Tuesday, October 03, 2006

Thoughts on investing and current market (Part 1)

This is a little data I collated and deductions are based on these. Like many, a hard-landing or sudden melt-down is highly worried and on the agenda of many businesses and economy. Of all, Buffett finds it a whole lot harder to find great buys the past few years, starting since the last crash in 2000. However, a point to note is he did not particularly points out the market is overvalued at present, unlike in the late 90s, he expressed his concerns through Fortune.

To start with, I do not think the market is at the wildest stage of speculation for stocks – though in commodities it may be – based on the few huge and big-name businesses that I’m going to present to you. The core set of business consists of Costco, Home Depot, Walmart, Tesco, Harley Davidson, Coca Cola, Pepsico, McDonald’s and Anheuser Busch (parent of Budweiser). To note, I am taking this group to represent the whole index like S&P, DJIA, and such. It may not be true that the whole index is at the same value. To be sure, it is better to find it out.

In 1999 and 2000, the average PE for this group was 37.1 and 35.4 respectively. The Price-to-book ratio in 1999 and 2000 averaged 8.7 times and 8.2 times book value. In 2006, the PE average 17.6 times earnings while the PB is 4.5 times book. The PE of 17.6 is surely not by definition cheap, it is just that slightly more expensive than what is average. Over the years, S&P has traded at 14-15 times earnings in the past. That doesn’t mean it will always be so. We are probably in the middle of a secular bear market that started since 2000.

What do all these numbers tell you? It shows as a whole, the market is valuing the business much lesser than what was experienced in a super-bull market. In fact, I shall bring you back further to the valuations in 1990 and 1995. If you recall, in 1990, there was a slight hiccup due to the Iraq war on Kuwait, dampening sentiments for a little while, but still, it does not affects much on fair valuation. In fact, part of what I am trying to present is a lot of people unduly gets over-worried on how the general economy as a whole will affects the individual business even if the business is valued at a fair price or valuation. No doubt that if all other businesses as a whole form together gets overvalue, it gives a higher chance for the market as a whole to crash. But this group which is part of the whole – being valued sensibly – will no doubt experience some adverse impact in the most minimal way but will recover just as fast to normal. So when you buy a business, you should not look at what the whole economy is being valued and value the business in the same way. The business can be fairly priced while the market or index as a whole is highly speculated. Warren once mentioned “The key to investing is not assessing how much an industry is going to affect the society, or how much it will grows, but rather determining the competitive advantage of any given company and above all, the durability of the competitive edge.” Likewise, if the price of the business is right, one should not let how the total value of the whole economy affects you much. Though you are right that if I am to buy today for a great business at a fair price of USD100 per share and if tomorrow, the market crashes, definitely, my share will goes down by some too. But it won’t tumble. It just goes down and recovers just much faster than anyone else. It is just like experiencing midair turbulence and the plane gains altitude again. When you have a competitive edge, it is also important to know the boundary of this circle of edge, many times, people do not recognize the boundary, thinking it is limitless.

A classic example of a durable competitive edge is to think about Coca Cola. If you are given a choice to buy between Coca Cola for 60 cents or China Cola for 50 cents, which will you buy? The answer you give will go a long way in determining the durability of the product. If you answer coke, well, it is logically the answer of many others. Even at 20% more costly than its rival, they have the edge. Another scenario is the alternative name of Coca Cola, which is Coke. That is a hell of an advantage over their closest rival, Pepsi Cola – although Pepsi won the taste test. So if you are not a Pepsi fanatic, when you want to order a Cola, you would most like to say “Coke” – correct me if I am wrong – the simple word of Coke goes a long way in extending this competitive edge over their rivals. This is also a classic example of how branding creates a competitive edge. It should be studied in detail by anyone who wants to be in the Advertising and Promotion industry.

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