Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
Hey Rob:
Value informed investing in my opinion is spot on, but I do have a question. If one were able to pick undervalued lower valuation stocks , would this change the final outcome.?Hypothetically buying low PE 10 stocks instead of the current high PE10 values
Max
Max:
Thanks for your kind words re Valuation-Informed Indexing and for your question. I’ll make an effort to respond to it below. But please understand that I do not consider myself any sort of “expert” re the subject of stock investing. I am a journalist. I noticed back in May 2002 that the Buy-and-Hold retirement studies lacked valuation adjustments and thus could not possibly get the numbers right. There were hundreds of people who responded to my post asking whether we should be taking valuations into consideration when calculating safe withdrawal rates with great enthusiasm and there were hundreds of others who responded by threatening to kill my wife and children if I did not stop asking questions that cast doubt on the Buy-and-Hold strategy. That reaction caused me to look deeper into this stuff and over the past 16 years I have explored many aspects of the story. I am of course happy to share with you what I have come up with. But please understand that the proper way to do things is to have hundreds or thousands of people all offering their thoughts on these sorts of questions, not just one guy whose only claim to expertise in the field is that he figured out how to get his words posted to the internet.
Your logic is perfect except for one thing. It is possible to predict long-term returns when looking at a broad stock index. It is not nearly so easy to do so when looking at an individual company’s stock or at the stocks of a small group of companies. Say that Company ABC has a very low P/E10 value, say a P/E10 value of “8.” Does that mean that that company’s stock is underpriced? It does not. It could be that that company is close to bankruptcy and that it has been assigned a low P/E10 value for perfectly rational reasons. Investing in that low P/E10 stock would not give you strong long-term returns.
It’s different when the entire stock market has a low P/E10 value. It cannot be that all of the companies in the U.S. market are about to go bankrupt. Or you might say that, if things are that bad, it hardly matters how you invest, we are all doomed anyway. A root premise of Valuation-Informed Indexing is that the U.S. economy as a whole is going to keep chugging along at least largely as it always has in the past. There are individual companies that are going to go bankrupt. So there are individual cases in which low P/E10 values are justified. But on an overall basis those low P/E10 values are not justified. On an overall basis, the U.S. economy is likely going to continue chugging along as always and the low P/E10 value assigned to the entire market will in time be transformed into a fair-value P/E10 value.
So this only works when you are investing in a broad index fund. It’s sort of like when pollsters take an opinion survey. If you ask 10 people how they are going to vote, that tells you next to nothing as to how an election is going to go. But when you ask 10 million people how they are going to vote, you can generate highly accurate predictions as to how things are going to turn out. Predictions will not work unless the things being looked at are statistically significant. And looking at one company does not give you enough information to know whether the low (or high) valuation is justified or not. However, looking at all the companies offers powerful insights.
Now —
It may be possible to apply the principles of Valuation-Informed Indexing to slices of the market smaller than the entire market. Perhaps you could say “Mid-cap stocks have a lower P/E10 value than the market as a whole, so that is a better place to put your money today.” That’s not a crazy thought. I am not prepared to say whether that would work or not. I think we need to see more research on the question done by lots of different people before we draw conclusions re that one. It might work. There is reason to think it would. But my confidence in the predictions generated diminishes when the number of stocks being examined diminishes. The worst of all options is to make investing decisions based in predictions that don’t prove out. So I feel safer limiting my predictions to ones that we know have always worked, predictions rooted in an analysis of the entire market.
Again, just my thoughts. Please feel free to ask other people their thoughts re this matter. I have hopes that in time we will be able to get some others posting here and that we will all be able to enjoy a rich learning experience as a result.
Thanks for stopping by. It’s always nice to hear your voice, my good friend.
Rob
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