Update No. 9 – 29/05/11

 EGP Fund No. 1 Pty Ltd. Up by 2.23%, leading the benchmark by 5%.

S&PASX200TR    The benchmark index is down by 2.76% since April 1 launch.

EGP 20.  The EGP20 index is down by 11.29%, lagging the benchmark by 8.53%.

I thought I’d talk about market-timing.  The market this week dipped (again) below its January 1 2010 opening price of 33985.86 (it was 33909.12 at time of writing).  So if you’d purchased the market on that date, in 17 months your return has been just short of zero.  If you own a managed fund that closely mimics the indices, you are probably 3 or 4 % short of a zero return, when factoring fees.  However, had you bought just 12 months earlier (January 1 2009 = 24801.27) you would be sitting on about a 37% gain.

So timing can greatly add to your performance, ignoring this fact is, well, ignorant.  Benjamin Grahams “Mr Market” allegory is as meaningful today as it was when written (over 60 years ago); the underlying business valuation is the most important factor.  But sensible consideration of the fairness of the overall market values could be some part of your plan, my caveat, though is it is not everything, owning the right businesses (stocks) acquired at the right prices (regardless of the market-price at the time) is far more important.  People, though, will always discuss timing, so I will give my take.  Stock-markets are enormously volatile over the short and medium term, but in the long run, will basically follow the performance (predominantly) of the underlying economy (with globalisation, obviously other factors also come into play).  If you are generally optimistic about the economic future in Australia, holding investments in Australian businesses is a sound idea.

I created this (very simple) spreadsheetfrom the available P/E data.  The data measures the P/E ratio of the All Ordinaries at the end of each month for the last 25 years.  It indicates the month-end high in the period was 23.29x on 30/11/99, interestingly, no ‘crash’ followed this point, but it was 43 months before the index broke above that month-end price and stayed there.  The lowest point was 8.19x on 31/01/2009, just over 1 month after this point of course, the market started a massive rise.  I would describe a general upward trend in optimism (as defined by increasing average P/E ratios) until about 2000, with a general slide in optimism since then.  We can see from this how highs and lows should be relatively recognisable.

Highs and lows are interesting, but data are most useful for ranges and averages, which tell us a historically ‘sensible’ price.  Of the 301 data points, the median is 15.72x, the mean is 15.98x, for 50-points either side of the mean is on average 15.76x & 100 points either side of the mean is on average 15.88x.  In short, I would suggest it a sensible policy would be the following:

1. If the market is between 15x and 16.9x, holding would be the best course of action.  Only add a new stock if you are very confident in its prospects.
2. Between a market P/E of 13.6x and 15x, steady/cautious accumulation should be profitable in the longer term on average, particularly when focusing on superior businesses.  Between 12.5x & 13.6x I would tend to accumulate with a fairly heavy hand, even lesser businesses should perform well from this position.  Under 12.5x, you should be very heavily invested in stocks, judicious buying at these (market) prices should result in very handsome gains over time.
3. Between a market P/E of 16.9x & 18.8x, you should be particularly careful about any type of buying, these are times to sell more often than buy.  Between market P/E’s of 18.8x & 19.7x, I would likely not even buy an outstanding business (excepting unusual valuation circumstances), I would consider selling any business close to my assessment of full value.  Over 19.7x, I would look seriously to sell anything fully valued as the market is too optimistic, a decline or an extended period of minimal index growth is more likely than not.

For those who have neither the time nor the inclination to closely follow market valuations, in order to ‘smooth’ out the entry prices, a ‘Dollar Cost Averaging’ system may be useful.  By purchasing in approximately similar amounts at regular intervals, over time you will on accumulate at prices that approximate fair value.

My second and final caveat for the week is take care in using a consistent measuring stick (for example, always take your P/E from the one place, if you use the AFR, always use the AFR, if you use Comsec, always use Comsec).  The most recent month end in the spreadsheet is 31/03/11, and points to a 15.05x ratio, now at the moment I believe the true ratio of the ASX200 is closer to 13.25x, which is about a 13.6% difference (this is why we must use the same measure consistently).  In any case, from either measure, the prices at the moment for the Australian market are, in my view, if not cheap, certainly not in ‘selling’ territory. Tony Hansen 29/05/11.