Step One to obtaining the rewards of stock valuation without doing all the work — Appreciate its importance.
I am mystified as to why many middle-class investors do not aim to invest in a valuation-informed way. There is nothing that you can learn about how to invest that will pay greater long-term rewards than learning about the benefits of stock valuation.
It’s simply not possible to invest intelligently without looking into valuation questions. To purchase stocks without engaging in some sort of valuation analysis is like purchasing a car or a house without first asking the price. It doesn’t make even a tiny bit of sense to do something like that.
If you purchase stocks without tackling stock valuation questions, you are shooting in the dark with your investment strategies. You have no way of knowing whether you are getting a good deal for the money you invest in stocks or not.
Step Two to obtaining the rewards of stock valuation without doing all the work — Accept that there is a price to be paid for not doing a lot of research.
The best way that I know of to become an expert at stock valuation is to study how Warren Buffett goes about determining whether a stock purchase makes sense or not. Buffett is the master.
The problem with the Buffett approach is that it is a difficult and time-consuming approach. Many middle-class investors are not cut out for it. This is why Buffett himself recommends index investing for the typical middle-class investor.
Many index investors argue that it is not possible for those following the Buffett approach to obtain gains better than those obtained by indexers. I don’t buy this argument. I believe that there are often rewards paid to those who take the time to research their stock picks carefully. Buffett’s long-term success is evidence of this.
I believe that, if you are not willing to engage in the years of research required to make you a top-notch stock picker, you are likely to pay a price for not doing so. I think it is a mistake for many indexers to argue so strongly that this is not so.
Step Three to obtaining the rewards of stock valuation without doing all the work — Understand that the price paid for not doing a lot of research need not be that large.
John Bogle revolutionized the world of middle-class investing by developing and popularizing the indexing approach to investing. When you buy an index, you lock in for yourself the return of the market as a whole. While I do not believe that this approach is likely to provide returns as good as the Buffett research-oriented approach, it can provide pretty darn good returns. I think of indexing as the “good enough” approach to investing.
Why settle for an approach that is merely good enough? Because the years of research work required to succeed using the Buffett approach are not needed to succeed at investing. With indexing, you don’t need to worry about whether you have picked good companies or not as your investment choices. You pick them all, the good and the bad, and, so long as the market as a whole earns good returns, so do you.
Given the returns typically earned by the market as a whole (the U.S. market has generated a long-term annualized real return of 6.8 percent), that’s a pretty darn good deal. I think of it as an application of the wonderful 80/20 rule. There are some endeavors in life in which you can obtain 80 percent of the potential benefits by engaging in 20 percent of the effort that it would take to obtain 100 percent of the potential benefits. In life endeavors in which that rule applies, it makes sense to tap into the benefits of the 80/20 rule.
Step Four to obtaining the rewards of stock valuation without doing all the work — Don’t fall into the trap of becoming an Indexing Purist.
Indexing is a wonderful deal. Unfortunately, there is a group of investors that I refer to as Indexing Purists or True Believers who manage to turn what should be a wonderful deal into something a lot more dubious. I noted above that indexers often argue that it makes no sense ever to pick individual stocks. I disagree.
It may be that you don’t generally have the time to perform the research needed to succeed at the Buffett approach to investing, but that you are able to do research on particular companies at particular times. If that’s the case, why not go ahead and do it? I would not advise putting too large a portion of your portfolio in a small number of stocks because you give up the benefits of diversification by doing so. But there are benefits to be had by following more than a single approach to investing. One obvious benefit to doing some stock picking is that you learn about the companies you investigate and over time that makes you a better-informed investor.
An even bigger problem with the Indexing Purists is that they often argue that valuations do not matter. This claim does not make sense, in my view. Please do investigate the indexing option. It is a great option for most middle-class investors. Please try to avoid the dogmatism of the Indexing Purists. Please keep in mind the importance of always examining stock valuation questions before you invest.
Step Five to obtaining the rewards of stock valuation without doing all the work — Combine the insights of Warren Buffett and John Bogle.
Due to the unfortunate influence of the Indexing Purists, many investors have come to think of Warren Buffett and John Bogle, who are both giants in the investing field, as coming from entirely different schools of thought. The idea seems to be that, if Warren Buffett is right in the way that he goes about investing, John Bogle must be wrong in the way that he goes about it. And, if John Bogle is right in the way that he goes about investing, Warren Buffett must be wrong in the way that he goes about it.
That’s dumb.
I noted above that Buffett himself endorses use of the Bogle approach for the typical middle-class investor. So obviously Buffett does not believe that it has to be his way or the highway. I don’t know what Bogle thinks about the Buffett approach, but it’s hard for me to imagine that Bogle doesn’t have a good deal of respect for the many powerful insights that Buffett has put forward. So let’s dismiss as True Believer silliness the idea that you need to choose between the thinking of one of these two giants.
Why not combine the best of Warren Buffett with the best of John Bogle? It’s my view that these two investing philosophies go together like peanut butter and chocolate. A combined approach makes more sense for most middle-class investors than does either approach standing alone.
