(!!) History - The Greatest Teacher (on Minsky Bubbles)

8/8/2019 (!!) History - The Greatest Teacher (on Minsky Bubbles)

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History

The Greatest Teacher

Dr Adrian SavilleChief Investment Officer

Cannon Asset Managers

[email protected]. www.cannonassets.co.za

2009

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mailto:[email protected]:[email protected]


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Those who cannot remember the past are condemned to repeat it.

George Santayana (1863-1952)

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1. Why This Time Is Not Different

The charm of history and its enigmatic lesson consist in the fact that, from age to age, nothing changesand yet everything is completely different.

Aldous Huxley

David McCullough, the American author, narrator and lecturer once remarked that History isa guide to navigation in perilous times. For investors, this observation is as important aslegendary investor Sir John Templetons statement that the four most dangerous words ininvesting are this time is different.

Yet, despite having access to the powerful lessons and insights offered by history, and beinggiven the opportunity to see far by standing on the shoulders of giants, investors tend to bemesmerized by short-term market movements and enslaved to crowd psychology. Instead,

then, they cling to the futile belief that, somehow, this time will be different. Indeed, whether itis on the way up, when the collective thought is things can only get better, or on the waydown, when the collective thought is the end is nigh, investors seem determined to repeat thepast by focusing on the immediate future and letting human behaviour and bias swamp soundjudgment and sensible decision making based on the long-term lessons and insights providedby history.

In its most dramatic form, this repetitive behaviour plays out in the form of booms and busts orasset price bubbles and collapses. For students of history, such as the prolific writer CharlesKindleberger and theoretician Hyman Minsky, there is much to learn from studying the pathtravelled by asset price bubbles.

Kindleberger and Minskys message is simple: bubbles follow predictable patterns. Byrecognizing these patterns, investors furnish themselves with the ability to avoid the frenziedinflation and collapse of asset price bubbles. In so doing, investors equip themselves to protecttheir investment capital from the devastating consequence of collapsing asset prices.

Equally important, Kindleberger and Minskys teachings demonstrate that it is in the final stageof the asset price life cycle, when most investors feel revulsion towards the asset class (such astechnology stocks in the early 2000s), that the best investment opportunities present themselves.In short, history demonstrates that it is in the darkest hour that the best investments are made and not during moments of euphoria. Yet this critical observation runs contrary to the beliefsand actions of most investors.

It is without coincidence that the global equity bubble that was pricked in the middle of 2007repeats this pattern. More importantly, the collapse in equity prices since then has left investorswith a strong sense of revulsion towards equities. As Kindleberger and Minsky as well asswathes of history have shown, this loathing is misplaced. To take the point further, ourobservation of historical patterns and our analysis of equity markets, and the South African


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equity market specifically, tell us that it is in this period of revulsion that exceptionalopportunity presents itself to investors.

This time is not different.

2. History: The Great Teacher1

Samuel Langhorne Clemens, better known by his pen name Mark Twain, once quippedHistory does not repeat itself, but it rhymes. For this simple reason, history constitutes one ofthe best teachers. History gives us perspective. It reminds us that it is impossible for trees togrow to the moon, and it reminds us what is possible when we find ourselves in the darkesthour.

Yet investors tend to prefer to ignore history. In this vein, Sir John Templeton, one of the mostsuccessful investors of the twentieth century, once observed that this time is different are thefour most dangerous words in investing. John Kenneth Galbraith (1994), a prolific author, andone of the leading proponents of twentieth-century American liberalism and progressivism, putthe same point a little more colourfully:

[Markets are characterized by] extreme brevity of the financial memory. Inconsequence, financial disasters are quickly forgotten. In further consequence, whenthe same or closely similar circumstances occur again, sometimes in a few years, theyare hailed by a new, often youthful, and always supremely self-confident generationas a brilliantly innovative discovery in the financial and larger economic world. Therecan be few fields of human endeavor in which history counts for so little as in theworld of finance.

When asked if investors are likely to learn anything from the recent financial meltdown, JeremyGrantham (2008) rejoined We will learn an enormous amount in the very short term, quite a bitin the medium term and absolutely nothing in the long term. That would be the historicalprecedent. In short, investors prefer to ignore history. Time and again, though, this proves tobe an expensive omission.

