MINI-COURSE SERIES
MUTUAL FUNDS Part I
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
MUTUAL FUNDS
1
STOCK VALUATION Ultimately, people buy stocks to own a piece of a corporation’s earnings. If the XYZ Widget Company earns $5 a share and its stock sells for $100 a share, it has a P/E ratio of 20; an investor is paying $20 for every $1 of earnings. As a broad generality, a company in a seasoned industry group selling at a 30 P/E is said to be expensive; one selling at a 10 P/E is said to be cheap. The market meltdown of 2008 and 2009 may or may not alter these historical numerical guidelines. Unfortunately, company earnings are not particularly stable. It is easy for corporate accountants to “fiddle” with reported earnings to the point where they are almost meaningless. For these reasons, P/E has only limited value. Ben Graham pointed out that corporate earnings provide useful information only when averaged over several years. Publicly traded companies have two P/E ratios: “trailing” and “estimated.” The trailing P/E is most commonly used and represents a corporation’s actual earnings over the past 12 months; estimated earnings are a forecast for 12 months in the future. Unless otherwise noted, all P/E figures shown are trailing. Over the past 80 years, the stock market’s P/E ratio has ranged from a negative number (the Great Depression) to over 45 (early 2002). By historical standards, when the market’s P/E is about 7, it is definitely cheap; when it is greater than 20, it is expensive. The table below shows year-end price/earnings ratios for the S&P 500 and Dow (sources: S&P and Barron’s Online). As of March 2012, the Dow’s trailing P/E was 14 (15.5 for the S&P 500).
Year-End P/E Ratios: S&P 500 and DJIA Year
S&P
DJIA
Year
S&P
DJIA
2011
15.6
14.4
2001
46.5
27.1
2010
18.0
14.8
2000
26.4
22.2
2009
20.6
14.1
1999
29.1
24.1
2008
18.8
13.3
1998
32.6
24.0
2007
16.8
17.0
1997
24.4
20.2
2006
17.4
17.1
1996
19.1
18.2
2005
17.9
22.5
1995
18.1
16.4
2004
20.7
18.3
1994
15.0
15.0
2003
22.8
20.1
1993
21.3
25.6
2002
31.9
21.6
1992
22.8
30.5
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MUTUAL FUNDS
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The P/E ratio shows how long it would take to earn back (through current earnings) the price paid to acquire 100% of a company. For example, On February 12th, 2012, Microsoft had a P/E of 11. If someone bought 100% of all Microsoft stock (thereby becoming the sole owner), it would take just 11 years for the investor to recover 100% of the purchase price—based on Microsoft’s current earnings (no projection for increased earnings, which would lower the number of years). Phrased another way, it would be impossible to duplicate Microsoft’s presence, market share, reputation, product line and research in 11 years (note: it would be highly unlikely such a feat could be done in 20 years—meaning Microsoft stock is a bargain based on its current P/E ratio). A number of blue-chip companies in 2008 and 2009 reported negative earnings—no earnings or a loss means a non-existent or negative P/E ratio. A company may not have any earnings but all companies have a book value. This indicator can be thought of as the net value of a company’s total assets. A stock with a P/B of less than 1 is said to be cheap; one with a P/B of more than 5 is expensive, at least relative to its book value. The book value of a stock is considered to be very stable. The price-to-book value ratio (P/B) represents the recent closing stock price divided by the theoretical dollar amount per common share one might expect to receive from a company's tangible book assets should liquidation take place. Some studies suggesting a low price-to-book can lead to a strong stock price rise in the future. Price-to-book generally does not measure financial services stocks well because of the nature of the financial services business. Over the past 80 years, the stock market’s P/B has ranged from less than 1 to 8 (both numbers are exceptions); it has averaged about 1.6. During 1999, the P/B ratio for U.S. stocks was just below 6 (vs. 4 for European stocks). The ratio has declined since then, leveling off to 2.2 beginning in the middle of 2002 through 2009. The S&P 500 had a P/B ratio of 3.9 as of February 2012 (vs. 3.5 for the Russell 2000).
PART I
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MUTUAL FUNDS
3
BOND PERFORMANCE The table below shows total return figures for U.S. Government securities and inflation. Over the past 10 years (2002-2011), the Barclays 20+ Year Treasury Index averaged 9.2% (11% for five years).
