from many good blogs. It also features a post of mine from last week on value investing. If you’re new to Invest Wisdom, I hope you enjoy the site, and subscribe if you like it!

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Berkshire Hathaway’s annual meeting is always part-carnival, part-symposium for the world’s greatest investors. Several years ago, Warren Buffett, the company’s leader, dubbed it “our capitalist’s version of Woodstock”, and the name has stuck.

Thousands flock for the weekend near the company’s headquarters in Omaha, Nebraska, and Buffett talks on a wide range of subjects, pertaining to the company specifically and the economy as a whole. It’s easy to get lost in the round-the-clock coverage of the Oracle of Omaha’s yearly salon, but I’ve culled from various news reports five things that Buffett said that I think average investors should pay attention to.

1. Buffett thinks inflation will go up. To pay for the trillions of dollars in fiscal stimulus being pumped into the economy, the government will have two choices: raise taxes or print money (that is, let inflation rise). Because politicians loathe the backlash of tax hikes, Buffett thinks they’re likely to pay for their spending the backhanded way, by devaluing the dollar.

What to do: If you think Buffett’s right, the most traditional defenses against inflation are Treasury Inflation-Protected Securities (a.k.a. TIPS), I Bonds, and commodities like gold and oil. Stocks also aren’t a bad investment, since their earnings should reflect rising prices, but depending on the business, companies can have trouble passing costs through. I’d go with TIPS or I Bonds because they’re designed to protect against inflation. Commodities, on the other hand, can be extremely volatile, no matter what inflation is actually doing. If you do go the commodity route, stick with ETFs rather than buy the actual materials, which can be hard to buy and sell.

2. He still thinks his equity put options will make money. Don’t worry about the technicalities of an equity put option. Basically, Buffett insured some investors against the possibility that major stock indexes would be down when the contracts expire between 2019 and 2028. At the meeting, he expressed confidence that those contracts would be pure profit for Berkshire. In other words, he firmly believes the stock market will have moved up and past the insured values in the next 10 to 20 years.

What to do: Buffett has always been candid about his feelings, whether it be on his own company or on the market as a whole. In fact, Buffett mentioned that he thinks he’ll probably lose money in his credit default contracts that expire in the next five years. In other words, he thinks he underestimated how many companies would go bankrupt in the near term. But Buffett’s bullish on the longterm rise of the stock market. For you, that probably means you shouldn’t hunker down for another “lost decade” as we had in the last 10 years and avoid stocks. If he’s right, it could cost you bigtime.

3) Buffett’s not planning to buy back shares of his own company. And more important, he thinks that Berkshire Hathaway’s $92,500 share price is not “demonstrably below” a conservative estimate of the company’s value, despite being down about 30% from a year ago.

What to do: On its own, Buffett’s basically saying he can’t make the case that his company is at a bargain basement price. But we can extrapolate a little to determine what price-to-earnings ratio Buffett views as conservative. In the May issue of Money, I (along with an unnamed money manager very familiar with the company) came up with an estimate of about $103,600 for Berkshire’s intrinsic value. To do that, we looked at the earnings of the companies that Berkshire held and multiplied them by a P/E below the average P/E of the sector.

So, for example, Buffett’s utilities companies earned about $1,100 per share in 2008. The average P/E of a utilities company was 10. So to be conservative, we multiplied the earnings by a P/E of 8 to get an estimated value of $8,800 per share of Berkshire’s utilities companies.

The fact that our estimate ends up above Buffett’s “conservative” estimate for his own company means that his “conservative” P/Es must be below the ones we used, even after factoring in the 11% decline in earnings that Berkshire suffered in the first quarter.

That would mean, if you wanted to buy a company at a discount that Buffett considers to be very low you’d want utilities companies with P/Es below 8, and financials and retailers with P/Es below 10. That’s not a perfect guideline (another popular way of valuing financials is a price-to-book ratio, for example) but it is helpful for a general understanding of how conservative Buffett is being when building in a margin of safety for his stock purchases. And the answer is: very conservative.

4. He sold $5 million worth of Treasury bills for more than $5 million. In other words, whoever bought those Treasuries from Buffett (on Dec. 18, 2008) was willing to get a negative yield on those Treasury bills. For the record, he sold it for only $90.97 over $5 million, but it’s still extraordinary that investors fear risk so much that they’d take a negative yield in the only no-risk investment out there.

