Iron Capital Insights

  • Iron Capital Insights
  • August 28, 2014
  • Chuck Osborne

Record Highs!

I walked in the office bright and early yesterday morning and was greeted with the same message we have been hearing for some time: The Nasdaq is higher than it has been since 2000. The Dow and S&P are at record highs. The message seems to be getting through, because we are hearing it from neighbors, friends, clients and even complete strangers. The sentiment is usually followed by one of two statements: “This must be good for your business,” or, “Should I be worried?” So here are the answers.
No, high markets are not necessarily good for business. Don’t get me wrong, we are blessed at Iron Capital with great clients, and yes, our compensation is tied to their success, so we do make more as clients’ asset values rise. However, rising markets lift all ships – those who are captained by fools right along with those who are prudently managed. I believe it was Warren Buffett who once said, “You find out who is swimming naked only when the tide goes out.” We gain most of our new clients when they discover that their former adviser had no clothes. I wish that was not the case, because I do not enjoy down markets, but it is human nature and not likely to change.
I once knew a sales manager who used to say that the key to winning business was answering “Yes” to every question. I don’t know what that says about his integrity, but I cannot deny that there is some truth in his comment. People generally want to hear yes more than no. That is true even when they are asking about worrying. Some people just want to worry. However, I place the utmost importance on integrity, and the answer to the second question above is again, “No.”
The truth is that the price of a stock is meaningless on its own; the price of an index is even more so. Perhaps an example will help. Apple recently hit an all-time high value when its stock hit $102.17. I know what you are thinking: Wasn’t Apple’s stock worth more than $700 per share just two years ago? Yes it was, but that is meaningless. Apple decided to split its stock, giving every shareholder seven shares for every one share they owned. A year and a half ago I wrote about Apple being a bargain at less than $500, and when it hit $400 I said it would go up at least 50 percent. It is now at approximately $100 and it has gone up 75 percent. Confused yet? Well, that one share at $400 is now seven shares at $100 each, or your $400 investment is now worth $700. The point is that share price is nothing but an accounting tool. Its only purpose is to allow the investor a way of easily seeing the results of their investment. Apple could have chosen to split the stock even more and the share price today could be $50 instead of $100. It would not matter.
So what does matter? How does one know if a stock, or an index of stocks, is expensive or cheap? What is one really buying when she invests her money in the stock of a company? There could be multiple answers to that question, but finance professors would say that she is buying the future earnings of that company. That is the monetary value of an investment to an investor. There are many ways to go about determining that value, but the simplest just happens to be one of the best: we call it the PE, which stand for the price-to-earnings ratio. It is simply the price of a share of stock divided by the earnings per share of stock. By that measure the market, as measured by all those indices (Nasdaq, S&P, Dow etc.), is nowhere near a record high. Most stocks are still within a normal range of values. Small company stocks do appear to be expensive, but even they are not near their record highs.
Still confused? Think of it like this: When one goes to the grocery store to buy a jar of peanut butter, is he buying jars or is he buying peanut butter? The small jar may have a smaller price than the big jar, but the peanut butter may actually be more expensive. If he really wants to save money he may go to Costco and get a five-gallon bucket of peanut butter. (Maybe that is a slight exaggeration but you get the point.) What matters is not the total cost of the jar, but rather the price per ounce of peanut butter.
The Dow, Nasdaq, S&P, etc. – they are all jars. The price of the jar is practically meaningless; it is what one pays for what is in the jar that matters. When looked at that way, record highs are a long way from here, and we are a long way from being worried.
Warm regards,
Chuck Osborne, CFA