Month: October 2011

How would you like a reliable forecast of your stock portfolio’s returns? While countless magazines, radio shows & TV programs are devoted to the task, most attempts are fruitless. This article points to one measure that can help in a specific case: a low Price/Book ratio when analysts predict a stock market crash.

First let’s define “Book” (or: Book Value) in the expression Price/Book (P/B in short). Book Value is the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated.

P/B measures how much people currently pay for the assets of the company, and can be seen as a measure of how cheap it is. When the P/B is high, the company can be viewed as expensive and when it is low, the company can be viewed as cheap. The intuition is simple: the company has a given set of assets determining its book value. For the given book value, a high P/B results from a high price, and a low P/B is the result of a low price.

Your first instinct may be to hold more stocks when their P/B is low and fewer stocks when their P/B is high. There are several problems with avoiding stocks at times of high P/B:

1. The P/B can be high and increasing for a number of years, before reverting. Avoiding stocks could result in missing substantial gains for years. For example, 2004-2007 were 4 years with relatively high P/B for both of QAM’s stock portfolios. At that time both portfolios more than doubled. Even at the lowest month of the 2008 decline, the portfolio did not decline below the 2004 level, so even if you were perfect at buying back the portfolio at the lowest month, you would have still missed gains.
2. When the P/B is high, it may decline gradually, more slowly than the increase in company book values. This would result in prices never declining as a result of the high P/B.

There is also a problem with over-investing in stocks (using borrowing-to-invest) at times of low P/B:

1. A low P/B can decline for a while before reverting. This could be accompanied by a severe decline in your portfolio. While the risk declines the lower the P/B, you should always be prepared for a severe decline. This does not contradict the following: If you get/save money while your portfolio has a low P/B, it is very wise to add it.

While it is impossible to time the market simply by tracking the P/B of a portfolio, there is one case that may be helpful to note:

While we do not have long-term data of Price/Book values, during the limited history available (since 1998 for QAM’s portfolios), we see that significant market declines typically started at times with high Price/Book ratios, not low ones.

This is also logical, supporting the limited statistical evidence. When the price of a company is lower than the value of its assets, you would expect the company to be appealing to the buyers of its stock. Each company is different, but for a diversified portfolio holding many different stocks in different industries, the claim is more likely to hold.

When do people fear a multi-year decline, despite a low P/B? When there is high uncertainty, and fear of a recession, stock prices tend to decline. Once in a while, the decline keeps going to the point of a low P/B. Specifically, as the price declines, if the book value does not decline at the same speed, you get a lower P/B. Many investors and analysts fail to notice or acknowledge how cheap stocks have become, and keep predicting multi-year market crashes despite the low P/B, leading them to sell stocks.

Why does this happen? Investors focus on portfolio prices, since they represent the current value of their savings. The Price/Book value is a less intuitive measure that gets neglected. When there are uncertainty and gloomy predictions, prices tend to drop. People tend to view their investments’ appeal based on these predictions, and worse, based on recent performance. The idea that a company that costs $100 one day, and $80 a month later is 20% cheaper, unless its book value also dropped, is not intuitive enough to follow.

How can we use the claim above to help your investment results? When you hear an investment professional predicting a multi-year decline, look at the P/B of your stock portfolio. If it is low, this may be a case of irrational panic. As long as you are prepared for a decline at any time (through holding bond/cash reserves, or by limiting the withdrawal rate from your stock portfolio), you have a chance of having nice returns by holding onto your investments, until the fear goes away. If you have money to add to your stock investments you may even make excess returns.