As Benjamin Graham (2003) argued in Chapter 3 of The Intelligent InvestorPrudence suggeststhat [the investor] have an adequate idea of stock market history, in terms particularly of themajor fluctuations With this background he may be in a position to form some worthwhilejudgment of the attractiveness or dangers of the market.

Given the importance of the role of history, James Montier (2008, 15) goes on to argue thatnowhere is an appreciation of the past more important than in understanding bubbles. In thisregard, the Kindleberger-Minsky model provides an exceptionally powerful framework foranalyzing bubbles and their history (Montier, 2007, Chapters 38 and 39).2 Essentially the model

1 This section draws heavily on James Montiers (2008) note The Tao of Investing.2 Charles Poor "Charlie" Kindleberger (1910-2003) was an historical economist and author of over 30 books. As aneconomic historian, Kindleberger relied on narrative exposition and knowledge of history rather than mathematical
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breaks a market bubbles rise and fall into five phases (see Figure 1). The mechanics of themodel are described more fully below.

Figure 1: Kindleberger-Minsky Model

Phase 1:Displacement

Stage 5:Revulsion

Phase 2: CreditCreation

Phase 4: CriticalStage/Financial

Distress

Phase 3:Euphoria

Source: Adapted from Montier (2007)

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models to prove his point. Today, his 1978 book Manias, Panics, and Crashes remains prescribed reading for anymodern student of market bubbles and collapses. Hyman Minsky (1919-1996), was an American economist andprofessor of economics at Washington University in St Louis. His research attempted to provide an understandingand explanation of the characteristics of financial crises. Minsky was sometimes described as a post-Keynesianeconomist, because, in the Keynesian tradition, he supported some government intervention in financial markets andopposed some of the popular deregulation policies in the 1980s. Minsky argued against the accumulation of debt.Contrary to expectation, his research was embraced by Wall Street.
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3. A Description of the Kindleberger-Minsky Model

The Kindleberger-Minsky Model divides the evolution of a market bubble into five phases,namely (i) the birth of a boom; (ii) the nurturing of a bubble; (iii) euphoria; (iv) financial

distress; and (iv) revulsion. Each of these phases is described below.

i. Displacement: The Birth of a BoomThe foundations of a bubble are set when a (typically exogenous) shock occurs that triggers thecreation of profit opportunities in some sectors, while closing down profit availability in othersectors. This process is referred to as displacement, and as long as the opportunities created aregreater than those that get shut down, investment and production will pick up to exploit thenew opportunities.

More fully, investment in financial and physical assets is likely to occur. Effectively we arewitnessing the birth of a boom. Modern history is filled with examples of displacement.Consider, for instance, the massive investment in railroad during the 1830s and 1840s; theautomobile and radio booms of the 1920s; the tronics boom of the early 1960s which sawinvestments flow into electronics companies making products like transistors and opticalscanners; the boom during the 1980s of investments in biotechnology businesses; or the dot.comsplurge of the 1990s which found its roots in the mid-1990s when it was recognized thatcompanies such as Netscape, whose browser brought the internet to people like you and me,would change the world forever.

ii. Credit Creation: The Nurturing of a BubbleJust as a fire needs oxygen and fuel to grow, so an economic and financial boom needs liquidity

to feed itself. Minsky argued that monetary expansion and credit creation are largelyendogenous to the system. That is to say, not only can money be created by existing banks butalso by the formation of new banks, the development of new credit instruments and theexpansion of personal credit outside the banking system.

As in other bubbles, debt has been a central ingredient in the recent real estate, emergingmarket and commodity bubbles. However, in the past two decades, debt has found new waysof creeping into the economy and capital markets. Consider, for example, private equity firmsand hedge funds, which today are key participants in capital markets, but whose role has beenfacilitated by heavily geared balance sheets. Similarly, the appetite for debt had ballooned inother parts of the financial sector in the credit bubble of the past decade. By way of example, by

2007 investment banks such as Lehman Brothers, Morgan Stanley and Goldman Sachs wererunning debt-to-equity ratios that ranged between 22:1 and 33:1. Similarly, according to theBank of England, the median ratio of debt-to-equity in big banks in the United Kingdom grewto more than 30:1 during the credit bubble. This means that, on average, these banks hadborrowed UK30 for every pound in capital held by the bank. In essence, a credit pyramid isestablished though what Minsky described as Ponzi.