What to do: In his annual report, Buffett wrote this gem:

When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

If you hold Treasury bonds directly, although they’re probably worth a lot right now, it would be difficult and costly to try to sell them to someone else unless you own a whole lot of them. On the other hand, if you have a lot of money tied up in long-term government bond mutual funds, now might be the time to get out of those and into something more fairly valued.

I’d personally invest it in a stock mutual fund, but if you want to stay with the risk-free route, TIPS or a mutual fund investing in them would seem to be a better deal. Even those with a regular old bond index fund should be wary. Vanguard’s Total Bond Index fund, for example, has 24% of its holdings in U.S. Treasuries. That doesn’t mean Vanguard’s doing something wrong; it’s just the nature of an index. But it’s one potential time bomb I’d keep your eye on.

5. Buffett wouldn’t buy U.S. newspapers at any price. He says he sees unending losses for the entire industry and no business model that could save them.

What to do: This probably doesn’t mean much to you (other than the death of your local newspaper). For me, a print journalist, it means I should be looking for a new job.

Thanks for reading.

- Joe Light

Tom Forester and the Forester Value Fund posted a tiny 0.4% gain in 2008. That’s nothing special until you consider that Forester Value was the only stock fund to make money last year, beating the S&P 500 by more than 37 percentage points.

Tom Forester of the Forester Value fund

The fund, which invests in large-cap value stocks, only had around $30 million in assets last year. But as you can imagine, its popularity has greatly increased. Forester says the firm will have more than $100 million in assets soon.

I had breakfast with Forester this morning. We talked about a lot of stuff, but he made one particularly counterintuitive point that I wanted to highlight. It’s timely, given that I’ve had such a focus on avoiding companies with debt problems recently.

Forester said this:

I think we might have too much quality in our portfolio. By that I mean that most of the companies we own have lots of cash or good balance sheets generally. That’s helped us a lot over the last few months. But I think going forward, it’s the lower quality companies that will perform better, at least in the shortterm. Those companies were hurt bad because of their debt issues. For a time, investors were afraid of this whole survival issue–who’s going to make it? As the credit market eases, those are the kinds of companies that will have a lot of losses to make up.

He didn’t mention any specific moves his company had made or was going to make. (It would probably be illegal or at least unethical for him to do that.)

But he did say that he thinks the kinds of stocks on the “edges” of quality will be the first to come back. And those would be cyclical stocks, like Boeing, FedEx, and 3M. That is, companies whose earnings can dramatically fluctuate depending on what stage of the economic cycle the country is in. Those companies, despite not having significant debt issues, were hurt because investors weren’t sure if their short-term earnings problems could cripple them as debt came due. As the concerns about financing debt ease, those companies start to look good again.

As a small investor without a lot of money to diversify in individual stocks, I’d still stick to companies with good balance sheets or to index funds. If there’s another hiccup in the credit markets, and a “low quality” company goes bankrupt, the pain of losing all your money in one stock would just be too great. In practice, I happen to stick to mutual funds, both because I think it’s the right thing to do for the amount of money I have and because I don’t want to have ethical issues with mentioning specific companies in things I write.

But even though mutual fund managers’ winning streaks tend to be shortlived, when the only guy to not lose money in 2008 makes a prediction, I’d pay attention. Over the next couple days (beginning Monday), I plan to talk about a few other things Forester brought up at our meeting.

I hope to see you back.

- Joe Light

This is the last in a four-part series on value investing. It follows a story I wrote for Money magazine in this month’s issue. Leading up to this post, I wrote about what value investing is, how to use a price-to-earnings ratio, and how to pick companies that will continue to grow earnings.

To finish off my series on value investing, I’m going to talk about a couple additional things value investors should do in this market that might not have been a focus in the past.

So did you understand how AIG made money? Be honest.

1) Buy businesses you can understand, and

2) Make sure the company doesn’t have a lot of debt that comes due soon.

Neither of these things are really “new”. Any value manager worth his salt should have done this before the credit crisis, but when earnings were rolling in and credit flowed freely, it might not have seemed urgent at the time.

