Preview of my Presentation to the Brooklyn Law School Business and Finance Society
Topic for Presentation on Feb 24:
The most important concept in Investing according to Benjamin Graham:
Why this is the first good time to buy stocks in our adult lifetimes: The relationship between long term bond yields and stock earning yields.
Explain basic terms: Earnings Yield is the inverse of the P/E ratio, Bond yield is the interest you are paid on your invested money.
Historically the returns on common stocks have been comparable to their earnings yield at the time they are bought. Long term bond yields generally represent the “risk free rate” against which the risk of common stocks should be measured. Since common stocks are not risk free, average earnings yields should normally be a bit higher than the risk free bond yields (although the extent of the risk premium is tempered by the fact that earnings can rise, while interest rates are locked in). Indeed, Benjamin Graham (Warren Buffett’s mentor) said that common stocks should not be bought without a 50% premium of earnings yield over the risk free rate. Meaning if govt. bond yields are 6%, the earnings yield on a stock should be at least 9% to be considered investment worthy.
10 years ago many companies had earnings yeilds of 0-2%, despite the risk free govt. bond rate being 6%. Furthermore, the riskier the company, often the lower the earnings yield demanded on the stock (for example, internet and high tech companies at the times often didn’t have any earnigns at all yet were very valuable on the stock market). This was a radical inverse of how the relationship should be, and foretold of the poor returns (indeed the heavy losses) investors have gotten over the last 10 years (show chart of 10 year performance of Dow, Nasdaq, S&P).
Today, large cap brand name companies such as Coca Cola, Procter and Gamble, Pepsi, and Johnson and Johnson have earnings yields of around 8-9%, and riskier companies offer much higher earnings yields (the way it should be). The risk free 10 year government bond rate is less than 3%. The relationship between the Long term bond yields and earnings yields have not only reversed back to the proper condition of earnings yields offering a premium over risk free bonds, but in fact has gone so far in the other direction that even the safest common stocks offer a 200% premium over the risk free rate.
The earnings yield of the S&P in 1999 was 3.1%. (Link here: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm)
The earnings yield of the S&P today is around 8%.
The last time we had such a large variance between earnings yields and government bonds was the early 1950’s. If you had invested then you would have gotten excellent returns in a low inflation environment, an ideal time to invest. (link here: http://seekingalpha.com/article/80580-t-bill-vs-s-p-500-earnings-yield-1936-2007). Since then, the only times earnings yields were high was when the risk free rate (and inflation) was high also.
The most important concept in Investing according to Benjamin Graham:
Why this is the first good time to buy stocks in our adult lifetimes: The relationship between long term bond yields and stock earning yields.
Explain basic terms: Earnings Yield is the inverse of the P/E ratio, Bond yield is the interest you are paid on your invested money.
Historically the returns on common stocks have been comparable to their earnings yield at the time they are bought. Long term bond yields generally represent the “risk free rate” against which the risk of common stocks should be measured. Since common stocks are not risk free, average earnings yields should normally be a bit higher than the risk free bond yields (although the extent of the risk premium is tempered by the fact that earnings can rise, while interest rates are locked in). Indeed, Benjamin Graham (Warren Buffett’s mentor) said that common stocks should not be bought without a 50% premium of earnings yield over the risk free rate. Meaning if govt. bond yields are 6%, the earnings yield on a stock should be at least 9% to be considered investment worthy.
10 years ago many companies had earnings yeilds of 0-2%, despite the risk free govt. bond rate being 6%. Furthermore, the riskier the company, often the lower the earnings yield demanded on the stock (for example, internet and high tech companies at the times often didn’t have any earnigns at all yet were very valuable on the stock market). This was a radical inverse of how the relationship should be, and foretold of the poor returns (indeed the heavy losses) investors have gotten over the last 10 years (show chart of 10 year performance of Dow, Nasdaq, S&P).
Today, large cap brand name companies such as Coca Cola, Procter and Gamble, Pepsi, and Johnson and Johnson have earnings yields of around 8-9%, and riskier companies offer much higher earnings yields (the way it should be). The risk free 10 year government bond rate is less than 3%. The relationship between the Long term bond yields and earnings yields have not only reversed back to the proper condition of earnings yields offering a premium over risk free bonds, but in fact has gone so far in the other direction that even the safest common stocks offer a 200% premium over the risk free rate.
The earnings yield of the S&P in 1999 was 3.1%. (Link here: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm)
The earnings yield of the S&P today is around 8%.
The last time we had such a large variance between earnings yields and government bonds was the early 1950’s. If you had invested then you would have gotten excellent returns in a low inflation environment, an ideal time to invest. (link here: http://seekingalpha.com/article/80580-t-bill-vs-s-p-500-earnings-yield-1936-2007). Since then, the only times earnings yields were high was when the risk free rate (and inflation) was high also.