History

The Greatest Teacher

Dr Adrian Saville
Chief Investment Officer

Cannon Asset Managers

adrian@cannonassets.co.za . www.cannonassets.co.za

2009
 
   

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“Those who cannot remember the past are condemned to repeat it.”

George Santayana (1863-1952)

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1. Why This Time Is Not Different

The charm of history and its enigmatic lesson consist in the fact that, from age to age, nothing changes
and yet everything is completely different.

Aldous Huxley

David McCullough, the American author, narrator and lecturer once remarked that “History is
a guide to navigation in perilous times.” For investors, this observation is as important as
legendary investor Sir John Templeton’s statement that the four most dangerous words in
investing are “this time is different”.

Yet, despite having access to the powerful lessons and insights offered by history, and being
given the opportunity to see far by standing on the shoulders of giants, investors tend to be
mesmerized by short-term market movements and enslaved to crowd psychology. Instead,
then, they cling to the futile belief that, somehow, this time will be different. Indeed, whether it
is on the way up, when the collective thought is “things can only get better”, or on the way
down, when the collective thought is “the end is nigh”, investors seem determined to repeat the
past by focusing on the immediate future and letting human behaviour and bias swamp sound
judgment and sensible decision making based on the long-term lessons and insights provided
by history.

In its most dramatic form, this repetitive behaviour plays out in the form of booms and busts or
asset price bubbles and collapses. For students of history, such as the prolific writer Charles
Kindleberger and theoretician Hyman Minsky, there is much to learn from studying the path
travelled by asset price bubbles.

Kindleberger and Minsky’s message is simple: bubbles follow predictable patterns. By

recognizing these patterns, investors furnish themselves with the ability to avoid the frenzied
inflation and collapse of asset price bubbles. In so doing, investors equip themselves to protect
their investment capital from the devastating consequence of collapsing asset prices.

Equally important, Kindleberger and Minsky’s teachings demonstrate that it is in the final stage
of the asset price life cycle, when most investors feel revulsion towards the asset class (such as
technology stocks in the early 2000s), that the best investment opportunities present themselves.
In short, history demonstrates that it is in the darkest hour that the best investments are made –
and not during moments of euphoria. Yet this critical observation runs contrary to the beliefs
and actions of most investors.

It is without coincidence that the global equity bubble that was pricked in the middle of 2007
repeats this pattern. More importantly, the collapse in equity prices since then has left investors
with a strong sense of revulsion towards equities. As Kindleberger and Minsky – as well as
swathes of history – have shown, this loathing is misplaced. To take the point further, our
observation of historical patterns and our analysis of equity markets, and the South African

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equity market specifically, tell us that it is in this period of revulsion that exceptional
opportunity presents itself to investors.

This time is not different.

2. History: The Great Teacher 1

Samuel Langhorne Clemens, better known by his pen name Mark Twain, once quipped
“History does not repeat itself, but it rhymes”. For this simple reason, history constitutes one of
the best teachers. History gives us perspective. It reminds us that it is impossible for trees to
grow to the moon, and it reminds us what is possible when we find ourselves in the darkest
hour.

Yet investors tend to prefer to ignore history. In this vein, Sir John Templeton, one of the most
successful investors of the twentieth century, once observed that “this time is different” are the
four most dangerous words in investing. John Kenneth Galbraith (1994), a prolific author, and
one of the leading proponents of twentieth-century American liberalism and progressivism, put
the same point a little more colourfully:

[Markets are characterized by] extreme brevity of the financial memory. In

consequence, financial disasters are quickly forgotten. In further consequence, when
the same or closely similar circumstances occur again, sometimes in a few years, they
are hailed by a new, often youthful, and always supremely self-confident generation
as a brilliantly innovative discovery in the financial and larger economic world. There
can be few fields of human endeavor in which history counts for so little as in the
world of finance.

When asked if investors are likely to learn anything from the recent financial meltdown, Jeremy
Grantham (2008) rejoined “We will learn an enormous amount in the very short term, quite a bit
in the medium term and absolutely nothing in the long term. That would be the historical
precedent.” In short, investors prefer to ignore history. Time and again, though, this proves to
be an expensive omission.

As Benjamin Graham (2003) argued in Chapter 3 of The Intelligent Investor “Prudence suggests
that [the investor] have an adequate idea of stock market history, in terms particularly of the
major fluctuations … With this background he may be in a position to form some worthwhile
judgment of the attractiveness or dangers … of the market”.