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iii. EuphoriaThe abundance of debt means that people are given latitude to buy widely and often wildly into the new era. Prices are seen as only capable of ever going up. In the recent real estatebubble this was true of perceptions around house prices, and this sentiment certainly was true

of technology stocks in the dot.com bubble. By way of example, in March 2000, James McCall, afund manager at Merrill Lynch, noted We dont get too hung up on valuations. Even if its agazillion times earnings, thats not my part of the decision. Thus, a wave of overoptimism andoverconfidence is unleashed, leading people to overestimate the gains, underestimate the risksand generally think they can control the situation.

Sympathetic with his Keynesian roots, Minsky referred to this phase of the bubble as beingfueled by a surge in animal spirits, and American president Herbert Hoover in privatedescribed this part of the 1929 stock market bubble as an orgy of speculation.

The mindless rush in animal spirits associated with this orgy leads to traditional valuationstandards being abandoned, and new measures introduced to justify the current price. Whendiscussing the abnormally high price-earnings ratios in existence in early 1999, James Glassmanand Kevin Hasset, authors of Dow 36,000, proffered Could it be that the model that Wall Streethas been using to assess whether stocks are overvalued a model based largely on historic [sic]price to earnings ratios is deeply flawed? We think so. Glassman, Hasset and other crowdfollowers might be near-term right, but inevitably they are long-term wrong as the euphoriatanks in the fourth phase of the bubble.

iv. Critical Stage/Financial DistressThe critical stage often is characterized by insiders cashing out. This is followed rapidly byfinancial distress, in which the excess leverage that has been built up during the boom becomes

a major problem. During the 1929 stock market bubble, the prominent and highly respectedWall Street banker, Paul Warburg, foresaw that if orgies of unrestricted speculation areallowed to spread too far then collapse is inevitable.

Also, financial fraud often emerges during this stage of the bubbles life. This last aspect of thecurrent debubbling process has been highlighted by a number of high profile financial fraudsthat have been unearthed in the past year. The most extraordinary act in this set is the fraudcommitted by Bernie Madoff which was uncovered in December 2008.

Madoff, an Americanbusinessman and former chairman of the NASDAQstock exchange, hasconfessed to, and been convicted of, operating a Ponzi scheme that has been called the largest

investor fraud ever committed by a single person. The scheme, which Madoff has described asone big lie, is estimated to have cost his 4 800 clients as much as US$64.8 billion. To put thisfigure into context, the combined market capitalization of South African-listed Firstrand,Goldfields, Naspers, ABSA, Telkom, Kumba Iron Ore, Old Mutual, Nedbank, Impala Platinumand Richemont SA equaled approximately US$65 billion at the start of April 2009.

Shortly after Madoffs deceit was revealed, Sir Allen Stanford, a prominent financier,philanthropist and sponsor of cricket in the Caribbean, was charged by the US Securities and
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Exchange Commission for alleged "massive ongoing fraud" involving US$8 billion in certificatesof deposits. Adding the market capitalizations of Sanlam, Remgro and Liberty Internationalwould equate to the size of Stanfords fraud. Given the extent of the crowd delusion, it isevident why, from here, it is a short step to the final stage of the bubble cycle, namely revulsion.

v.

Revulsion

Revulsion is the final stage of a bubbles life cycle. In this part of the cycle investors areexhausted. Many tend to have given up hope and have lost all sense of optimism. A recentarticle in the Financial Times (Brewster, 2009) captures this mood by citing the argument of a LosAngeles-based business owner whose holdings were worth more than US$3 million at the endof 2007:

I havent opened a[n investment] statement since October [2008] I know its bad,but what can I do about it? There is no point in depressing myself. I need to focus onmy business, which is going well. My investments are pretty much gone I had lotsof stocks bank stocks, Bear Stearns, theyre gone. I see the statements come in the

mail and I throw them right in the garbage.