Understand the business

You probably thought you knew how banks and insurance companies made money. But needless to say, most of the companies that are in deep trouble right now were the same ones that found “innovative” profit centers during the boom. AIG, for example, had plenty of vanilla insurance products that you’d recognize from its cheesy and now laughable commercials. But unfortunately for investors, it delved into credit default swaps, which basically bankrupted the company.

Before you invest in any company, pull their most recent annual and quarterly reports, which you can find in “Investor Relations” at the company’s websites, and read them front to back, including footnotes. If there’s anything that you don’t understand, research the topic until you do understand it or don’t invest at all.

AIG’s failure was spectacular, but mistakes can be made on a less dramatic scale. Warren Buffett famously avoids investing in most tech companies, not because he doesn’t think they have potential, but because he doesn’t understand how the companies work. He prefers investing in companies like Coca Cola and See’s Candies (which isn’t a public company), which make profits in very understandable ways. His companies’ profits can still go down, but at least that risk was known before the investment.

For me, personally, that means no investments in banks, insurance companies, and companies that rely on new technology. I do, on the other hand, know a lot about media properties and real estate companies, by virtue of the business I work in and the businesses I’ve covered in my career. (I also know enough to see that there aren’t many great investments in those areas). Your expertise is probably completely different.

Check a company’s debt structure

This is probably the most complicated thing I’ll talk about in this series, but it’s also one of the most important and is unique to this crisis.

Several years ago, companies had no trouble borrowing money. If they had bonds that matured (which means that they have to pay back the millions of dollars that they had initially borrowed), the companies could just roll over (i.e. refinance) that debt without a problem. But now, even companies with good credit history are having trouble refinancing large amounts of debt. If they are able to refinance, they’re having to pay very high interest rates.

That kind of a problem can bankrupt or seriously cripple an otherwise healthy company. And for that reason, make sure the company doesn’t have a bundle of debt coming due in the next three years. Hopefully, by 2012 or sooner the credit markets will have completely loosened up. But until then, take nothing for granted.

To make sure that a company isn’t about to face a refinancing problem, follow the steps detailed in my value investing story for Money in the last section. Again, this might not be a huge issue once the credit markets finish thawing, but right now, it most definitely is.

Well that’s it for now. Even in a few thousand words, this is really only a basic outline of some of the things value investing encompasses. If you don’t have the time or inclination to continue studying the subject, stick with an index fund or an actively managed fund that focuses on value stocks. (For a list of funds that Money magazine recommends, click here.)

Thanks again for reading.

- Joe Light

The Federal Reserve decided to leave the target interest rate between 0% and 0.25% today. Even before the Fed’s news, the market had soared, and it’s continued its climb upward since the Fed’s announcement. As of this writing, it’s up more than 2.5%.

I’ve always tried to be as candid in this blog as possible. While I did write that the stock market appears to be undervalued a couple months ago, I don’t understand why the stock market run up has been so dramatic. As the Fed’s statement today noted, the economic picture is still worsening, albeit at a slower pace.

Fed chairman Ben Bernanke

What really has me worried though is what happens once the economy does turn around. The stock market tumble has been marked by a flight to quality: risky assets, such as stocks, have been shunned in favor of ultrasafe assets. The ultrasafe asset of choice for the world’s investors has always been the U.S. Treasury bond.

So, billions of dollars that got pulled out of the stock market went into Treasuries, driving their prices down, and allowing the federal government to finance this bailout at extremely low rates. As long as people desperately want Treasury bonds, the government can continue to borrow money at only 1% to 3% interest.

But what happens when confidence in the market is restored, and that money comes streaming out of Treasury bonds and back into stocks? Sure, the picture looks good for the stock market, but what interest rate will the government have to offer to get people to keep buying Treasuries?

Take this quote from the Federal Reserve statement: “In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.”

In other words, to keep interest rates low, the Federal Reserve is already buying Treasuries. This means that the federal government is already printing money.

Once people are willing to take risk again and less liable to buy Treasuries, how is the Federal Reserve going to be able to keep interest rates from getting out of control as tons of Treasury debt needs to be refinanced? A common answer is that the U.S. economy could grow its way out from under all that debt, but if nothing else, hasn’t the market proven itself to change its perception rapidly between euphoria and fear and back again? If so, do we have time for the market to grow the country out of debt?

