Provided by TheDraconian.com
In particular, this graph plots the P/E ratio of the Dow Jones Industrial Average (DJIA) using trailing 10 year average earnings and the resulting 10 year total return of the DJIA. As shown, there are two distinct clusters in the graph: a lower cluster that represents most of the history of the DJIA and an upper cluster that deviates significantly from the lower portion. This upper portion largely corresponds to the build up of the tech bubble and the resulting aftermath. As indicated by the graph, in a typical environment, such as shown in the lower cluster, a trailing 10 year P/E of 20 would result in negative or flat returns over the next decade. On the other hand, in the top cluster, there were cases where such a P/E resulted in near 200% gains!
From the tech bubble, the DJIA began with a trailing 10 year P/E near 40 and has moved down to the current trailing 10 year P/E of 21 or so. If historic 10 year returns are presumed, the current trailing 10 year P/E implies that the next 10 years may not be stellar on a broad-market basis. On the other hand, using more recent valuation multiples, fair returns are also possible. However, some amount of skepticism should be applied to these earnings. For example, the two recessions in the last decade may lower the trailing 10 year earnings more than is warranted (thereby causing a higher trailing 10 year P/E than should be used). On the other hand, the current earnings (e.g., over the last few years) may be inflated due to high profit margins well above historic norms. Regardless, we are not investors in the broad market, so these considerations should not have much impact in our investment selection process.
In addition to the indices, this multiple regression can also be seen for individual companies. For example, large cap companies such as Coca-Cola, Microsoft, Colgate, and many others commanded an extremely high P/E during the tech bubble and even after its burst. The following is a graph comparing price and P/E for Coca-Cola:
Provided by ycharts.com
As you can see, Coca-Cola’s price has begun rising from the height of the last decade only in the past year or so; however, it began with an extremely high P/E (>70) and has only recently come down to normal or below normal P/Es . Thus, the company itself has been growing earnings steadily throughout the last decade, but this earnings growth has not been reflected in the price due to the steadily decreasing P/E multiple. However, once the P/E reaches a low enough level, the price will be forced to move up with underlying earnings growth again, which has begun to occur. The overall appearance of this graph (relatively flat prices and decreasing P/Es) is similar for a large number of companies, particularly high quality, large cap companies. After nearly a decade of high prices relative to earnings, these companies are finally worth considering as investments!
Thus, both the market as a whole and individual companies have undergone significant compression in valuation multiples. However, in many cases, particularly for the market as a whole, these multiples have not reached historic norms. It is unclear whether or how soon multiples will reach these “normal” levels. Regardless, in our view, market and individual company valuations are in a much better place than they have been over the past 10 or even 15 years.
As always, we will continue to search out for investments in individual companies with durable competitive advantages and large margins of safety to ensure out-sized gains.