What does it mean to combine the Buffett approach with the Bogle approach? It means to never lose sight of Buffett’s focus on stock valuation while tapping into the investing-made-easy benefits of Bogle’s indexing revolution. Practice indexing, but do so in a valuation-informed way.
Step Six to obtaining the rewards of stock valuation without doing all the work — Think through William Bernstein’s explanation of why it is easier to predict the returns of entire markets than it is to predict the returns of individual companies.
Why is it that Warren Buffett and those who follow his investing approach spend so much time and effort in the pursuit of effective stock valuation? It is because they want to know that the stocks they are buying are worth the money they are paying for them. The purpose of stock investing research is to predict the return to be obtained from the stock purchased.
Most investors who pick individual stocks engage in stock valuation. They would feel irresponsible not to do so. Most indexers do not do this. I cannot tell you why. I find it an exceedingly strange reality. But it is a fact that most indexers do not do this. A good number are even hostile to the idea of engaging in stock valuation.
The incredible reality is that stock valuation is a far easier task when directed to the task of valuing an index than it is when directed to the task of valuing an individual company. William Bernstein explains why in his book The Four Pillars of Investing. Bernstein tells us: “Not infrequently, promising companies with large expected future dividends streams stumble and fall; nearly as often, companies given up for dead recover and provide shareholders with prodigious amounts of future income. On the other hand, when you examine an entire market, consisting of hundreds or thousands of companies, these unexpected events average out. For this reason, the income stream of the market as a whole is a much more reliable calculation.”
The incredible investing reality of June 2006 is that most investors following the Warren Buffett approach engage in stock valuation (even though it is hard work when investing in individual companies), but most investors following the John Bogle approach do not engage in stock valuation (even though it is not too hard to do when investing in a broad index). You make sense of that one, if you can. Please drop me an e-mail if you come up with anything good.
Step Seven to obtaining the rewards of stock valuation without doing all the work — Familiarize yourself with the P/E10 valuation tool.
The intuitive way to practice stock valuation when investing in index funds is to check the price/earnings level that applies for the market in which you are planning to invest. You want to know how many dollars you are being asked to pay for each dollar of earnings you are purchasing. The P/E value purports to tell you that.
There’s a problem with looking at the plain P/E value of the market. The problem is that changes in earnings can jump wildly from year to year because of recessions and other temporary events. These wild swings can cause dramatic jumps upward or downward in the P/E value that do not reflect well the true value proposition of a purchase of the shares of that stock market. If you want to engage in effective stock valuation for an index-fund purchase, you need to do a little more than look at the plain P/E value.
Not much more, though. An good way of smoothing out artificial earnings jumps and falls is to instead look to the P/E10 value, the price of the index divided by the average of its earnings for the past 10 years. While the plain P/E does not always provide reliable stock valuation information, the P/E10 tool works reasonably well. This is the tool used by both Robert Shiller (author of the book Irrational Exuberance) and John Walter Russell, publisher of the Early-Retirement-Planning-Insights.com web site.
If you plan to engage in stock valuation in the indexing context, you should familiarize yourself with the P/E10 tool.
Step Eight to obtaining the rewards of stock valuation without doing all the work — Don’t get too cute.
You have probably heard that short-term timing does not work when investing in stock index funds. There is a good bit of research indicating that that is indeed the case. If you make too many moves in and out of the market, you will probably hurt yourself. If you shift large amounts of your assets in response to small changes in valuations, you will probably hurt yourself. If you try to pick precise bottoms and tops in market prices, you will probably hurt yourself.
Forget the discredited short-term approach to market timing. Aim instead to engage in a more sensible approach to taking stock valuations into account in determining how high to go with your stock allocation. Clifford S. Asness stated the message of the historical stock-return data well in an article (“Rubble Logic: What Did We Learn from the Great Stock Market Bubble?”) recently published in the Financial Analysts Journal. Asness tells us: “Changing your exposure to the stock market based on current prices with a long horizon in mind, and perhaps only at extremes, seems like a form of market timing that would be beneficial.”
Step Nine to obtaining the rewards of stock valuation without doing all the work — Start slow.
I think that Valuation-Informed Indexing is an approach to investing that makes a lot of sense. It is a new approach, however. Many find it strange to try to combine the best insights of Buffett with the best insights of Bogle. Many feel that investors need to choose one path or the other.
Why not ease your way into this new approach? When the P/E10 value for the S&P index is high (as it is in June 2006), lower your allocation to the S&P index. When the P/E10 value for the S&P drops to moderate levels, increase it a bit. When the P/E10 value for the S&P drops to low levels, increase it still more.
I believe that the more you think about the Valuation-Informed Indexing approach, the more you will come to see that it represents the best of the Buffett and Bogle worlds combined into one very exciting package. If you run into problems, please let me know. I hope to be able to develop this approach as fully as possible before stock prices fall, so that middle-class investors seeking an alternative to the Indexing Purist or True Believer approach when that approach fails them will have something available to them that permits them to put the long-term buy-and-hold concept to a more realistic and more practical and more effective use.