Mr Market's 10% Opportunity

Sitting on my book shelf you will find a copy of Seth Klarman’s book “Margin of Safety”.  A few of you may recognize this book published back in 1991, but not necessarily for what is in the book.  Instead you may know it for what others are willing to pay for a copy.  You can obtain your own used copy from Amazon for $799.00.  One collectible copy is currently available for $1499.00.  My copy was special ordered in 1991 from “The Bookworm” at the cost of $25.00 plus tax.  A few years ago, when money was easy and hedge fund managers were the anointed ones, this $25.00 book was selling for two to three times its current $799.00 bid.

Maybe I should sell my copy to cut my losses?  Maybe I should buy another copy because they sold three times the current price a couple of years ago and it will surely return to that price?  Maybe, just maybe, I should do nothing at all and see what happens; what do you think?

This is Mr. Market at work.  If you had your own copy of Mr. Klarman’s book you would find inside this quote from Benjamin Graham:

“An ever helpful fellow, Mr. Market stands ready every business day to buy or sell a vast array of securities in virtually limitless quantities at prices that he sets.  He provides this service free of charge.  Sometimes Mr. Market sets prices at levels where you would neither want to buy nor sell.  Frequently, however, he becomes irrational.  Sometimes he is optimistic and will pay far more than securities are worth.  Other times he is pessimistic, offering to sell securities for considerably less than underlying value”. 

Given that the last ten years produced the two worst bear markets since the Great Depression, it is understandable why individuals have been selling stocks and buying bonds.  It’s a little harder to understand why corporate and state pension plans have been mass sellers of common stocks until we realize that Mr. Market works his magic on professionals just as easily as he does the individuals. This exodus is Mr. Market in action; and yes, he is offering to sell some of his securities at less than the underlying value.

Not all securities are being sold cheaply.  But enough are that an enterprising investor can profit with the passage of time.  One of the more popular measures of common stock valuation is the comparison of earnings per share with the current price of each share: what many of you know as the Price to Earnings ratio (P/E).  If you just reverse the equation and divide the per share earnings by the current share price, you are given the earnings yield (E/P).  The earnings yield gives you an easy way to determine how much the company earns on every dollar you pay for your shares.  It also gives you an easy way to compare what your company is earning for you relative to the amount you would earn if you loaned your money at interest.  Of course the highest earnings yields for quality stocks only come about when Mr. Market is pessimistic. 

 Here are a few points to ponder: 

• Based on trailing 12 month earnings, there are 71 companies in the S&P 500 with an earnings yield greater than 10% (P/E less than 10).  The range of these stocks’ earnings yield is 31% to 10.05%.
• Based on current fiscal year estimated earnings per share, there are 80 companies in the S&P 500 with an earnings yield greater than 10% (P/E less than 10).  The range of these stocks’ earnings yield is 27.9% to 10.07%
• Finally, based on estimated earnings over the next four quarters (12 month forward earnings estimates), there are 112 companies in the S&P 500 with an earnings yield greater than 10% (P/E less than 10).  The range of these stocks earnings yield is 27.02% to 10.07%

Given the number of companies you can buy with an earnings yield of greater than 10%, you should be able to create a long-term portfolio that has a better than average probability of rewarding you with a higher return.  Buy the way; I have decided to keep my copy of Seth’s book.  It has given me far more comfort than the $800.00 I could get for selling, the many times Mr. Market has driven me crazy.