The Dow has fallen.
A reader asks: Is it time to get back into stocks?
I’m not an investment advisor. I don’t feel comfortable telling others what to do with their money. I prefer to say what I’m doing and why and then let my readers decide if it makes sense for them.
So, am I getting back into stocks? Not now. I’ll tell you why.
How I Judge a Stock
We just went through one of the longest and largest bull markets in my lifetime. From March 9, 2009 to March 11, 2020, the Dow and S&P 500 rose 351% and 400%, respectively. That was a fun ride – and I’m glad I was on it. But it became clearer and clearer as time passed that the bull I was riding was getting old.
The day the World Health Organization declared the coronavirus a pandemic, the market tumbled 6%. It has fallen since then, and is currently down about 25% from its high. (Erasing more than $8 trillion of the U.S. market capitalization.)
When deciding to buy a stock, there are two simple ways I judge its value. The first, which I’ve been doing forever, is the price-to-earnings ratio (P/E). That is determined by dividing the stock price by the earnings per share. (If the price of stock X is $50, and the earnings per share are $5, the P/E is 10.)
There are other ways to measure share value. A popular one is the price-to-sales ratio. It is determined by dividing a company’s market cap (the total value of outstanding shares) by its revenue. This is a good quick way to compare prices of companies within a given industry, but it doesn’t make sense to value stocks across the board.
Another metric is the price-to-book ratio. A business’s book value is determined by subtracting its liabilities from its assets. You take that book value and divide it by the number of outstanding shares, which gives you the book value per share. Then you divide the share price by the book value per share. I don’t use this method because it’s just too much work for my purposes.
What I like about the P/E is that it corresponds to the way I value private businesses. I wouldn’t be interested in buying a company based on sales. And I certainly wouldn’t value it that way. I’m interested in profits. Earnings are profits.
The other thing I like about the P/E is that, because it values the shares on profits, it can be used to fairly value large, established businesses in most industries – from manufacturing to agriculture to communications to energy, and so on.
In other words, it’s useful for valuing the sort of stocks I want to own: large cap, dividend-giving, industry-dominating companies that have a long history of profitability and are likely to be here far into the future.
I Don’t Try to Beat the Market
If I traded stocks or invested in growth stocks, I’m sure I’d be interested in getting more sophisticated with my value calculations. But my strategy for stocks is based on my confidence that I do not and will not ever have the interest in or patience for beating long-term market averages. I’m happy to get 8% to 12% on my money over the long haul.
Today, the average P/E for the Dow is 16.4. That’s down two points from a year ago, and it’s getting very close to the historical average of 16. P/E ratios are not reliable predictors of short-term market moves, but over 10 years or more, they work pretty well. Thus, buying stocks with P/E ratios of 15 or less would make sense. And many value investors use that as a buy-in signal.
As an investor in private businesses, I have never paid anywhere near 15 times earnings. For newer, growing businesses, I’ve paid up to 10 times earnings. But for larger, established businesses in my industry, the range is usually a four to six times multiple of the average earnings over the prior three years.
In other words, for a business that made profits of $80,000, $100,000, and $120,000 over the prior three years (an average of $100,000 per year), I’d be willing to pay up to $600,000.
You can’t do that with larger, stable public companies. Priced at the historic P/E of 16, I’d have to pay $1.5 million for the same company.
The reason for this is supply and demand. In the public sector, there are billions of dollars of buying demand every day. The larger, institutional buyers are happy to pay 16 times earnings for the sorts of stocks I prefer to buy. And they usually will. So for me, I’m motivated to buy these stocks in the 12 to 14 P/E range.
The Dow-to-Gold Ratio
Recently, I’ve added a second tool to my valuation kit. I’m not exactly sure how I will use it, but I’m looking at it because I think it makes sense.
It’s called the Dow-to-Gold ratio. I learned about it from Bill Bonner, the founder of Agora, and Tom Dyson, a colleague, who helped me assemble the core holdings of the stock portfolio I have now.
Here’s how Tom described this tool:
It’s NOT a speculation in gold. It’s a long-term buy-and-hold stock market investment strategy… with a simple market-timing element that helps us buy low and sell high.
Most of the time, we hold the stock of the world’s best dividend-raising companies. We call these “dividend aristocrats” – companies like McDonald’s, Coca-Cola, Hershey’s, P&G, J&J, and Philip Morris. [Note: This is basically the same core group that I have in Legacy stocks. No surprise there, since Tom helped design the Legacy Portfolio.]
Some of the time – when these stocks get too overbought and expensive – we go to the sidelines in gold.
We never cash out. And we never hold anything except gold and dividend aristocrats. We just wait for the Dow-to-Gold ratio to reach extremes… and then we rotate between stocks and gold accordingly.
As such, the Dow-to-Gold ratio is the only number that matters to us.
For Bill and Tom, the Dow-to-Gold buy-in ratio is 5. When they can buy all the Dow stocks for five times the value of an ounce of gold, they will be all-in.
Right now, the ratio is well above 5. But it’s moving down with stock prices down and gold moving up. It’s likely that gold will move up considerably more if the economy doesn’t drastically improve by midsummer. If that’s the case, we will see the Dow-to-Gold ratio moving toward 5.
But I’m not going to wait that long. As I said, this is a new metric for me. It makes the most sense in the long view. As individual stocks that I favor move toward a P/E of 12 and the Dow-to-Gold ratio continues to drop, I’ll start buying.
But on an individual basis.
In the meantime, I’ll keep my money in cash and wait to see what happens.