Given the importance of the role of history, James Montier (2008, 15) goes on to argue that
nowhere is an appreciation of the past more important than in understanding bubbles. In this
regard, the Kindleberger-Minsky model provides an exceptionally powerful framework for
analyzing bubbles and their history (Montier, 2007, Chapters 38 and 39). 2 Essentially the model
                                                            
1This section draws heavily on James Montier’s (2008) note The Tao of Investing.
2Charles Poor "Charlie" Kindleberger (1910-2003) was an historical economist and author of over 30 books. As an
economic historian, Kindleberger relied on narrative exposition and knowledge of history rather than mathematical
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breaks a market bubble’s rise and fall into five phases (see Figure 1). The mechanics of the
model are described more fully below.

Figure 1: Kindleberger-Minsky Model

Phase 1:
Displacement

Stage 5: Phase 2: Credit

Revulsion Creation

Phase 4: Critical
Phase 3:
Stage/Financial
Euphoria
Distress

Source: Adapted from Montier (2007)

                                                                                                                                                                                                
models to prove his point. Today, his 1978 book Manias, Panics, and Crashes remains prescribed reading for any
modern student of market bubbles and collapses. Hyman Minsky (1919-1996), was an American economist and
professor of economics at Washington University in St Louis. His research attempted to provide an understanding
and explanation of the characteristics of financial crises. Minsky was sometimes described as a post-Keynesian
economist, because, in the Keynesian tradition, he supported some government intervention in financial markets and
opposed some of the popular deregulation policies in the 1980s. Minsky argued against the accumulation of debt.
Contrary to expectation, his research was embraced by Wall Street.
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3. A Description of the Kindleberger-Minsky Model

The Kindleberger-Minsky Model divides the evolution of a market bubble into five phases,
namely (i) the birth of a boom; (ii) the nurturing of a bubble; (iii) euphoria; (iv) financial
distress; and (iv) revulsion. Each of these phases is described below.

i. Displacement: The Birth of a Boom

The foundations of a bubble are set when a (typically exogenous) shock occurs that triggers the
creation of profit opportunities in some sectors, while closing down profit availability in other
sectors. This process is referred to as displacement, and as long as the opportunities created are
greater than those that get shut down, investment and production will pick up to exploit the
new opportunities.

More fully, investment in financial and physical assets is likely to occur. Effectively we are
witnessing the birth of a boom. Modern history is filled with examples of displacement.
Consider, for instance, the massive investment in railroad during the 1830s and 1840s; the
automobile and radio booms of the 1920s; the ‘tronics boom of the early 1960s which saw
investments flow into electronics companies making products like transistors and optical
scanners; the boom during the 1980s of investments in biotechnology businesses; or the dot.com
splurge of the 1990s which found its roots in the mid-1990s when it was recognized that
companies such as Netscape, whose browser brought the internet to people like you and me,
would change the world forever.

ii. Credit Creation: The Nurturing of a Bubble

Just as a fire needs oxygen and fuel to grow, so an economic and financial boom needs liquidity
to feed itself. Minsky argued that monetary expansion and credit creation are largely
endogenous to the system. That is to say, not only can money be created by existing banks but
also by the formation of new banks, the development of new credit instruments and the
expansion of personal credit outside the banking system.

As in other bubbles, debt has been a central ingredient in the recent real estate, emerging
market and commodity bubbles. However, in the past two decades, debt has found new ways
of creeping into the economy and capital markets. Consider, for example, private equity firms
and hedge funds, which today are key participants in capital markets, but whose role has been
facilitated by heavily geared balance sheets. Similarly, the appetite for debt had ballooned in
other parts of the financial sector in the credit bubble of the past decade. By way of example, by
2007 investment banks such as Lehman Brothers, Morgan Stanley and Goldman Sachs were
running debt-to-equity ratios that ranged between 22:1 and 33:1. Similarly, according to the
Bank of England, the median ratio of debt-to-equity in big banks in the United Kingdom grew
to more than 30:1 during the credit bubble. This means that, on average, these banks had
borrowed UK£30 for every pound in capital held by the bank. In essence, a credit pyramid is
established though what Minsky described as Ponzi.