In short, investors are so scarred by the events in which they participated that they can nolonger bring themselves to participate in the market at all. From a behavioural stance it is easyto understand why this is the case. In the same breath, though, the almost universal rejection ofthe asset class results in prices collapsing to the point that asset prices fall into bargain basementterritory. Perversely, it is often from this base that the greatest fortunes are made, whereasfortunes are lost in the third and fourth stages of euphoria and crisis.

4. Revulsion Sets the Stage for Investment Success

Sir John Templetons success as an investor exemplifies this last argument. After the stockmarket collapse of 1929 and the Great Depression of the early 1930s, Templeton bought 100shares of each company trading for less than US$1 a share, and within four years had mademany times the money back. This same contrariness saw Templeton become one of the firstglobal investment managers to buy into Japanese companies in the mid 1960s ahead of thatcountrys extraordinary rise from the ashes of World War II. Templeton attributed much of hissuccess to his ability to maintain an elevated mood, avoid anxiety and stay disciplined. In thisvein, Templeton became known for his philosophies of "avoiding the herd" and "buying whenthere is blood in the streets".

A different and more modern example of crisis and despair producing exceptionalopportunity comes in the form of the Russian financial crisis of 1998. The so-called "Rublecrisis" hit the country in August 1998, triggered by the collapse of the emerging market bubblewhich had been popped by the Asian financial crisis of 1997. The ensuing plunge in worldcommodity prices meant that countries such as Russia, that were heavily dependent on theexport of raw materials, were severely hit. In the case of Russia, an effort to prop up thecurrency and stem the flight of capital was made by hiking the key interest rate to 200 percent.
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Nevertheless, crumpling tax revenues, a growing mountain of unpaid wage debt, irregularinternal debt payments and plunging foreign exchange reserves saw the Russian stock, bond,and currency markets fall apart in mid-August 1998 following the governments default on itsdebt. However, the Russian economys recovery was surprisingly quick, aided by the recoveryin oil prices, a surge in government revenue and a sharp reversal in the current account.

Consequently, buyers of distressed Russian debt experienced extraordinary investment returnsover the next few years. Buyers of Russian government debt at the start of 1999 would havemade more than five times their initial investment by 2004 an exceptional result by anymeasure.

A third, and more contemporary, example of finding cheap assets in the period of revulsioncomes from the bursting of the dot.com bubble in 2000. Out of the ashes of this collapse haverisen some extraordinarily successful business and investment cases, including newcomersSkype, Facebook and Google, whilst stalwarts such as Hewlett Packard, Nokia, Apple, AdobeSystems, Infosys, Symantec, Yahoo, Intel, SAP, Texas Instruments, Amazon and eBaycollectively have produced stellar returns. In the five years following the technology crash of2000, Apple, Amazon and eBay generated returns of 350 percent, 630 percent and 1 500 percent,respectively. But stock picking with hindsight is cheating. Instead, assuming that the averageperson buying in the revulsion stage of the technology collapse had bought the Nasdaq Index,the reward over the next five years would have been in the order of 50 percent greater than thebroader market index, the S&P 500, over the same period.

5. A Time for RevulsionTo everything - turn, turn, turn

There is a season - turn, turn, turnAnd a time for every purpose under heaven

A time to be born, a time to dieA time to plant, a time to reap

A time to kill, a time to healA time to laugh, a time to weep

The Byrds, Turn! Turn! Turn!

Drawing on the examples above, and to return to the argument, the lesson from history is thatthe final stage of the de-bubbling process is revulsion. This phase is characterized byoverwhelmingly cheap asset prices and, whilst cheap markets can always get cheaper, it is these

deep trenches in investor sentiment that often provide extraordinary entry points, oropportunities for entrenchment, for long-term investors.

The rapid unwinding in equity prices since the middle of 2007 has brought us to levels ofvaluation that are normally associated with revulsion. Using the trailing price-earnings ratio,for instance, the reading for the Johannesburg Stock Exchanges All Share Index (JSE ALSI) ofaround nine times trailing earnings that we have seen in the first quarter of 2009 was last seen


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in the first quarter of 2003 (see Figure 2). It was from this point in 2003 that the domestic equitymarket staged an extraordinary bull run that spanned five years, delivering capital growth of300 percent over the period.