It’s a classic catch-22. The government’s success in restoring confidence in the markets will also make it more expensive for them to borrow money. I don’t have the answers to any of those questions. It’s just one more fear of mine that will or won’t play out down the road.

- Joe Light

On Monday and Tuesday, I wrote about what value investing is and provided an introduction to the price-to-earnings ratio.

Today, I’m going to write about four things that value investors look for beyond a low P/E:

1) Wide economic moats

2) Strong brands

3) Consistent earnings, and

4) A margin of safety

Investors study economic moats, brands, and earnings consistency (and many aspects in addition to them) for the same reason: They want to make sure that the E (earnings) in the P/E ratio stays steady or grows after they buy the stock. In yesterday’s example, we looked at Wal-Mart, which had earnings per share of $3.43 in the last twelve months. That gave it a P/E of 14.5, which was below that of its industry and of the S&P 500.

But what if those earnings per share dropped sharply after you bought the stock? Let’s say they dropped by 30%, which doesn’t look that unreasonable in this economy. Instead of $3.43, Wal-Mart’s earnings would be about $2.40. A stock that you bought at a P/E of 14.5 would suddenly have a P/E of nearly 21. And more than likely, the stock price would drop as a result of that.

Studying the factors above helps investors predict whether or not there’s a chance those earnings will erode.

Wide economic moats

A wide economic moat is basically a high barrier of entry into the industry. A mom-and-pop hero sandwich shop, as I talked about a couple days ago, has a very small economic moat. Anyone could start their own hero shop next door and immediately cut into the original store’s business.

That makes its earnings extremely vulnerable. Even though that hero store owner might make $300,000 in one year. If someone started a store on the opposite corner and charged lower prices, he’d likely lose business and have to lower his own prices.

Wal-mart, which is a discount retailer on a massive scale, has a very wide economic moat. To offer the prices that Wal-Mart offers, a retailer would have to buy inventory in bulk, have a huge distribution system with razor-thin expenses, and rent about 100,000 square feet of retail space for each store. That’s not impossible, but it’s unlikely another retailer will enter the business. There is another major retailer that still survives in the space — Target. But Target is a known competitor whose impact on Wal-Mart’s earnings should already be reflected.

Company’s with wide economic moats tend to have low costs, high return on capital, and huge marketshare in their industries.

Now let’s take a look at a company like Research in Motion, the maker of the Blackberry. Research in Motion is basically in the communications business–its device lets you view emails on your cell phone and send them instantly between devices or to computers.

At one time, it might have looked like such a network was unique and had a wide economic moat. But now, pretty much every phone maker out there is putting out a “smart phone” designed to attack the very same business Blackberry has relied on. The iPhone has already been a major entrant into the scene. While Research in Motion’s earnings per share was $3.11 in the last twelve months, it seems unlikely that they can maintain that as the iPhone’s reach expands.

Strong brands

A couple months ago, PepsiCo redesigned many of the major logos of its brands. Some were a success, but there was one overwhelming failure: the redesign of Tropicana orange juice.

Tropicana's new design (left) and its old design.

Instead of the characteristic orange with a straw stuck inside, shoppers saw a slicker, toned down version that some people complained looked like a generic brand. The result? Tropicana orange juice sales plunged 20%. Needless to say, they’re returning to the old design.

A company with a strong brand has an emotional connection with the consumer. They look for the characteristic metallic red cans and cursive writing that signify a can of Coke or the slick white or silver designs that mark an Apple product. Brands develop overtime and can’t easily be replaced by a competitor.

Coke and Apple, as mentioned, are easy examples of companies with strong brands. They don’t necessarily have to have a well-recognized brand among the general populace. Cemex, while not the most well-known company among the general populace, is certainly known by construction companies that purchase their cement.

Young companies, of course, don’t have that brand recognition, which makes their business more vulnerable to competitors.

Strong normalized earnings

If you just look at the current P/E of a company, all you’re really getting is a snapshot of how the company performed at a moment in time. For mature companies, many investors like to look at something called “normalized” earnings rather than the earnings of the last year.

Earnings that are normalized are averaged over time. So instead of looking at a company’s 2008 earnings, you look at its average earnings for 2004 through 2008. By looking at a longer time period, you smooth out the peaks and valleys that companies might experience because of a temporary setback or economic cycles.

