Monday Morning: In Investing 101, no easy answers on valuation

A group of students in professor Don Pitti’s Managing Investment Funds course at St. John’s University in New York are being given $1.5 million to invest as part of their course work. Their task is to initiate a student-run investment program that will ultimately fund scholarships for future students. Each semester, the students taking Mr. Pitti’s course will continue to manage the portfolio.

Though the ground rules for the way students manage the money are still being established, the students are already debating what kind of investment strategy they should adopt.

During class last week, one of the students argued strongly for a 100% aggressive equity portfolio. He said that the market correction had beaten stocks down so far that there were real bargains to be had, especially among the dot-com and tech stocks.

Playing the devil’s advocate as a guest speaker, I argued that despite the correction, the price-earnings ratios of many leading tech companies, such as Cisco Systems Inc., and many large-cap stocks, are still far above the historical average.

In fact, according to the Leuthold Group in Minneapolis, the median p/e of the 300 largest companies is 26.9. That’s way high by historical standards.

Given that, I asked, is a 100% aggressive growth approach prudent? Are stocks like Cisco, which have been beaten down, really cheap at this price, or might they get cheaper?

Clearly, the students must address some key concerns. For what time period are they investing? Are they investing to make an impact before the end of term, or are they investing to lay a foundation for the future?

In addition, they and the university’s administration have to agree on an acceptable risk level.

The students will soon discover, as every financial adviser discovers, that even when you have agreed upon the investment goals and the risk profile, it’s still not easy to decide on an appropriate investment strategy.

If you believe the market is still overvalued after the correction, that the “irrational exuberance” has not yet been wrung out of it, then the strategy should be conservative. If, on the other hand, you believe the correction has positioned the market for further advances, then you can try to identify the sectors and stocks that will prosper in the foreseeable future.

Their high median p/e suggests that large-caps, at least, are still overvalued. The low median p/e for small-caps, less than 14, suggests that the sector is undervalued.

But small-cap stocks have been undervalued – and have underperformed – since the mid-1980s. Is now the time when they will catch up, or is it just another false dawn?

To complicate matters further, the growth of the money supply, as measured by M2, suggests that the economy will recover in the second half of the year, and stock prices also should move up this year.

According to Hugh Whelan, portfolio manager at Aeltus Investment Management in Hartford, Conn., M2 grew at an annualized rate of 9% during the past three months.

If history repeats itself, that should jump-start both the economy and the stock market, because M2 growth has been a reasonably good predictor of the economy, and equity returns tend to improve as money growth accelerates.

So perhaps the student in Mr. Pitti’s class was not too far off track with his suggestion for an aggressive equity portfolio to start off the investment program.

Of course, as the students debate the issue, they will receive excellent guidance from their professor, whom many financial planning veterans will recognize. Mr. Pitti, a consultant to InvestmentNews, is one of the founders of the International Foundation for Financial Planning, a precursor of the Financial Planning Association.

Mike Clowes is the editorial director of InvestmentNews.

Related Topics: Just Thinking