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Source: McGregor BFA; analysis by Cannon Asset Managers

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Figure 2: Price-Earnings Ratio (x) for the ALSI (1980-Present)

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As shown in Figure 2, other examples of similar low price-earnings ratios for the market includethe early 1980s, late 1980s and early 1990s. In these cases, the JSE ALSI has delivered five-yearreturns in the order of 250 percent from the early 1980s, 200 percent from the late 1980s and

170 percent in the case of the early 1990s. In each case, these periods match not just withextremely low valuation multiples but also investor repulsion towards equities. The early1980s, for instance, corresponded with the collapse of the gold price spike and the onset offinancial sanctions against South Africa; the late 1980s corresponded with the 1987 market crashand the crisis of the apartheid state; and the early 1990s corresponded with investor cautionahead of South Africas democratic transition as well as the economic slowdowns in Europe andthe US.

An analysis of the recent dividend yield history for the JSE reveals a similar story. Indeed, thecurrent yield in the order of five percent is unprecedented in recent history.


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Figure 3: Dividend Yield (%) on the ALSI (1995-Present)

Moreover, if contrasted to bonds, the dividend yield-to-bond yield ratio of 1.4 times recorded inthe first quarter of 2009 presents an all-time low for the series in the past decade. This readingoffers further evidence of investors revulsion towards equities. Other examples of investorrevulsion are evident by eyeballing Figure 4.


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Figure 4: R157 Bond Yield-to-ALSI Dividend Yield Ratio (x) (1997-Present)

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However, an objection to using trailing price-earnings ratios and trailing dividend yield figures,as in the above analysis, is that these numbers are flattered by good earnings growth (and byimplication good dividend payments) in recent years. For instance, aggregate earnings ofresource stocks, which account for 50 percent of the JSE ALSI by weight, increased by 50 percent

between 2007 and 2008. Thus, anything less than a 50 percent increase in the price of resourcestocks would have equated to a derating of resource company valuations.

Fortunately, valuation metrics exist that are able to immunize against the near-term bias ofmetrics such as the one-year trailing price-earnings ratio and one-year trailing dividend yield.The most obvious metric in this regard is the price-to-book ratio which measures the net assetsthat are bought by each Rand that is allocated to the market. Thus, a price-to-book ratio of lessthan one implies that a Rand allocated to the market to buy an investment will buy more than aRand in net company assets. As such, the attraction of the price-to-book ratio is that it issomewhat protected from spurious near-term events that distort company valuations, such as aonce-off earnings boost or an inflated earnings platform that cannot be sustained.

That aside, considering price-to-book ratios for the JSE since the early 1990s, the availableevidence offers strong support for the view that low price-to-book ratios provide a platform forsound equity returns. Specifically, as shown in Figure 5, the price-to-book ratio for the JSEreached a low of 1.2 times in August 1998. This low was followed by a gain in the JSE of98 percent over the next three years and 106 percent over the next five years.

In similar vein, the price-to-book ratio for the JSE reached a localized low of 1.4 times in 2001.This was followed by a three-year return of 47 percent and a five-year return of 180 percent.

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Source: Factset

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Figure 5: Price-to-Book Ratio (x) for the JSE (1992-Present)

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Away from anecdotal evidence, quintile analysis shows that low price-to-book ratios in SouthAfrica are correlated with good investment performance from equities. Specifically, as shownin Figure 6, when the price-to-book ratio has been in the lowest quintile, the returns from SouthAfrican equities over the next five years, measured in Rand terms, have averaged 28.8 percent per annum. By contrast, when the price-to-book ratio has ranked in Quintile Five, five-year

returns have averaged -11.4 percentper annum. Usefully, the relationship is well behaved, withfive-year equity returns falling almost monotonically as the price-to-book ratio for the JSE rises.

