October 12, 2020: Stock Indexes As Businesses | Better Financial Future -- MyPlanIQ

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday November 2, 2020.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Stock Indexes As Businesses

It’s well known that stock investments are just business investments. When people purchase a piece of property, such as a farm, a rental property, or a private business like a restaurant, they tend to view them as business investments: they measure their investment results based on how much such a business makes along the time. Seldom they keep checking their business’s valuation quotes monthly, let alone daily. Over times, they might need to exit such a business and only then they start to quote and value their properties as a wholesale price.

This is not what happens in public stock investing: with the advent of daily, hourly and even stock price quotes in seconds, the investors’ wealth or fortune fluctuate wildly based on these real time stock quotes. Unfortunately such appraisal is not accurate and can swing to both extremes.

It’s thus advocated by many successful investors such as Ben Graham and Warren Buffett that investors should focus on the underlying business of a stock, ignore short term prices and invest just like an investor in a private market (a private investor such as a startup investor, private business investor or a rental property investor). If the underlying business performs well and your purchase price is right (cheap enough), you’ll make money.

Index fund investing removes individual stock/company risk by investing in hundreds or even thousands of companies. It’s common that you hear/learn in financial media on long term investing: buying and holding an index fund for a long time to achieve its long term returns. However, it’s less common to hear that investing in an index fund is not much more different than investing in an individual company, except in this case, your ‘individual’ company is a ‘conglomerate’ that consists of a collection of businesses from its underlying stock components.

We have mentioned this concept several times before. The following newsletters discuss S&P 500 index and some of its sectors as an aggregate business.

In this newsletter, we further look at S&P 500 from business investment angle (this is also called ‘fundamental investing’ but we prefer calling it ‘business investment’). In the next newsletter, we will look at US Real Estate Investment Trusts (REITs).

Long term S&P 500 Return on Equity (ROE)

One of the most important metrics to evaluate a business is Return on Equity (ROE). Equity is the actual business value owned by a shareholder. It’s the total asset value of the business minus its liability. ROE measures the percentage return the owners makes in a period of time. In general, if you possess a business that can return more than 10% out of your equity annually, you’d consider it’s a reasonably good business. An annual 15% ROE would be considered as very good.

Well, it turns out that if you are an owner of a S&P 500 index fund such as SPY, VOO or VFINX, you actually own a very good business. The following recent chart from Goldman Sachs shows that S&P LTM (Last Twelve Month) ROE has been around 15% since 1976:

In fact, the lowest ROE since 1976 was around 10% in 2008-2009 period. So even at its worst, it still had a very reasonably good ROE.

This is compared with General Electric ROE since 2006:

GE’s ROE has been around 10% since 2009 and then started to drop precipitately from 2015. Remember GE was used to be a bellwether for US businesses for a long time.

S&P 500 Profit Margin

The other important metric is the profit margin of a business. The following two charts show the history of its profit margin and operating profit margin:

Courtesy of Yardeni Research

Since 1994, S&P 500 aggregate operating profit margins and profit margins (trailing four quarters) has never been negative even in the severe financial crisis in 2008 and the 2000s tech bubble induced bear market. This is remarkable as many individual companies were in red in those times.

Essentially, owning an S&P 500 index fund is like owning a good and relatively stable business. It should reward its owners in a long term. This is reflected in its long term stock index returns. The following chart shows the long term stock market returns (total returns including price and dividend reinvested):

Long term stock market returns since 1900 — Credit Suisse

Real returns are the excessive returns over inflation. S&P 500 index doesn’t represent the whole US stock market. But it actually delivered slightly better returns in a long term.

This is again not surprising as we have pointed out that in a long term, a fair capital market like the ones in the western countries should reward business owners or at least compensate the risk they take in their businesses (so called ‘risk premium’). Furthermore, capitalization weighted stock market indexes have embedded filters to weed out bad businesses: first, only reasonably good businesses can have an IPO to a public stock market. To further stay in the public market, they also need to maintain reasonable performance. Otherwise, they will be delisted. This thus serves as a natural filtration. Secondly, the better the underlying businesses, the better their individual stock prices and that translates more weights to these ‘good’ businesses (not always but in a long term, they converge to reflect such) in an index. So an embedded momentum based mechanism is actually a good enough capital allocator.

To summarize, investing in a good broad base stock index (fund) is actually like owning a reasonably good business. You just need to make sure the price is right when you purchase it.

Market overview

Financial assets (stocks and bonds) are again bid up. It does look like investors are extremely complacent with the current situation: the upcoming US presidential election, the ongoing pandemic and whatever other geopolitical or financial events can’t deter their enthusiasms. We suspect that the powerful government support (pledged or actual) is the key factor behind this. Nevertheless, we are reminded that markets are in an overly extended state with extremely high valuation. For an investor with 10 to 15 year horizon, the prices are not really right. For others who have much longer time horizon (20 years or even longer), the current expensiveness of stock markets becomes less deleterious but still important.

Again, we shouldn’t rely on our subjective opinion and should follow our strategies instead:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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