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iii. Euphoria

The abundance of debt means that people are given latitude to buy widely – and often wildly –
into the new era. Prices are seen as only capable of ever going up. In the recent real estate
bubble this was true of perceptions around house prices, and this sentiment certainly was true
of technology stocks in the dot.com bubble. By way of example, in March 2000, James McCall, a
fund manager at Merrill Lynch, noted “We don’t get too hung up on valuations. Even if it’s a
gazillion times earnings, that’s not my part of the decision.” Thus, a wave of overoptimism and
overconfidence is unleashed, leading people to overestimate the gains, underestimate the risks
and generally think they can control the situation.

Sympathetic with his Keynesian roots, Minsky referred to this phase of the bubble as being
fueled by a surge in “animal spirits”, and American president Herbert Hoover in private
described this part of the 1929 stock market bubble as “an orgy of speculation”.

The mindless rush in animal spirits associated with this orgy leads to traditional valuation
standards being abandoned, and new measures introduced to justify the current price. When
discussing the abnormally high price-earnings ratios in existence in early 1999, James Glassman
and Kevin Hasset, authors of Dow 36,000, proffered “Could it be that the model that Wall Street
has been using to assess whether stocks are overvalued – a model based largely on historic [sic]
price to earnings ratios is deeply flawed? We think so.” Glassman, Hasset and other crowd
followers might be near-term right, but inevitably they are long-term wrong as the euphoria
tanks in the fourth phase of the bubble.

iv. Critical Stage/Financial Distress

The critical stage often is characterized by insiders cashing out. This is followed rapidly by
financial distress, in which the excess leverage that has been built up during the boom becomes
a major problem. During the 1929 stock market bubble, the prominent and highly respected
Wall Street banker, Paul Warburg, foresaw that “if orgies of unrestricted speculation are
allowed to spread too far” then collapse is inevitable.

Also, financial fraud often emerges during this stage of the bubble’s life. This last aspect of the
current debubbling process has been highlighted by a number of high profile financial frauds
that have been unearthed in the past year. The most extraordinary act in this set is the fraud
committed by Bernie Madoff which was uncovered in December 2008.

Madoff, an American businessman and former chairman of the NASDAQ stock exchange, has
confessed to, and been convicted of, operating a Ponzi scheme that has been called the largest
investor fraud ever committed by a single person. The scheme, which Madoff has described as
“one big lie”, is estimated to have cost his 4 800 clients as much as US$64.8 billion. To put this
figure into context, the combined market capitalization of South African-listed Firstrand,
Goldfields, Naspers, ABSA, Telkom, Kumba Iron Ore, Old Mutual, Nedbank, Impala Platinum
and Richemont SA equaled approximately US$65 billion at the start of April 2009.

Shortly after Madoff’s deceit was revealed, Sir Allen Stanford, a prominent financier,
philanthropist and sponsor of cricket in the Caribbean, was charged by the US Securities and
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Exchange Commission for alleged "massive ongoing fraud" involving US$8 billion in certificates
of deposits. Adding the market capitalizations of Sanlam, Remgro and Liberty International
would equate to the size of Stanford’s fraud. Given the extent of the crowd delusion, it is
evident why, from here, it is a short step to the final stage of the bubble cycle, namely revulsion.

v. Revulsion

Revulsion is the final stage of a bubble’s life cycle. In this part of the cycle investors are
exhausted. Many tend to have given up hope and have lost all sense of optimism. A recent
article in the Financial Times (Brewster, 2009) captures this mood by citing the argument of a Los
Angeles-based business owner whose holdings were worth more than US$3 million at the end
of 2007:

I haven’t opened a[n investment] statement since October [2008] … I know it’s bad,
but what can I do about it? There is no point in depressing myself. I need to focus on
my business, which is going well. My investments are pretty much gone … I had lots
of stocks – bank stocks, Bear Stearns, they’re gone. I see the statements come in the
mail and I throw them right in the garbage.

In short, investors are so scarred by the events in which they participated that they can no
longer bring themselves to participate in the market at all. From a behavioural stance it is easy
to understand why this is the case. In the same breath, though, the almost universal rejection of
the asset class results in prices collapsing to the point that asset prices fall into bargain basement
territory. Perversely, it is often from this base that the greatest fortunes are made, whereas
fortunes are lost in the third and fourth stages of euphoria and crisis.

4. Revulsion Sets the Stage for Investment Success

Sir John Templeton’s success as an investor exemplifies this last argument. After the stock
market collapse of 1929 and the Great Depression of the early 1930s, Templeton bought 100
shares of each company trading for less than US$1 a share, and within four years had made
many times the money back. This same contrariness saw Templeton become one of the first
global investment managers to buy into Japanese companies in the mid 1960s ahead of that
country’s extraordinary rise from the ashes of World War II. Templeton attributed much of his
success to his ability to maintain an elevated mood, avoid anxiety and stay disciplined. In this
vein, Templeton became known for his philosophies of "avoiding the herd" and "buying when
there is blood in the streets".