Source: Data from Factset; analysis by Cannon Asset Managers

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Figure 6: Average Annual Returns over Five Years for the JSE Based onPrice-to-Book Quintiles (1992-Present) (%)

As an aside, the more detailed information on price-to-book ratios and subsequent marketreturns set out in Table 1 make it clear that the relationship is not nearly as well behaved overshorter periods. For instance, the best one-year equity returns are reported when the price-to-book ratio sits in Quintile Four, which implies that somewhat expensive markets become a littlemore expensive before blowing out. This makes a case for momentum investing.

Table 1: Price-to-Book Quintiles and JSE Average Annual Returns (1992-Present) (%)

Quintile One Year Three Years Five Years

1 0.7 11.9 28.82 -5.8 9.1 20.53 26.1 30.6 21.34 38.0 20.4 2.65 -5.5 -8.1 -11.4

Source: Data from Factset; analysis by Cannon Asset Managers

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By contrast, over three years, the best equity returns are recorded from Quintile Three. It isinteresting to note, though, that, on average, over one, three and five years, markets that arepriced in Quintile Five deliver negative returns. This outcome reinforces the danger ofinvesting in expensive, go-go markets. Put simply, very expensive markets only have one wayto go. But the focus of this note is on cheap markets which are located in Quintile 1.

Returning then to the discussion on cheap markets, by distinction, over one, three and fiveyears, markets that start in Quintile 1, on average, deliver positive returns, ranging from0.7 percent to 28.8 percent per annum in Rand terms. This has at least two implications. First,cheap markets do not stay cheap. Second, the best investment returns (five years) are deliveredfrom investing in cheap markets (Quintile 1), which are markets associated with revulsion.

Given this backdrop, valuations on the JSE appear cheap after the price declines of the past 18months. Specifically, the current price-to-book ratio of 1.5 times is just over one standarddeviation below the long-term average of 2.2 times. Further, the current reading places the JSEwell inside Quintile One, with only ten months in the past 185 recording lower price-to-bookratios than the current reading. In addition, based on extant book values, the market pricewould need to rise 30 percent to lift the price-to-book ratio out of Quintile One.

Another way of getting a sense of the attractiveness of equities is to consider the price-to-bookratio at the stock level. On this basis, the evidence supports the conclusion that South Africanequities are cheap. As shown in Figure 7, during the bull market of 2007, about 15 percent ofthe 250 companies surveyed traded at less than book value (or net asset value). Breaking thisuniverse into subsets reveals little differentiation across super-sectors at that time, with10 percent of resource stocks and 20 percent of financial stocks trading at less than book value.

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Source: Data from McGregor BFA; analysis by Cannon Asset Managers

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By contrast, the 2008 bull market in resource stocks, which was accompanied by a collapse infinancial stocks, meant that although a quarter of stocks surveyed traded at less than bookvalue, just 14 percent of resource stocks traded at less than book value whilst 45 percent offinancial stocks traded at less than book.

However, the general price decline of the past 18 months means that almost half of the 250companies surveyed trade at less than book value today, with 48 percent of resource stocks and61 percent of financial stocks trading at less than their net asset value. This result reinforces theargument that deep value is evident amongst equities, and particularly that part of the marketthat has caused the greatest investor revulsion, namely financial stocks.

6. Another Way to Say the Same Thing: Equities Are Cheap

Whilst the above evidence points to deep value amongst equities, an even more compellingpicture is offered by way of the Graham and Dodd price-earnings ratio. This tool has at leastthree elements that are attractive to the analyst.

First, the Graham and Dodd price-earnings ratio overcomes the problems brought by using anartificially inflated or deflated earnings denominator that arises where the price-earnings ratioemphasizes the recent past, say the past year. As noted above, such a near-term focus onfinancial information can be deeply misleading. Thus, Graham and Dodd argued the price-earnings ratios should not be based on only one years worth of earnings, but rather not lessthan five years, preferably seven or ten years of trailing earnings (with earnings being adjustedfor the effects of price inflation). Second, by using trailing earnings the problems associatedwith forecasting are avoided. Third, by using between five and ten years worth of information,the resultant earnings denominator captures normalized earnings which recognizes that

inflated earnings fall and deflated earnings rise.

