Those "buy-and-watch" physician-investorshave experienced one of the mostunsettling periods in their investmentlives. They've seen the value of investments soarto heights that would have cast a shadow onIcarus, and then plummet to depths that few ofus have ever seen. These extraordinarybubbles and busts have tested the faiththat many have in fundamental investmentprinciples and likely causedsome to abandon their discipline.Many who stayed the course are stillquestioning whether they should havebeen able to tell when the market wasgoing to take its dive.
Of course, the best way to keep yourmind at ease through times like these isperspective. Those who are thoroughlygrounded in long-term thinking knowthat these kinds of events are transientand will eventually work out. Patienceand vigilance are the only attributes aninvestor needs to get through them. Anew approach is found in rational price or rationalvalue, which pertains to a portfolio whose stockshave been priced at their rational prices.
There's no question that the most recent bubblewas the product of what Federal ReserveChairman Alan Greenspan termed "irrationalexuberance."We now know that in the course of ayear, the price of a stock can go up or down,departing as much as 50% from the average price.The distortion that applies to the price is alsoapplicable to the price/earnings (P/E) ratio, whichis a function of the price. Viewing the P/E ratio asmerely a rate you pay for a dollar's worth of earningsmakes perfect sense.
During the course of a 5-year cycle, the market'sP/E ratio will typically make evengreater departures from the norm. Andseveral times during a century, excursionsfrom the average can be extremeand either delightful or painful.
The significant thing for physician-investorsto remember is this: If the priceis truly driven by earnings in the longterm, and successful methodology saysthat it is, then deviations in the P/E ratio,the "rate," must be caused by somethingother than earnings. If it weren't, theprice and P/E ratio would always marchin absolute lock step with the mostrecently reported earnings per share.
KNOW THE HUMAN FACTOR
What is that mysterious force thatcauses the price and P/E ratio to vary upand down, sometimes by huge amounts? It's nothingmore than the collective perception or opinionabout the effect that the daily host of mediareports, stories, current events, earnings forecasts,speculation, etc, will have on the economy, themarket, an industry, or a company. It's fear, greed,paranoia, and euphoria that uninformed or over-informedspeculators act on. These change everyminute; reported earnings do not.
How, then, should you compensate for thesefleeting, disconcerting, and often misleadingtrends? We recognize that the daily, short-termfluctuations in the P/E ratio are not importantwhen compared to earnings over the long term.This allows us to calculate a rational price for eachof our stocks and a rational value for our holdings.
Simply stated, the rational price tells what theprice of our stock would be if the public's decisionsto buy or sell were governed by earningsand not by all the unpredictable factors. Ineffect, the rational price answers the question, "Ifthe public really had it together, what would theybe paying for my stocks?"
To calculate a price, use the "signature P/Eratio" and earning per share. The simplest way todo this is to multiply a company's 10-year averageP/E ratio by the most recent trailing 12 months'earnings. Once you've calculated your rationalprices, you can analyze your portfolio and calculateits rational value (ie, the sum of the productsof the number of shares and their rational prices).
The benefit to be derived from this exercise issignificant. It puts whatever irrationality Mr.Market might be currently laboring under intoperspective and gives you a view of just how irrationalhe is at any time. It's a way to quantify justhow right you are compared to the rest of theworld, which goes a long way toward providingcomfort when times are bad, and temperingeuphoria when they're good. And, if nothing else,it may be just the encouragement a physician-investorneeds to stay the course. That may be thebest medicine of all.
Ellis Traub, author ofTake Stock: A Roadmap to Profiting from Your First Walk Down WallStreet (Dearborn; 2000), is chairman of theInve$tWare Corp (www.investware.com), manufacturers of stock analysissoftware. He welcomes questions orcomments at 954-723-9910, ext 222, or firstname.lastname@example.org.