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Tom Au is Chief Economist with the Wentworth China Fund, a NY-based investment advisor, and is the author of A Modern Approach to Graham and Dodd Investing. He also writes for thestreet.com, the Prudent Bear, and other investment newsletters. Mr. Au graduated cum laude, with a B.A. in Economics and History from Yale University, and an M.B.A. in Finance from New York University. He is a Chartered Financial Analyst (CFA).
We spoke with Tom Au on April 3, 2008.
As an introduction for our readers, can you describe the investment principles in your book and, in particular, how they diverge from traditional Graham & Dodd investing? What is “modern” about your approach?
The foundation originally laid by Graham and Dodd, in 1930, was to look at equities as a bond plus a call option. These principles were popularized by Bill Gross of PIMCO, who spooked the market in 2002 when he proclaimed that the Dow was worth only 5,000. What he meant was the bond value was 5,000 and the excess was a call option on the new economy. At the time, I agreed, although I said the comparable valuation on the Dow was only 4,000.
In the 20th century, the trend line for equity valuation was inflation plus dividends plus 0.6% in real returns. Bill Gross implied that US blue chips were like TIPS, providing no real return over inflation over periods of 35 years or more.
Today, most US investors treat equities as options, which explains the high levels of volatility in the market. Bonds are inherently less volatile.
The Graham and Dodd philosophy does not apply to small caps, which are valued more like private equity and venture capital. For mid and large caps, they devised a test that that shows that low P/E and P/B ratios are attractive. In addition, they prefer a dividend yield greater than the yield of the 10 year Treasury. The majority of US equities don’t meet this test. Today, in the S&P 500, there are perhaps 50 stocks meeting this criterion - mostly utilities and REITs. Prices for a lot of the pharmaceuticals have lowered to the point where their yields meet this criterion. In this case, investors are being reward for extra risk they incur, vis-à-vis bonds.
Traditional Graham and Dodd valuation calls for all three criteria to be met – low P/E, low P/B, and high dividend yields. My approach requires just one of these criteria, and I advocate allowances that can be made if either of the other two is not met. I also utilize a proprietary investment valuation metric, which looks at book value plus ten times dividends, and this combines all criteria. Plus, the modern version uses more cash flow analysis because cash flow statements are available now, but they weren't in Graham and Dodd's time.
For wealth managers that serve HNW and UHNW clients, what would you say are the key insights your book offers in terms of investment strategy?
People need to be realistic about U.S. stock market returns over the next ten or so years. The fact that they've averaged 10%-11% over the 20th century is a bit misleading. Instead, we've had 35-year long cycles, incorporating 17-18 years of 18%-20% average annual returns along with 17-18 years of 2%-4% average returns. We're now in that bad cycle from 2000-2017 or so. In essence, we borrowed returns during the good times from 1983 to 2000.
The HNW have more to lose, but my advice applies to everyone. We are in for 10 more rough years. My advice is to be proactive, and to look to foreign markets, commodities, or - if you have a really trusted hedge fund manager – try an alternative investment strategy
A buy and hold strategy that worked well over most of the recent past will work poorly in this environment. People don’t realize that we have long stretches of good and bad markets, but we do.
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