Using this advice, we calculate a Graham and Dodd price-earnings ratio based on seven yearsworth of trailing earnings. Figure 8 shows the trailing earnings series that is calculated forSouth Africa with data starting in 1980. The earnings reported in the figure are used as thedenominator in the Graham and Dodd price-earnings ratio. Eyeballing the data it is evidentthat over time earnings grow at a steady pace and that any near-term earnings disruption isexactly that, namely near term.


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Figure 8: Seven-Year Moving Average of Reported Earnings(Inflation Adjusted) (1987-2009)

By contrast, Figure 9 shows the non-smoothed one-year trailing earnings for the JSE from 1980to present. It is evident from this result that near-term trailing earnings are volatile which, inturn, produces high volatility in the one-year trailing price-earnings ratio. The high near-termearnings volatility also underscores the problems associated with forecasting. In short, theresults presented in Figures 8 and 9 offer strong support for Graham and Dodds assertion thatforecasting should be avoided and that trailing earnings should be derived from many years ofdata and not simply the most recent year.


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Figure 9: Trailing Reported Earnings (Inflation Adjusted)(1980-2009)

These notes aside, the resultant Graham and Dodd price earnings ratio for the period 1987 topresent is shown in Figure 10. It is interesting to note that the average Graham and Dodd price-earnings ratio over the period measures 16.6 times. This squares up neatly with Graham andDodds observation that the maximum one should be willing to pay for an investment is 16times the long-term average earnings.


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Figure 10: Graham and Dodd Price-Earnings Ratio for the JSE(1987-Present)


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Related to this, Graham and Dodds figure of 16 times trailing long-term earnings can be usedto distinguish cheap markets from expensive markets.

The results of this toolkit are summarized in Figure 11.

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Source: Cannon Asset Managers

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Figure 11: Average Annual Real Returns (%) for the JSE Based onGraham and Dodd Price Earnings Ratio (1987-Present)

Ratio < 16 times smoothed earnings

Ratio > 16 times smoothed earnings

From the results shown above, it is evident that applying the rule of 16 to the Graham and

Dodd price-earnings ratio is effective in terms of the investment results that follow. Forinstance, using this benchmark, the average real return produced by domestic equities over oneyear is 21.2 percent when the Graham and Dodd price-earnings ratio is less than 16 times and9.3 percent when the ratio is above 16 times.

Over three years the average annual real return is 23.2 percent when the market is on a ratio ofless than 16 times and 8.4 percent when the market is above 16 times.

Over five years, a cheap Graham and Dodd price-earnings ratio produces average annual realreturns of 17.5 percent versus the 11.0 percent produced by expensive markets.

In short, a simple application of Graham and Dodds price-earnings ratio rule provides effectiveguidance to equity investors.


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Source: Cannon Asset Managers

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Figure 12: Average Annual Real Return (%) over Five Years(1987-Present)

Further guidance is offered to equity investors by considering the returns produced by the JSEbased on quintile analysis of the Graham and Dodd price-earnings ratio. The results reinforcethe argument that relatively lower Graham and Dodd price-earnings ratios correlate withrelatively higher equity market returns. Buying the JSE on a Graham and Dodd ratio located inthe lowest quintile is associated with average annual real returns of 20.8 percent over five yearsversus the return of 10.6 percent associated with the most expensive quintile.

Currently, as illustrated in Figure 10, the JSE trades on a Graham and Dodd price-earnings ratioof 12.7 times. This reading locates the ratio in Quintile 1, which returns us to the argument thatdomestic equities are cheap.

7. Bottom Up Meets Top Down

Whilst top-down analysis offers overwhelming support for the view that domestic equities arecheap, it is useful to complement this with bottom up analysis to ensure that the average is notbeing distorted by anomalies. There are many ways to think about bottom up analysis(including the price-to-book headcount applied earlier). Usefully, though, the Graham andDodd approach can be extended effectively to the case of individual stocks.

The result confirms the top-down view. Of the 250 stocks surveyed in the South Africanuniverse, 76 percent have a Graham and Dodd price-earnings ratio of less than 16 times. Inother words, not only is the market cheap, but an overwhelming majority of the marketconstituents are cheap. The result is in sympathy with outcomes in larger markets which show


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that between 60 percent and 70 percent of stocks in these markets are priced on Graham andDodd ratios of less than 16 times (see Figure 13).

