"The Rule of Twenty Can Make You Plenty"

Old_Skeet

In an earlier post this week I referenced the “Rule of Twenty.” “The Rule of Twenty Can Make You Plenty” is an article featured in a Seeking Alfa article. I have linked this article for those that might be interested in reading more about it. http://seekingalpha.com/article/309239-the-rule-of-20-can-make-you-plenty

And another take on the "Rule of Twenty" by Capital Invetment Services. Below is a paragraph form their take that resonates with me. A link to their complete commentary on the subject is found below.

1982 to 2013
Average CPI% was 3%
Average Actual P/E ratio was 16.7X

"Currently, the CPI (less Food and Energy year-over-year %) has been increasing at a 2% annual rate which, according to the “Rule of 20” model, would suggest the S&P 500 P/E ratio should fundamentally be closer to 18 times. This would translate into an additional 25% rise in the market valuation.

We believe stock investors should be more focused on inflation conditions than the absolute level of the market P/E ratio. If inflation can remain near recent levels of about 2% (which we believe is likely), valuations have further room to improve and drive higher stock prices."

We remain focused on understanding the current trends in fundamentals because it gives us the best probability for success. And if you’re an active social media user, please consider sharing this topic with your acquaintances.

http://www.capinv.com/rule-of-20/

Have a good weekend … and, I wish all … “Good Investing.”

Old_Skeet

Charles

"...money goes where it is treated best."

I like that.

Let's hope for higher earnings.

cman

Seems like the 'rule of 20' broke down in the mid 90s suggesting other factors at play that affect multiples or more likely the curve fitting relationship was just an accidental one neither correlated nor causal. One could probably make a similar nonsensical rule about inflation and life expectancy misusing averages and forced curve fitting.

Personally, I think stock prices became derivatives on a company over the last two decades rather than be a direct measure of company valuation that they started as. By that, I mean the prices were determined more by supply of money into the markets looking for shares and the gains determined by this betting against each as a first derivative of earnings using only the direction rather than magnitude.

Vaguely remember a book a decade ago that busted Wall Street myths like 'rule of 20'.

Old_Skeet

Hi cman,

That is an interesting point that you make regarding stocks prices have now become derivatives rather than a direct measure of a company valuation. With this ... It raises a question ... How should stocks now be valued? Any idea?

Old_Skeet

cman

Reply to @Old_Skeet: Don't have a clue because I think valuation is now simply a measure of investor sentiment more related to behavioral finance than efficient markets and subject to flows of money in and out of broad indices rather than into or out of individual stocks. If there is a lot of money pouring in, multiples expand with questionable rationalizations, otherwise they contract.

It has always been this way for pre-ipo companies in the venture capital world. Now that seems to be happening in post-ipo markets as well since public companies are not required to have dividends or even earnings to provide gains from direct betting with agreement only on direction.

Charles

Really good discussion here.

Near-term, P/E seems to be a very dependent variable..."a derivative," as you describe.

But in the limit, seems to me it must converge to reflect a reasonable return on invested capital.

Else, we shouldn't be investing in the stock market.

Ha! In case of Jeff Bezos, the limit may be a very, very long way out!

Old_Skeet

Here is a take on how earnings reporting gets managed ... Naw, Corporate America would not do that? Or, would they? Now the question ... How will revenues come in? That might be something to look at, along with earnings, as a way to value a company's stock. It's hard to trick up revenue. If a company is growing revenue, it's earnings should also be growing. My thinking is that if earnings are reported to be growing without revenue growth, then perhaps earnings are being tricked up. Seems revenues have been lagging although earnings have been quite steller over the past year, or so, for the S&P 500 Index.

http://www.zerohedge.com/contributed/2013-12-14/signs-top-and-few-opportunities-value

Something to think on.

Old_Skeet

Charles

Reply to @Old_Skeet: Now, I do not agree with the Phoenix Capital Research report. But your point on tracking revenues, that's good stuff Old_Skeet. I suppose EBIT and EBITDA are also metrics that may be somewhat tougher for the accountants to manipulate than earnings (net income).

That said, at the end of the day, dividends and reinvested cash must come out of earnings. I suspect you can fool earnings for a while but over time, the truth must come out.

'Cause, like you and I know, all things based on falsehood will eventually be proven wrong.