A different – and more modern – example of crisis and despair producing exceptional
opportunity comes in the form of the Russian financial crisis of 1998. The so-called "Ruble
crisis" hit the country in August 1998, triggered by the collapse of the emerging market bubble
which had been popped by the Asian financial crisis of 1997. The ensuing plunge in world
commodity prices meant that countries such as Russia, that were heavily dependent on the
export of raw materials, were severely hit. In the case of Russia, an effort to prop up the
currency and stem the flight of capital was made by hiking the key interest rate to 200 percent.
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Nevertheless, crumpling tax revenues, a growing mountain of unpaid wage debt, irregular
internal debt payments and plunging foreign exchange reserves saw the Russian stock, bond,
and currency markets fall apart in mid-August 1998 following the government’s default on its
debt. However, the Russian economy’s recovery was surprisingly quick, aided by the recovery
in oil prices, a surge in government revenue and a sharp reversal in the current account.
Consequently, buyers of distressed Russian debt experienced extraordinary investment returns
over the next few years. Buyers of Russian government debt at the start of 1999 would have
made more than five times their initial investment by 2004 – an exceptional result by any
measure.

A third, and more contemporary, example of finding cheap assets in the period of revulsion
comes from the bursting of the dot.com bubble in 2000. Out of the ashes of this collapse have
risen some extraordinarily successful business and investment cases, including newcomers
Skype, Facebook and Google, whilst stalwarts such as Hewlett Packard, Nokia, Apple, Adobe
Systems, Infosys, Symantec, Yahoo, Intel, SAP, Texas Instruments, Amazon and eBay
collectively have produced stellar returns. In the five years following the technology crash of
2000, Apple, Amazon and eBay generated returns of 350 percent, 630 percent and 1 500 percent,
respectively. But stock picking with hindsight is cheating. Instead, assuming that the average
person buying in the revulsion stage of the technology collapse had bought the Nasdaq Index,
the reward over the next five years would have been in the order of 50 percent greater than the
broader market index, the S&P 500, over the same period.

5. A Time for Revulsion

To everything - turn, turn, turn

There is a season - turn, turn, turn
And a time for every purpose under heaven

A time to be born, a time to die

A time to plant, a time to reap
A time to kill, a time to heal
A time to laugh, a time to weep

The Byrds, Turn! Turn! Turn!

Drawing on the examples above, and to return to the argument, the lesson from history is that
the final stage of the de-bubbling process is revulsion. This phase is characterized by
overwhelmingly cheap asset prices and, whilst cheap markets can always get cheaper, it is these
deep trenches in investor sentiment that often provide extraordinary entry points, or
opportunities for entrenchment, for long-term investors.

The rapid unwinding in equity prices since the middle of 2007 has brought us to levels of
valuation that are normally associated with revulsion. Using the trailing price-earnings ratio,
for instance, the reading for the Johannesburg Stock Exchange’s All Share Index (JSE ALSI) of
around nine times trailing earnings that we have seen in the first quarter of 2009 was last seen

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in the first quarter of 2003 (see Figure 2). It was from this point in 2003 that the domestic equity
market staged an extraordinary bull run that spanned five years, delivering capital growth of
300 percent over the period.

Figure 2: Price-Earnings Ratio (x) for the ALSI (1980-Present)

25.0
1987 crash and
apartheid state
20.0
Collapse of
gold price
spike and
15.0 onset of
sanctions
10.0

5.0
Global slowdown and
democratic transition
0.0
Jul-81

Jul-84

Jul-87

Jul-90

Jul-93

Jul-96

Jul-99

Jul-02

Jul-05

Jul-08
Jan-80

Jan-83

Jan-86

Jan-89

Jan-92

Jan-95

Jan-98

Jan-01

Jan-04

Jan-07
Source: McGregor BFA; analysis by Cannon Asset Managers

As shown in Figure 2, other examples of similar low price-earnings ratios for the market include
the early 1980s, late 1980s and early 1990s. In these cases, the JSE ALSI has delivered five-year
returns in the order of 250 percent from the early 1980s, 200 percent from the late 1980s and
170 percent in the case of the early 1990s. In each case, these periods match not just with
extremely low valuation multiples but also investor repulsion towards equities. The early
1980s, for instance, corresponded with the collapse of the gold price spike and the onset of
financial sanctions against South Africa; the late 1980s corresponded with the 1987 market crash
and the crisis of the apartheid state; and the early 1990s corresponded with investor caution
ahead of South Africa’s democratic transition as well as the economic slowdowns in Europe and
the US.