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Source: Cannon Asset Managers and SG Global Strategy

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Figure 13: Stocks with Graham and Dodd Ratio Less Than 16 (%) (2009)

In short, both top-down and bottom-up analysis reveal that the sharp decline in prices over thepast 18 months has produced deep value amongst South African equities. Further, the valuethat is evident is that which is normally associated with the final stage of the Kindleberger-Minsky model of asset price bubbles, namely revulsion.

However, whilst investor exhaustion can be understood from a behavioural or psychologicalperspective, it suggests little investment intelligence. To the contrary, this environment shouldmake the intelligent investor especially more patient and deep value investors feel like wide-eyed kids in a candy store.

8. Concluding RemarksHistory teaches everything including the future.

Lamartine

George Santayana famously observed Those who cannot remember the past are condemned torepeat it. This simple but powerful observation goes a long way in explaining why investorsare able to produce asset bubbles that have devastating consequences for most participants withgreat frequency. By studying the past we equip ourselves to avoid this financial devastation.


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By the same token, history reveals that the pattern followed by asset price bubbles means thatthe best opportunities for investors come in the darkest hour, when the market collapseproduces widespread revulsion towards the asset class. In the case of equities, the asset pricebubble that was pricked in mid 2007 has resulted in such a collapse and elicited revulsion.South African equities and investors in equity markets have followed this pattern.

Yet, our analysis of equities generally, and South African equities specifically, demonstratescompelling value and exceptionally opportunity. More importantly, the lesson from history isthat this time is not different: from a top-down or bottom-up perspective buying equities hasnot been this easy for years.


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9. References

Brewster, D (2009) I Havent Opened a Statement for Months: Theres No Point in DepressingMyself, Financial Times, 25 March 2009.

Galbraith, JK (1994)A Short History of Financial Euphoria. Penguin Business: London.

Glassman, J.K. and Hassett, K.A. (2000) Dow 36,000: The New Strategy for Profiting From theComing Rise in the Stock Market. Three Rivers Press: New York.

Graham, B (2003) The Intelligent Investor, Revised Edition. Collins Business: New York.

Grantham, J (2008) Jeremy Grantham in Weekend Barron's, published by Paul Kedrosky atpaul.kedrosky.com/archives/2008/10/jeremy_grantham_6.html

Montier, J (2007) Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance.Wiley and Sons: Chichester, West Sussex.

Montier, J (2008) The Tao of Investing: The Ten Tenets of My Investment Creed, Mind Matters,Societe Generale Cross Asset Research, 24 February.

This report has been prepared by the author identified on the front page of this document. However, contributions to this report may have been madeby employees of Cannon Asset Managers (Pty) Ltd other than the author identified. Each contributor has not and will not receive any compensationfor providing a specific recommendation or view in this report. Conflicts of interest may exist with any one or more of the securities recommended inthis report. These conflicts include situations where Cannon Asset Managers or an associate makes a market in securities of a company mentioned inthe report; the author/s of the report or a member of his/her household own a direct position in securities issued by a company mentioned orderivatives thereof; an employee of Cannon Asset Managers acts as a director of a company mentioned in the report; Cannon Asset Managers ownssecurities or derivatives thereof in a company mentioned in the report; or Cannon Asset Managers receives compensation for providing financialservices to a company mentioned in the report.

The publication is based on information believed to be reliable, but is not guaranteed as to accuracy and completeness. Cannon Asset Managersaccepts no liability for any loss arising from the use of the contents of this report, or from any acts or omissions based on such contents. Viewsexpressed are those of Cannon Asset Managers research team only, and are subject to change without notice. Neither this report nor any opinionexpressed herein should be construed as an offer or solicitation of an offer to sell or acquire any securities mentioned. This publication is confidential,and is for the information of the addressee only and may not be reproduced in whole or in part, copied, circulated, or disclosed to another party,without the written prior consent of Cannon Asset Managers. Please cite source when quoting.Cannon Asset Managers (Pty) Ltd is a Financial Services Board licensed asset management company. For further information or correspondence, thecompanys contact details are set out below.

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Documents

(!!) History - The Greatest Teacher (on Minsky Bubbles)