Take a look at Wal-Mart’s 10-year earnings track record. Over five years, its earnings has averaged $2.60 a year. Over the last ten years, it’s been $1.99. The 10-year average is much lower because Wal-Mart’s earnings grew pretty sharply over that period.

Divide Wal-Mart’s per share price of $48.47 by the normalized earnings, and you get a P/E of 18.6 for the five-year earnings and of 24.4 for the 10-year. To put it in terms of yield, paying $48.47 for a share of Wal-Mart right now would yield you about 5.4% if Wal-Mart’s earnings keep up with its 5-year track record.

The margin of safety

As you can see, all of the things listed above are very subjective. Does Coca Cola have a stronger brand than Pepsi? Is Wal-Mart really invulnerable to a start-up competitor or an expansion of Target? In other words, there’s a very good chance that at least one of your assumptions will be wrong.

The “margin of safety” is supposed to give you leeway in case your estimates are off. By definition, the margin of safety is the difference between the market price of a stock and the “intrinsic value” of a stock.

Let’s say you look a company such as Wal-Mart and decide that the company’s earnings consistency and wide economic moat make an investment in such a company about 5% riskier than the yield you could get in an ultrasafe CD. In other words, given what you know about Wal-Mart, you’re willing to put your money at risk for an additional 5% of return. What do you know? Wal-Mart’s P/E of 14.5, gives you a 7% yield exactly. So you buy the stock at its current price of $48.47.

But, as is likely the case, pretend one of your assumptions about Wal-Mart’s safety was wrong, and its earnings dropped by 10%. Now you only have a yield of 6.4%, below your target. You can’t just sell the company, as its stock price has probably fallen to reflect that.

Your purchase had no margin of safety, and just the slightest error caused it to be a bad investment.

Now let’s pretend Wal-Mart was selling for $40 per share, instead of $48.47. You would have been happy with a 7% yield in Wal-Mart, but at $40 per share, Wal-Mart is actually yielding 8.6% ($3.43/$40 * 100). Your estimate ends up being wrong, and earnings drop 10%. Even with the miscalculation, your yield is still 7.7%, which is well above your target. ($3.09/40 * 100). In fact, at the share price of $40, you could withstand an 18% drop in earnings without passing your target.

That, in a nutshell, is why value investors never want to pay what they calculate as the “fair value” of a stock. They want to pay a huge discount to that.

How big a margin of safety is big enough? As a general rule of thumb, the more uncertain you are about your estimate, the bigger a margin you want. I’d feel pretty confident in my earnings prediction for a company that’s earned exactly $1 per share per year for the last 10 years. Whereas I might not be as confident (and would want a bigger margin of safety) for a company whose earnings wavered between $1 per share and $5 per share in that time period, or for a company who makes a product that could easily being overtaken by the next hot item.

Tomorrow, I’m going to talk a little bit about other ways investors try to value companies and about what’s changed about value investing since Graham and Dodd articulated the process. If you got to the end of this post, congratulations! You’ve read nearly four times more about value investing than I was able to detail in my recent Money article. And really, we’ve only brushed the surface.

Thanks for reading.

- Joe Light

Hello attendees of the Carnival of Personal Finance at Weakonomics! Thanks for checking out my blog. The post below was the second in a four part series on value investing. The series started here, and continued here and here.

I really appreciate that you’ve come to check the series out. Subscribe here if you like what you see. And remember to check out today’s post which highlights five things investors should remember from Berkshire Hathaway’s annual shareholder meeting (the company Warren Buffett runs).

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Yesterday, I wrote about the foundation of value investing and what value investors strive to do.

Today, I’m going to give a quick summary of value investors’ most popular tool, the Price-to-Earnings (i.e. P/E) ratio.

The P/E ratio is probably the most widely used measure of a stock’s value out there. I’d argue it’s also the most understood. I’ve read about investing strategies that rely on nothing but the P/E ratio to choose stocks. That doesn’t make sense, and I’ll do my best to explain why.

Calculating a price-to-earnings ratio is easy. You take the company’s current stock price and divide it by its earnings per share. Both of those can be found as popular websites, such as Yahoo! Finance, but most of the time, those same websites will simply give the P/E to you, already calculated.

