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Brett Arends' ROI
May 27, 2011, 12:00 a.m. EDT
By Brett Arends, MarketWatch
BOSTON (MarketWatch) "” What sort of returns are investors likely to get from stocks from here?
That's the question that comes to mind following the latest intriguing research from Dylan Grice, investment strategist for SG Securities in London.
Barrons.com editor Randy Forsyth stops by the Markets Hub to test the adage "sell in May and go away" against current market conditions.
By his analysis, global equities from today's valuations are unlikely to do as well as even certain low-risk bonds.
OK, so it's just one view. SG has a reputation for bearishness, and has been too gloomy before.
But Grice's view isn't based on predictions of the future. On the contrary, he argues that all such predictions should be taken with fistfuls of salt. He's just comparing today's booming share prices to companies' "intrinsic value."
Intrinsic value, what's that? It's the higher, according to Grice, of a company's earnings power or its book value. If a company earns returns that are sustainably higher than its cost of capital (think Apple Inc. /quotes/comstock/15*!aapl/quotes/nls/aapl AAPL +0.34% ), then the intrinsic value is based on those returns. But if a company's returns are less than its cost of capital, the intrinsic value is just the value of its net assets, if any.
Simply put, a company is only worth more than its net assets if it is actually earning superior returns on a sustainable basis.
What's intriguing is that Grice has gone back in time and applied this methodology to the global stock market since 1987. His conclusion: For an investor, so-called IVP, or "Intrinsic Value to Price," has worked very well as a valuation measure over that period. Someone who spent those 24 years buying stocks that traded below their "intrinsic value," and either selling or avoiding stocks trading above it, would have beaten the stuffing out of the market.
Grice's hypothetical "long-short" portfolio, based on this measure, would have turned an initial $1,000 investment into about $10,000 today (before costs, to be sure). According to FactSet Research, its global index over the same period would have turned $1,000 into just $7,450.
That's some margin.
Grice now has applied IVP methodology to today's share prices.
His conclusion: Global stocks today are priced to yield meager future returns of about 5%, before inflation. As global inflation has averaged about 3%, he says, you're looking at real future returns of 2%.
It's intriguing, because I notice you can pretty much earn that with no risk by buying long-dated inflation-protected Treasury bonds, or TIPS. The 30-year TIPS currently offer a "real yield" of 1.83%. In other words, the yield is guaranteed to beat the CPI by 1.83% a year over the life of the bond.
For technical reasons, some of these bonds also come with protection against deflation, or falling prices as well. (That's because TIPS never pay back less than par value, so if we enter into an era of Japanese-style deflation, your final repayment will be worth more and more in real, purchasing-power terms.)
I've recently criticized the negative real yield on short-term TIPS. The long-term TIPS are no bargain by historical standards (they have often yielded much more than 2% real), but they may be better than many alternatives.
Even though Grice's analysis looks gloomy overall, he is nonetheless finding value in places. The stock markets of Greece, Italy, Portugal, Spain and Japan look pretty cheap by his measures. Greece looks really cheap, he says. (You can understand why. But don't let that necessarily scare you; buying in a crisis is when you can sometimes make the big returns.)
If you really fancy picking individual stocks, Grice has a list of stocks that are both cheap on an IVP basis and boast really strong balance sheets. Among his top U.S. picks are some big household names, such as American Eagle Outfitters /quotes/comstock/13*!aeo/quotes/nls/aeo AEO 0.00% , Best Buy Co. /quotes/comstock/13*!bby/quotes/nls/bby BBY +1.64% , Carnival Corp. /quotes/comstock/13*!ccl/quotes/nls/ccl CCL +0.60% , CME Group Inc. /quotes/comstock/15*!cme/quotes/nls/cme CME -0.36% , Colgate-Palmolive Co. /quotes/comstock/13*!cl/quotes/nls/cl CL +0.62% , Lexmark International Inc. /quotes/comstock/13*!lxk/quotes/nls/lxk LXK +0.78% , Lowe's Cos. /quotes/comstock/13*!low/quotes/nls/low LOW +0.12% , Merck & Co. /quotes/comstock/13*!mrk/quotes/nls/mrk MRK -0.60% and Staples Inc. /quotes/comstock/15*!spls/quotes/nls/spls SPLS +0.49%
Brett Arends is a senior columnist for MarketWatch and a personal-finance columnist for the Wall Street Journal.
"Look out, stocks are called above intrinsic value http://on.mktw.net/jSQLy9" 11:29 p.m. EDT, May 26, 2011 from MKTWArends
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Brett Arends is an award-winning financial columnist with many years experience writing about markets, economics and personal finance in Europe and the U.S. He has received an individual award from the Society of American Business Editors and Writers for his financial writing, and was part of the Boston Herald team that won two others. He was educated at Cambridge and Oxford Universities, and has worked as an analyst at McKinsey & Co. He is a Chartered Financial Consultant (ChFC) and Accredited Asset Management Specialist (AAMS). His latest book, "Storm Proof Your Money," has just been published by John Wiley & Co.
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