An analysis of the recent dividend yield history for the JSE reveals a similar story. Indeed, the
current yield in the order of five percent is unprecedented in recent history.

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 Figure 3: Dividend Yield (%) on the ALSI (1995-Present)
6.0

5.0

4.0

3.0

2.0

1.0

0.0
Dec-96

Sep-97

Dec-99

Sep-00

Dec-02

Sep-03

Dec-05

Sep-06

Dec-08
Jun-95

Mar-96

Jun-98

Mar-99

Jun-01

Mar-02

Jun-04

Mar-05

Jun-07

Mar-08
Source: McGregor BFA; analysis by Cannon Asset Managers

Moreover, if contrasted to bonds, the dividend yield-to-bond yield ratio of 1.4 times recorded in
the first quarter of 2009 presents an all-time low for the series in the past decade. This reading
offers further evidence of investors’ revulsion towards equities. Other examples of investor
revulsion are evident by eyeballing Figure 4.

Figure 4: R157 Bond Yield-to-ALSI Dividend Yield Ratio (x) (1997-Present)

8.0
Euphoria
7.0
Revulsion
6.0

5.0

4.0

3.0

2.0

1.0

0.0
Mar-98

Dec-98

Sep-99

Mar-01

Dec-01

Sep-02

Mar-04

Dec-04

Sep-05

Mar-07

Dec-07

Sep-08
Jun-97

Jun-00

Jun-03

Jun-06

Source: McGregor BFA; analysis by Cannon Asset Managers

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However, an objection to using trailing price-earnings ratios and trailing dividend yield figures,
as in the above analysis, is that these numbers are flattered by good earnings growth (and by
implication good dividend payments) in recent years. For instance, aggregate earnings of
resource stocks, which account for 50 percent of the JSE ALSI by weight, increased by 50 percent
between 2007 and 2008. Thus, anything less than a 50 percent increase in the price of resource
stocks would have equated to a derating of resource company valuations.

Fortunately, valuation metrics exist that are able to immunize against the near-term bias of
metrics such as the one-year trailing price-earnings ratio and one-year trailing dividend yield.
The most obvious metric in this regard is the price-to-book ratio which measures the net assets
that are bought by each Rand that is allocated to the market. Thus, a price-to-book ratio of less
than one implies that a Rand allocated to the market to buy an investment will buy more than a
Rand in net company assets. As such, the attraction of the price-to-book ratio is that it is
somewhat protected from spurious near-term events that distort company valuations, such as a
once-off earnings boost or an inflated earnings platform that cannot be sustained.

That aside, considering price-to-book ratios for the JSE since the early 1990s, the available
evidence offers strong support for the view that low price-to-book ratios provide a platform for
sound equity returns. Specifically, as shown in Figure 5, the price-to-book ratio for the JSE
reached a low of 1.2 times in August 1998. This low was followed by a gain in the JSE of
98 percent over the next three years and 106 percent over the next five years.

In similar vein, the price-to-book ratio for the JSE reached a localized low of 1.4 times in 2001.
This was followed by a three-year return of 47 percent and a five-year return of 180 percent.

Figure 5: Price-to-Book Ratio (x) for the JSE (1992-Present)

4.00

3.50

3.00

2.50

2.00

1.50

1.00

0.50 Price-to-Book Average

Two Standard Deviations Upper Two Standard Deviations Lower
0.00
Dec-92

Oct-93

Jul-94

Apr-95

Jan-96

Oct-96

Jul-97

Apr-98

Jan-99

Oct-99

Jul-00

Apr-01

Jan-02

Oct-02

Jul-03

Apr-04

Jan-05

Oct-05

Jul-06

Apr-07

Jan-08

Oct-08

Source: Factset

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Away from anecdotal evidence, quintile analysis shows that low price-to-book ratios in South
Africa are correlated with good investment performance from equities. Specifically, as shown
in Figure 6, when the price-to-book ratio has been in the lowest quintile, the returns from South
African equities over the next five years, measured in Rand terms, have averaged 28.8 percent
per annum. By contrast, when the price-to-book ratio has ranked in Quintile Five, five-year
returns have averaged -11.4 percent per annum. Usefully, the relationship is well behaved, with
five-year equity returns falling almost monotonically as the price-to-book ratio for the JSE rises.

