If you have heard fund managers talk about the way they invest,
you know a great many employ a top down approach. First, they
decide how much of their portfolio to allocate to stocks and how
much to allocate to bonds. At this point, they may also decide
upon the relative mix of foreign and domestic securities. Next,
they decide upon the industries to invest in. It is not until all
these decisions have been made that they actually get down to
analyzing any particular securities. If you think logically about
this approach for a moment, you will recognize how truly foolish
it is.
A stock's earnings yield is the inverse of its P/E ratio. So, a
stock with a P/E ratio of 25 has an earnings yield of 4%, while a
stock with a P/E ratio of 8 has an earnings yield of 12.5%. In
this way, a low P/E stock is comparable to a high - yield bond.
Now, if these low P/E stocks had very unstable earnings or
carried a great deal of debt, the spread between the long bond
yield and the earnings yield of these stocks might be justified.
However, many low P/E stocks actually have more stable earnings
than their high multiple kin. Some do employ a great deal of
debt. Still, within recent memory, one could find a stock with
an earnings yield of 8 - 12%, a dividend yield of 3- 5%, and
literally no debt, despite some of the lowest bond yields in half
a century. This situation could only come about if investors
shopped for their bonds without also considering stocks. This
makes about as much sense as shopping for a van without also
considering a car or truck.
All investments are ultimately cash to cash operations. As such,
they should be judged by a single measure: the discounted value
of their future cash flows. For this reason, a top down approach
to investing is nonsensical. Starting your search by first
deciding upon the form of security or the industry is like a
general manager deciding upon a left handed or right handed
pitcher before evaluating each individual player. In both cases,
the choice is not merely hasty; it's false. Even if pitching left
handed is inherently more effective, the general manager is not
comparing apples and oranges; he's comparing pitchers. Whatever
inherent advantage or disadvantage exists in a pitcher's
handedness can be reduced to an ultimate value (e.g., run value).
For this reason, a pitcher's handedness is merely one factor
(among many) to be considered, not a binding choice to be made.
The same is true of the form of security. It is neither more
necessary nor more logical for an investor to prefer all bonds
over all stocks (or all retailers over all banks) than it is for
a general manager to prefer all lefties over all righties. You
needn't determine whether stocks or bonds are attractive; you
need only determine whether a particular stock or bond is
attractive. Likewise, you needn't determine whether "the market"
is undervalued or overvalued; you need only determine that a
particular stock is undervalued.
Clearly, the most prudent approach to investing is to evaluate
each individual security in relation to all others, and only to
consider the form of security insofar as it affects each
individual evaluation. A top down approach to investing is an
unnecessary hindrance. Some very smart investors have imposed it
upon themselves and overcome it; but, there is no need for you to
do the same.
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