The number that’s used for the earnings per share can vary between services. Most of the time, the default is to use the earnings from the trailing twelve months (TTM). But sometimes you’ll see a P/E based on estimated earnings for the forward 12 months or for the current fiscal year. All three of these kinds of P/Es are important. A service such as Morningstar will give you all three P/Es.

In effect, the P/E tells you what your money will yield, similar to the yield calculated for the hero sandwich shop in yesterday’s post. Except the ratio is inverted. To get the earnings yield, you divide the earnings per share by the price. The P/E is just the opposite.

Rather than take two mythical companies as we did yesterday, let’s look at an actual stock — Wal-Mart (WMT).

Go to the Morningstar page for Wal-Mart, click on “Valuation Ratios”, and you’ll get this page.

Wal-Mart’s price-to-earnings ratio, using trailing twelve month earnings, is 14.5. The retailing industry has a P/E of 15.8, and the market as a whole (represented by the S&P 500) has a P/E of 15.5.

I just threw a whole lot of numbers out there, but the basic premise is pretty easy. All else being equal, you want a company whose P/E is lower than that of its peers and that of the market. Wal-Mart’s stock meets both criteria.

If you look at Wal-Mart’s P/E based on estimated earnings (Click on the “Forward Valuation” tab), you’ll see a forward P/E of 12.5. This is even lower than its current P/E and means that analysts predict the stock’s earnings will go up this year.

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Easy buy, right?

Well, the problem is the “all else being equal” part. Analysts regularly underestimate and overestimate earnings. What’s more, the P/E ratio doesn’t take into account any assets or debt that company has.

Take two companies. One has a P/E of 14, $100 million in cash on its balance sheet, and no debt. The other has a P/E of 14, $50 million in cash, and $400 million in debt. If you looked just at the P/E ratio, those companies would look equal. But take a look at the company’s balance sheet (where the assets and debts are recorded) and you’ll see a big difference.

Some investors try to take this discrepancy into account by subtracting cash from the share price or adding debt to the share price to calculate the true cost (known as “enterprise value”) of the company.

If you look at Wal-mart, for example, you’ll see that the company has $52.9 billion in “current” or liquid assets and $102.3 billion in total liabilities. (To find that, click on “Financial Statements” > “10-year balance sheet”) So its net liabilities are $49.4 billion. Divide that by the number of shares of Wal-Mart (about 3.9 billion) and you get net debt per share of about $12.61.

So while a share of Wal-Mart costs about $48.40, you’re actually taking on an extra $12.61 of debt, bringing the total per share price to $61.02.

Take $61.02 and divide by Wal-Mart’s per share earnings ($3.43) and you get an enterprise value/earnings ratio of 17.8. Doesn’t look as good now, right?

——

That’s just one of many reasons why a P/E is too blunt an instrument to use by itself in valuing companies. 17.8 seems like a high ratio, but Wal-Mart gets a premium for being a market leader in its industry and for having strong growth prospects in a recession. Unlike those of a company whose earnings are dropping (like an automaker), Wal-Mart’s earnings will probably grow over time. Investors know that. So they’re willing to pay a higher P/E for Wal-Mart.

In addition to looking at the P/E of companies in the traditional way, I’d recommend thinking of the P/E in an absolute sense. A company with a P/E of 10, for example, is giving you about a 10% yield for your money. That’s compared to guaranteed 2% to 4% yields in ultrasafe investments like CDs or money market accounts. When you see the 10% yield, tell yourself, “I could guarantee myself a 2% yield if I just stuck my money in a bank account. How confident am I that the company will be able to maintain or improve its earnings? And does the extra 8% yield pay for that additional risk?” If the answer is “very confident”, then the 10% yield is a very good deal.

A P/E of 10 in a company like Wal-Mart looks much better than a P/E of 10 in a company like GM. That’s what value investors mean when they say they look for companies with stable earnings, wide economic moats, and strong brands. What they’re really saying is just that they look for companies where they’re confident the earnings won’t erode.

Unfortunately, that kind of judgment is qualitative, not quantitative, and it separates brilliant investors like Warren Buffett from the also-rans.

You don’t have to be as adept as Buffett to find bargain companies. Most of the “secret” is simply to build in a margin of safety in case your estimates are off by a small (or sometimes wide) margin. I’ll address those qualitative measures in tomorrow’s post.