Figure 6: Average Annual Returns over Five Years for the JSE Based on
Price-to-Book Quintiles (1992-Present) (%)
35.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
‐5.0
‐10.0
‐15.0
1 2 3 4 5
Cheap ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ Price‐to‐Book Quintile ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ Expensive
Source: Data from Factset; analysis by Cannon Asset Managers

As an aside, the more detailed information on price-to-book ratios and subsequent market
returns set out in Table 1 make it clear that the relationship is not nearly as well behaved over
shorter periods. For instance, the best one-year equity returns are reported when the price-to-
book ratio sits in Quintile Four, which implies that somewhat expensive markets become a little
more expensive before blowing out. This makes a case for momentum investing.

Table 1: Price-to-Book Quintiles and JSE Average Annual Returns (1992-Present) (%)

Quintile One Year Three Years Five Years

1 0.7 11.9 28.8

2 -5.8 9.1 20.5
3 26.1 30.6 21.3
4 38.0 20.4 2.6
5 -5.5 -8.1 -11.4

Source: Data from Factset; analysis by Cannon Asset Managers

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By contrast, over three years, the best equity returns are recorded from Quintile Three. It is
interesting to note, though, that, on average, over one, three and five years, markets that are
priced in Quintile Five deliver negative returns. This outcome reinforces the danger of
investing in expensive, go-go markets. Put simply, very expensive markets only have one way
to go. But the focus of this note is on cheap markets – which are located in Quintile 1.

Returning then to the discussion on cheap markets, by distinction, over one, three and five
years, markets that start in Quintile 1, on average, deliver positive returns, ranging from
0.7 percent to 28.8 percent per annum in Rand terms. This has at least two implications. First,
cheap markets do not stay cheap. Second, the best investment returns (five years) are delivered
from investing in cheap markets (Quintile 1), which are markets associated with revulsion.

Given this backdrop, valuations on the JSE appear cheap after the price declines of the past 18
months. Specifically, the current price-to-book ratio of 1.5 times is just over one standard
deviation below the long-term average of 2.2 times. Further, the current reading places the JSE
well inside Quintile One, with only ten months in the past 185 recording lower price-to-book
ratios than the current reading. In addition, based on extant book values, the market price
would need to rise 30 percent to lift the price-to-book ratio out of Quintile One.

Another way of getting a sense of the attractiveness of equities is to consider the price-to-book
ratio at the stock level. On this basis, the evidence supports the conclusion that South African
equities are cheap. As shown in Figure 7, during the bull market of 2007, about 15 percent of
the 250 companies surveyed traded at less than book value (or net asset value). Breaking this
universe into subsets reveals little differentiation across super-sectors at that time, with
10 percent of resource stocks and 20 percent of financial stocks trading at less than book value.

Figure 7: Percentage of Stocks with Price-to-Book Ratio of Less than One

(2007-2009)
75
Market
65 Resources

55 Financials

45 Industrials

35

25

15

5
2007 2008 2009

Source: Data from McGregor BFA; analysis by Cannon Asset Managers

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By contrast, the 2008 bull market in resource stocks, which was accompanied by a collapse in
financial stocks, meant that although a quarter of stocks surveyed traded at less than book
value, just 14 percent of resource stocks traded at less than book value whilst 45 percent of
financial stocks traded at less than book.

However, the general price decline of the past 18 months means that almost half of the 250
companies surveyed trade at less than book value today, with 48 percent of resource stocks and
61 percent of financial stocks trading at less than their net asset value. This result reinforces the
argument that deep value is evident amongst equities, and particularly that part of the market
that has caused the greatest investor revulsion, namely financial stocks.

6. Another Way to Say the Same Thing: Equities Are Cheap

Whilst the above evidence points to deep value amongst equities, an even more compelling
picture is offered by way of the Graham and Dodd price-earnings ratio. This tool has at least
three elements that are attractive to the analyst.

First, the Graham and Dodd price-earnings ratio overcomes the problems brought by using an
artificially inflated or deflated earnings denominator that arises where the price-earnings ratio
emphasizes the recent past, say the past year. As noted above, such a near-term focus on
financial information can be deeply misleading. Thus, Graham and Dodd argued the price-
earnings ratios should not be based on only one year’s worth of earnings, but rather not less
than five years, preferably seven or ten years of trailing earnings (with earnings being adjusted
for the effects of price inflation). Second, by using trailing earnings the problems associated
with forecasting are avoided. Third, by using between five and ten year’s worth of information,
the resultant earnings denominator captures normalized earnings which recognizes that
inflated earnings fall and deflated earnings rise.

