Take stock and mind your PEs

It's been a lousy five years on the stock markets, but a lot of investors have still managed to earn attractive returns over that time. How come?

I say "lousy" compared to the longer-term averages. For context, the Toronto S&P TSX composite index provided average total annual returns of 1.7 per cent for the five-year period ending March 31, 2012. This includes dividends received. The American S&P 500 (large U.S. companies) returned two per cent, when measured in U.S. dollars, ignoring currency effects.

The 20-year averages are closer to nine per cent.

So, here's a pop quiz for you: When the recent averages are less than the historical long-term averages, is this likely to be a better time to invest, or a worse time?

Here's some more information -- the three-year S&P TSX return is 15.6 per cent. Not bad. But the one-year return to March 31 was negative 9.8 per cent.

The three-month return to March 31 was positive 3.66 per cent, but the market has dropped over three per cent since April 1.

So, a good time to invest or not?

Here's another question: Why does the average mutual fund investor earn less than the average return of the fund in which he or she invests?

It's because they buy when the markets are high and sell when the markets are low, basing their decisions on headlines, economic forecasts and their personal outlook on the future. Call it buying on optimism and selling on pessimism.

The market on which shares trade every day -- what we generally call the stock market -- is subject to moods, based on its collective outlook for the future. When the mood is pessimistic, stock prices are low, usually a better time to buy. "Low" in this case means you pay less -- on average -- for each dollar of earnings per share for the average company.

The cost of a dollar of earnings is called the price to earnings ratio, or PE. If a share is trading at $10 and the company's current profits are one dollar per share, then this is a PE of 10. If shares are trading at $20 for every dollar of profit, then the PE is 20 for that company.

Investors are willing to pay a higher PE for companies they expect to grow and lower for ones they don't expect to grow, or if they expect profits to actually fall.

Across the market average, the PE multiple is a measure of the market's outlook for the market and the economy in general. When there's too much optimism -- think of 1999 and 2007 -- you have to pay too much for stocks.

When there is "blood in the streets," as there was at the end of 2008 and the first few months of 2009, and stocks are dirt cheap, it is because everyone is afraid of them. Interestingly, if you had invested in the S&P TSX index at the time of maximum pessimism on March 1, 2009, you made about 50 per cent over the following 12 months.

This is largely thanks to a phenomenon called PE multiple expansion. That's a fancy name for saying the fearful market was only willing to pay, say, $5 for $1 of earnings in March 2009, and 12 months later growing optimism encouraged the market to pay, say, $10 for $1 of earnings. That meant, on average, company share prices doubled, even if their profits have not increased.

This is a rising tide that lifts all boats and can result in big increases in share prices.

What if you pick companies that are also increasing their profits? Over time, the market rewards good companies more than mediocre ones, so picking the right companies generally means more price stability in times of pessimism and a bigger increase when optimism also results in PE expansion.

OK, so here's your homework:

Find out the current PE ratio, either for a certain stock market index or for an individual company stock in which you are interested. Compare that to the long-term average PE ratio for that market index or company, and send me an email telling me if now is a good time to invest and why you came to that conclusion.

Have a great weekend, and remember, there are only two more weeks left to file your 2011 income tax return.

David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).

dchristianson@wellwest.ca

Republished from the Winnipeg Free Press print edition April 13, 2012 B11