Thanks for reading.

- Joe Light

If you’re coming from the Carnival of Financial Planning, welcome, and thanks for stopping by. If you like what you see here, remember to subscribe!

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Yesterday, the market dropped 1%. Most media outlets assigned the drop to fears that swine flu could cause a worldwide pandemic.

I’ll admit that I was first skeptical of the idea that investors would react that way to a disease that’s only infected 50 people and killed no one in the U.S. (as of last night). Tamiflu, which has been found to be an effective treatment, is already stockpiled. (And if it’s resistant to Tamiflu, stockpiles of other drugs are available.

Now don’t get me wrong. It sounds like this flu has the potential to be a big deal. I feel sorry for those who have suffered from it or died, and I know that I’m suffering from a bit of “boy who cried wolf” fatigue, after the bird flu and SARS false alarms. But swine flu causing the market to fall?

Well, before I went into a huff about how the markets and the media always blow a small problem out of proportion, I did a little research. Last year, the World Bank estimated that a massive pandemic, such as the Spanish flu in the early part of the 20th century would cause world GDP to drop by 4.8%. A “moderate” pandemic, such as the 1957 Asian flu which killed 14 million people, would hurt GDP by 2%. A mild flu pandemic, such as the one starting in Hong Kong in 1968, would hurt GDP by less than a percentage point.

The big question, of course, is how bad will this one be? And how much would the market suffer as a result of that?

A popular method of measuring world stock market values is to take a country’s total market capitalization (that is, the total value of all companies in the country) and divide it by the country’s gross domestic product.

Right now, the market cap of the S&P 500 is $7.5 trillion. The U.S.’s GDP in the fourth quarter of 2008 was $14.2 trillion. That gives us a ratio of about .53 .

The World Bank’s estimate was for world GDP, but let’s assume a potential pandemic affected the U.S. proportionally. The U.S.’s GDP is already expected to fall this year for other reasons, but let’s just measure what the swine flu’s impact alone would be.

In the event of a major pandemic, where U.S. GDP dropped by 4.8%, U.S. GDP would drop to $13.5 trillion. Keeping the .53 ratio, the S&P’s market cap would drop to about $7.2 trillion, which is a 4.5% 4.8% drop in the S&P 500’s value.

For a moderate pandemic, where GDP drops by 2%, you’d expect a 1.7% 2% market drop.

For a mild pandemic, where GDP drops 0.7%, you’d expect a 0.36% 0.7% drop.

The market’s drop of 1% yesterday (if it wasn’t paying attention to anything else, which is unlikely), factored in a pandemic somewhere between the mild 1968 Hong Kong flu and the moderate 1957 Asian flu, if you believe the World Bank’s numbers.

Now for my disclaimer: There are so many assumptions I just made that it’s difficult to list them all. The market cap to GDP ratio might not remain consistent in the event of a GDP drop, since investors tend to look past short-term setbacks. In other words, while GDP would drop 4.8% in the event of a major flu, would there also be a huge rebound once the flu passed? Does the current economy’s fragility make it more susceptible to a setback by the flu? And so on.

I do hope, however, that this helps put the crisis in perspective.

Come back later for my second post in my series on value investing.

Update: I now realize that I did a bunch of calculations that really just explained something very simple: the market cap should fall in proportion to the GDP’s fall. And a 1% drop in the market, would seem to project a 1% drop in GDP, which is somewhere between the mild and moderate flu pandemic scenarios. Not sure why actually sticking all those numbers in a calculator came up with slightly different numbers. It probably has something to do with rounding and dealing with trillions of dollars.

- Joe Light

As far as I can tell, I’ve finally completed the process of moving Invest Wisdom to its own domain. You can now find the blog at www.investwisdomblog.com, so please update your bookmarks and links if you have them!

All traffic going to the original wordpress.com site should automatically forward to this site. I’ve also updated Feedburner. So those subscribed to Feedburner’s feed should receive the blog just as they always have. Those of you subscribing some other way can find the feed at www.investwisdomblog.com/feed .

Please let me know if anything seems messed up, and I’ll get right to work on it. You can contact me at joelight at gmail dot com.

Thanks again.

- Joe Light