Using this advice, we calculate a Graham and Dodd price-earnings ratio based on seven year’s
worth of trailing earnings. Figure 8 shows the trailing earnings series that is calculated for
South Africa with data starting in 1980. The earnings reported in the figure are used as the
denominator in the Graham and Dodd price-earnings ratio. Eyeballing the data it is evident
that over time earnings grow at a steady pace and that any near-term earnings disruption is
exactly that, namely near term.

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 Figure 8: Seven-Year Moving Average of Reported Earnings
(Inflation Adjusted) (1987-2009)
120

100

80

60

40

20

Jul-04
Jul-99
Jul-94
Jul-89

Apr-08
Apr-03

Jan-07
Apr-98

Jan-02
Apr-93

Jan-97
Apr-88

Jan-92
Jan-87

Oct-05
Oct-00
Oct-95
Oct-90

Source: Data from McGregor BFA; analysis by Cannon Asset Managers

By contrast, Figure 9 shows the non-smoothed one-year trailing earnings for the JSE from 1980
to present. It is evident from this result that near-term trailing earnings are volatile which, in
turn, produces high volatility in the one-year trailing price-earnings ratio. The high near-term
earnings volatility also underscores the problems associated with forecasting. In short, the
results presented in Figures 8 and 9 offer strong support for Graham and Dodd’s assertion that
forecasting should be avoided and that trailing earnings should be derived from many years of
data and not simply the most recent year.

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 Figure 9: Trailing Reported Earnings (Inflation Adjusted)
(1980-2009)
2500

2000

1500

1000

500

Jul-07
Jul-02
Jul-97
Jul-92
Jul-87
Jul-82

Apr-06
Apr-01

Jan-05
Apr-96

Jan-00
Apr-91

Jan-95
Apr-86

Jan-90
Apr-81

Jan-85

Oct-08
Jan-80

Oct-03
Oct-98
Oct-93
Oct-88
Oct-83

Source: Data from McGregor BFA; analysis by Cannon Asset Managers

These notes aside, the resultant Graham and Dodd price earnings ratio for the period 1987 to
present is shown in Figure 10. It is interesting to note that the average Graham and Dodd price-
earnings ratio over the period measures 16.6 times. This squares up neatly with Graham and
Dodd’s observation that “the maximum one should be willing to pay for an investment” is 16
times the long-term average earnings.

Figure 10: Graham and Dodd Price-Earnings Ratio for the JSE
(1987-Present)
30

25

20

15

10

0
Jan-07
Jan-02
Jan-97
Jan-92
Jan-87

Oct-05

Apr-08
Oct-00

Apr-03
Oct-95

Apr-98

Jul-04
Oct-90

Apr-93

Jul-99
Apr-88

Jul-94
Jul-89

Source: Data from McGregor BFA; analysis by Cannon Asset Managers

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Related to this, Graham and Dodd’s figure of 16 times trailing long-term earnings can be used
to distinguish cheap markets from expensive markets.

The results of this toolkit are summarized in Figure 11.

Figure 11: Average Annual Real Returns (%) for the JSE Based on
Graham and Dodd Price Earnings Ratio (1987-Present)
25

Ratio < 16 times smoothed earnings

20 Ratio > 16 times smoothed earnings

15

10

0
One Year Three Years Five Years
Source: Cannon Asset Managers

From the results shown above, it is evident that applying the “rule of 16” to the Graham and
Dodd price-earnings ratio is effective in terms of the investment results that follow. For
instance, using this benchmark, the average real return produced by domestic equities over one
year is 21.2 percent when the Graham and Dodd price-earnings ratio is less than 16 times and
9.3 percent when the ratio is above 16 times.

Over three years the average annual real return is 23.2 percent when the market is on a ratio of
less than 16 times and 8.4 percent when the market is above 16 times.

Over five years, a cheap Graham and Dodd price-earnings ratio produces average annual real
returns of 17.5 percent versus the 11.0 percent produced by expensive markets.

In short, a simple application of Graham and Dodd’s price-earnings ratio rule provides effective
guidance to equity investors.