U.S. Government Bond Performance By Decade [1970-2011] U.S. Government
1970s
1980s
1990s
2000s
2002-2011*
Long-term (20 year)
5.5%
12.6%
8.8%
7.7%
8.9%
Med-term (5 year)
7.0
11.9
7.2
6.2
4.8
T-bill (1 month)
6.3
8.9
4.9
2.8
3.2**
Inflation (CPI)
7.4
5.1
2.9
2.5
--
* mutual fund categories, net of expense ratios / ** short-term government bond funds
The returns fixed-income securities enjoyed during the 1980s, 1990s, and up through 2004 were partially due to a falling interest rate environment. As an example, the prime interest rate peaked briefly at 21.5% during the first half of 1981 and pretty much fell from there. Even in 2005-2012, interest rates were historically low.
BONDHOLDER’S TOTAL RETURN Suppose you buy a 10% coupon bond at par, or $1,000. The investment pays annual interest and matures in 25 years. You hold it to maturity. Would you realize a 10% yield to maturity, also known as the true compound rate of return? The answer depends on what you do with the interest payments, which total $2,500 over the 25 years ($100 per year times 25). Here is an analysis of the case: 1.
If you spent your interest checks when received, your y-t-m (yield to maturity) would not even come close to 10%. It would be 5.1%.
2.
Instead, suppose you reinvested in a passbook account at 4%. You would accumulate $4,165 in interest, but your realized yield to maturity would be only 6.8%.
3.
To earn the full 10% y-t-m, you would have to reinvest each payment at 10%. The accumulated interest would amount to $9,835.
The track record of professional rate forecasters is mediocre at best. The smart strategy for most investors is simply to use bond funds to meet liquidity, preservation of capital, and income needs. PART I
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MUTUAL FUNDS
4
TARGET RETIREMENT FUNDS Sometimes referred to as life-cycle funds, target retirement mutual funds are being promoted as “one investment choice for a lifetime.” Each fund is identified with a specific retirement year, such as 2020 or 2025. As the target date approaches, the allocation becomes more conservative, favoring bonds and cash. After the target date passes, most of these funds either merge into a retirement income fund or adopt an allocation that preserves purchasing power. There are a number of problems with these types of funds. First, the objectives of people with a similar target date can be quite different. Someone age 65 and in poor health may need more money each year. Second, most target funds are based on 10-year intervals instead of five. Third, some fund groups increase the expense ratios for these “fund of funds.” Fourth, a number of the “sub” funds have track records that are less than 10 years, making analysis somewhat limited. Fifth, some companies offer their best funds, others use a mix of some of their good and some of their not-so-good funds.
The Biggest Problems The greatest concern about target retirement funds is that their allocations are all over the board. As an example, the AIG SunAmerica High Watermarket fund has a target maturity of 2020 and a stock allocation of just over 86%. The Russell LifePoints Strategy has the same target date of 2020, but its stock allocation is 50%. Similarly, the Seligman TargETFund has a target date of 2025 with over a 94% allocation to stocks. The Vanguard Target Retirement fund has the same 2025 target retirement date, but a stock allocation of less than 57%. A major contributing factor to the wide allocation variances is how the fund describes “retirement.” A retirement fund’s objective could be an allocation policy until retirement or it could be for life expectancy. Obviously a fund that “tacks on” an additional 18-25 years to its time horizon is going to be much more equity oriented. These funds offered little protection during the 2008 meltdown (-38% vs. -38% for large cap blend funds).
Target Retirement Funds [target date 2031-2035] 2011
2010
2009
3 Year*
5 Year*
10 year*
-4%
14%
30%
12.6%
-1.0%
n/a
* annualized (note: std. dev. over the past 3 years was 22% vs. 23% for large cap blend stock funds
PART I
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MUTUAL FUNDS
5
BEAR MARKET PERFORMANCE Stock (S&P 500) and bond (Merrill Lynch U.S. Corporate and Government Master Index) returns often move in different directions. The return figures below are cumulative (sources: Lipper and Bloomberg).
Stocks vs. Bonds During Bear Markets [1977-2011] Bear Market Jan. ’77 — Feb. ‘78
S&P 500
U.S. Bonds
-14.2%
3.2%
Dec. ’80 — July ‘82
-17.2%
21.0%
Sept. ’87 — Nov. ‘87
-29.6%
2.3%
June ’90 — Oct. ‘90
-14.7%
3.7%
May ’98 — Aug. ‘98
-13.4%
4.2%
Mar. 2000 — Dec. 2002
-33.0%
33.1%
Oct. 2007 — Mar. 2009
-56.2%
7.05%*
Average for Above
-25.5%
+12.4%
* total return for a 50/50 mix of 5-year and 20-year government bonds
THINGS TO DO Your Practice List the five investment and planning topics you know most about as well as five you would like to know more about. The Next Installment Your next installment, Part II, covers five topics: REITs, investing in a house, bank loan funds, rolling period returns, enhanced appreciation notes and long-short funds. You will receive Part II in a few days. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com. PART I
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