When something happens in the stock market people often turn to the ‘experts’ to see what they think is going to happen.
Unfortunately the ‘experts’ don’t know; their comments are often just knowledgeable-sounding waffle.Curiously a number of experts always react the same way when asked what the market is going to do. They are always bearish. I have often wondered why this is the case. I think it has parallels with the ways some people are left wing and some people are right wing; they are just born that way.
Left wing people see Pinochet as a more evil figure than Stalin; vice versa for right-wingers. All party persuasions hated Hitler but then he was a National Socialist so he had something for all of us to become worked up about; plus he was a spectacularly unsavoury individual.
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You can’t be 100% bullish all the time
The problem with the stock market is that it doesn’t quite work to always be bullish, a posture I am tempted to adopt. Anyone who was always bullish, on all past experience, would always be right in the long term and right most of the time in the short term.
However the rare occasions of being wrong could be disastrous. Anyone who was bullish in early October 1929, in the summer of 1973, in early October 1987 or in March 2000 was about to have a painful experience.
One way around this is to do what Warren Buffett appears to have done, which is to buy shares in solid growth businesses and hold them forever. This enables you to capitalise on the long-term trend in financial assets, which is always higher. You will know this if you are fortunate enough to own a property originally acquired by your forebears in Norman, Elizabethan or Georgian times. Whatever your ancestor paid, the price will have risen 100s or even 1000s of times to the present day.
I have never figured out quite how Buffett made so much money. He is obviously a super-clever guy under his folksy image and, in addition, he bought shares at the perfect time and his frugal spending habits (he apparently really does like diet coke and burgers and still lives in his original house) enabled him to show unending patience while waiting for his shares to come good. He was also a stock picker of genius. What is not in doubt is that his ultra long-term strategy carried him through the last three of the severe stock market setbacks listed above. He would probably argue that, for him, big market setbacks are opportunities. .
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Two common mistakes people make
Most people either haven’t the patience to do what Buffett did or, if they do, they pick the wrong stocks. There are two common mistakes that people make. They buy the riskiest stocks that seemed to offer the greatest potential for reward. The vast majority fail to deliver. Alternatively they go for safety above everything and end up with shares in boring companies that are going nowhere.
I like the same kind of stocks as Buffett does, high quality growth stocks. My reasoning is simple. If the business does not grow why should the shares go up. The key factor in making a share go up in the long term is not how cheap it was when you bought it but how much the business grows afterwards.
The only proviso I would make is that it is important to avoid buying shares when investors are in a frenzy of excitement. This is based on simple crowd theory. In order for a share to rise there must be more buyers than sellers. Once everybody is excited there is no one left to buy so there is no possibility of more buyers than sellers. On the contrary, there is a serious risk that some of the huge crowd of buyers will turn sellers as happened so dramatically to technology shares in 2000. .
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Beware wild periods of excitement
Vulnerability in 2000 was also indicated by valuations. Businesses with modest assets and unprofitable business models were on huge valuations. It really was a kind of South Sea Bubble though, I have to confess, it was easy to be caught up in all the excitement at the time.
There is no sign of any comparable over-enthusiasm in the market at the moment. US shares are valued at around 14.5 to 15 times earnings. At a time when US long bonds are yielding under five per cent and there is no sign of a serious acceleration in inflation that does not make shares expensive. .
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High-quality UK growth shares are not expensive
I have the same feeling in the UK. Last week I recommended shares in RPS, an outstanding growth company by any standards. The company is on a prospective PE ratio of around 25. Some people might think that is a little high.
I think it is undemanding for a company that has grown earnings per share over the last 15 years by over 20 per cent a year. Furthermore the forecasts could easily prove conservative. In January 2006 the analysts forecast that RPS would have earnings of 9.8p in 2006. The earnings actually reported by the company were 11.94p, nearly 22 per cent higher.
Pick any high quality UK growth stock at random and the rating is likely to be reasonable. Plumbing distribution business, BSS, is a strongly growing business that is also in the TSW portfolio. First-half profits reported in November were up 37 per cent and the group recently issued a statement saying that it expected full year profits, due to be reported at the end of May, to be slightly ahead of expectations.
The shares are currently 494.75p versus my latest recommendation price of 372.5p and the prospective PE ratio of around 19 for a year that has just ended doesn’t look remotely overblown. The true prospective PE, based on likely earnings for the year to 31 March 2008, could easily be around 17 or even less; that looks cheap.
My conclusion is that there is no sign that share values are overblown or that investors are over-enthusiastic. If anything the contrary is true. This further implies that if investors did become excited values could be pushed a great deal higher. I believe that now is a good time to be buying shares. .
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