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 Figure 12: Average Annual Real Return (%) over Five Years
(1987-Present)
25

20

15

10

0
Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5
Low Graham and Dodd Ratio ------- High Graham and Dodd Ratio
Source: Cannon Asset Managers

Further guidance is offered to equity investors by considering the returns produced by the JSE
based on quintile analysis of the Graham and Dodd price-earnings ratio. The results reinforce
the argument that relatively lower Graham and Dodd price-earnings ratios correlate with
relatively higher equity market returns. Buying the JSE on a Graham and Dodd ratio located in
the lowest quintile is associated with average annual real returns of 20.8 percent over five years
versus the return of 10.6 percent associated with the most expensive quintile.

Currently, as illustrated in Figure 10, the JSE trades on a Graham and Dodd price-earnings ratio
of 12.7 times. This reading locates the ratio in Quintile 1, which returns us to the argument that
domestic equities are cheap.

7. Bottom Up Meets Top Down

Whilst top-down analysis offers overwhelming support for the view that domestic equities are
cheap, it is useful to complement this with bottom up analysis to ensure that the average is not
being distorted by anomalies. There are many ways to think about bottom up analysis
(including the price-to-book headcount applied earlier). Usefully, though, the Graham and
Dodd approach can be extended effectively to the case of individual stocks.

The result confirms the top-down view. Of the 250 stocks surveyed in the South African
universe, 76 percent have a Graham and Dodd price-earnings ratio of less than 16 times. In
other words, not only is the market cheap, but an overwhelming majority of the market
constituents are cheap. The result is in sympathy with outcomes in larger markets which show

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that between 60 percent and 70 percent of stocks in these markets are priced on Graham and
Dodd ratios of less than 16 times (see Figure 13).

Figure 13: Stocks with Graham and Dodd Ratio Less Than 16 (%) (2009)
90
80
70
60
50
40
30
20
10
0
South Africa United States United Europe Japan Asia
Kingdom

Source: Cannon Asset Managers and SG Global Strategy

In short, both top-down and bottom-up analysis reveal that the sharp decline in prices over the
past 18 months has produced deep value amongst South African equities. Further, the value
that is evident is that which is normally associated with the final stage of the Kindleberger-
Minsky model of asset price bubbles, namely revulsion.

However, whilst investor exhaustion can be understood from a behavioural or psychological

perspective, it suggests little investment intelligence. To the contrary, this environment should
make the intelligent investor – especially more patient and deep value investors – feel like wide-
eyed kids in a candy store.

8. Concluding Remarks

History teaches everything including the future.

Lamartine

George Santayana famously observed “Those who cannot remember the past are condemned to
repeat it.” This simple but powerful observation goes a long way in explaining why investors
are able to produce asset bubbles that have devastating consequences for most participants with
great frequency. By studying the past we equip ourselves to avoid this financial devastation.

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By the same token, history reveals that the pattern followed by asset price bubbles means that
the best opportunities for investors come in the darkest hour, when the market collapse
produces widespread revulsion towards the asset class. In the case of equities, the asset price
bubble that was pricked in mid 2007 has resulted in such a collapse and elicited revulsion.
South African equities and investors in equity markets have followed this pattern.

Yet, our analysis of equities generally, and South African equities specifically, demonstrates
compelling value and exceptionally opportunity. More importantly, the lesson from history is
that this time is not different: from a top-down or bottom-up perspective buying equities has
not been this easy for years.

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9. References

Brewster, D (2009) I Haven’t Opened a Statement for Months: There’s No Point in Depressing
Myself, Financial Times, 25 March 2009.

Galbraith, JK (1994) A Short History of Financial Euphoria. Penguin Business: London.

 
Glassman, J.K. and Hassett, K.A. (2000) Dow 36,000: The New Strategy for Profiting From the
Coming Rise in the Stock Market. Three Rivers Press: New York.

Graham, B (2003) The Intelligent Investor, Revised Edition. Collins Business: New York.

Grantham, J (2008) Jeremy Grantham in Weekend Barron's, published by Paul Kedrosky at

paul.kedrosky.com/archives/2008/10/jeremy_grantham_6.html

Montier, J (2007) Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance.

Wiley and Sons: Chichester, West Sussex.

Montier, J (2008) The Tao of Investing: The Ten Tenets of My Investment Creed, Mind Matters,
Societe Generale Cross Asset Research, 24 February.

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Cannon Asset Managers (Pty) Ltd Cannon Asset Managers (Pty) Ltd
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