How Do We Value the Market?

One of our favorite benchmarks for assessing the relative value of the US stock market is... Total Market Cap / GDP. *End of trading on April 26, 2013, the Total Market Index was valued at 16,698.8 billion. Total Market Capitalization is approximately 106% of GDP (including dividend returns of 2%).

Warren Buffett has pointed out that the percentage of total market cap relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.” [while GNP and GDP are different, the two numbers have historically been 1% of each other]

The Market has 5 zones of valuations: Ratio = Total Market Cap / GDP

1. Ratio < 50%: Significantly Undervalued

2. Ratio 50% - 75%: Undervalued

3. Ratio 75% - 90%: Fair Value

4. Ratio 90% - 115%: Overvalued

5. Ratio > 115%: Significantly Overvalued

**Where are we today (04/26/2013)? Ratio = 106% Overvalued (not far from Significantly Overvalued)

Based on these two numbers, one would have a mathematical expectation of achieving 2.8% return (per year) in an index fund.

Over the long-haul, stock market returns are governed by three main factors: 

I. Interest rates

II. Corporate profitability

III. Market valuations

I. INTEREST RATES

Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”—Warren Buffett 

II. CORPORATE PROFITABILITY

Corporate profitability has historically averaged 6%.

  A. Corporate profit margins Shrink in BAD economic times.

  B Corporate profit margins Grow in GOOD economic times.

*Similar to GNP and GDP, long-term economic growth and long-term corporate profitability tend to be about the same.

III. MARKET VALUATIONS

Peter Drucker used to explain how stocks and stock market valuations revert to its mean.

  A. Buying indexes at HIGH valuations will demonstrate LOW long-term returns.

  B. Buying indexes at LOW valuations will demonstrate HIGH long-term returns.

Source of influence: GuruFocus

Who Wants To Be A Billionaire? by William Ackman

WILLIAM ACKMAN, Activist Investor, Hedge-Fund Manager

Warren Buffet is fond of saying that the first rule of investing is never lose money and rule number two is never forget rule number one. William Ackman takes this lesson as a point of departure for his Floating University lecture.

Ackman asks how can you avoid loses and earn an attractive return over time? Ackman's answer is that you don't want to be jumping from one company to the next. Instead, Ackman says, pick a company that you can own forever. In other words, if the stock market were to close for 10 years, you'd be perfectly happy with this investment. Two examples of these types of companies that Ackman offers are Coca Cola and McDonald's. These are companies, according to Ackman, are easy to understand, they're not complicated, have long-term track records, demonstrate an attractive profit, and can grow over time.

Watch William Ackman here:

We all want to be financially stable and enjoy a well-funded retirement, but we don't want to squander our hard-earned money on poor investments. William Ackman, the CEO of Pershing Square Capital, is here to tell you Everything You Need to Know About Finance and Investing –– in less than an hour. In this powerful lecture, Ackman navigates the complex landscape of how businesses work and how to make smart investments following a simple business model we can all relate to: a lemonade stand. From balance sheets and growth assumptions to the difference between debt and equity, by the end of the hour you will have a working vocabulary of financial terms. Why did Albert Einstein say the most powerful force in the universe is compound interest? Through questions like these, you will learn both what it takes to finance and grow a successful business and how to make sound investments that will allow for a cash-comfy retirement. The principles outlined in this lecture will also benefit your decision making when it comes to major financial decisions like buying a home, providing for a family, and developing your career.

Why would you as a business owner consider a taking loan over issuing stock? How can you generate enough cash to live on while you are growing your business? What advice would an expert investor give his own mother about investing? In this hour you'll get a personal introduction to the world of business from an expert advisor –– a solid foundation on which to invest in businesses and begin building your own company. Whatever your goals in life, smart investment strategy will help you to achieve them.

A Road Map for Problem Solving...

While the Phoenix Checklist nails down the proper questions we should be asking, McKinsey's Road Map provides a visual aid to the problem solving sequence.

Best Practices for Problem Solving - The Phoenix Checklist

I friend of mine recently shared with me a set of questions developed by the CIA to enable their agents analyze problems thoroughly. These questions are context neutral, designed to “encourage agents to look at a challenge from many different angles. Using Phoenix is like holding your challenge in your hand. You can turn it, look at it from underneath, see it from one view, hold it up to another position, imagine solutions, and really be in control of it” (BBH-Labs). Enjoy!

THE PROBLEM

* Why is it necessary to solve the problem?
* What benefits will you receive by solving the problem?
* What is the unknown?
* What is it you don't yet understand?
* What is the information you have?
* What isn't the problem?
* Is the information sufficient? Or is it insufficient? Or redundant? Or contradictory?
* Should you draw a diagram of the problem? A figure?
* Where are the boundaries of the problem?
* Can you separate the various parts of the problem? Can you write them down? What are the relationships of the parts of the problem? What are the constants of the problem?
* Have you seen this problem before?
* Have you seen this problem in a slightly different form? Do you know a related problem?
* Try to think of a familiar problem having the same or a similar unknown
* Suppose you find a problem related to yours that has already been solved. Can you use it? Can you use its method?
* Can you restate your problem? How many different ways can you restate it? More general? More specific? Can the rules be changed?
* What are the best, worst and most probable cases you can imagine?

THE PLAN

* Can you solve the whole problem? Part of the problem?
* What would you like the resolution to be? Can you picture it?
* How much of the unknown can you determine?
* Can you derive something useful from the information you have?
* Have you used all the information?
* Have you taken into account all essential notions in the problem?
* Can you separate the steps in the problem-solving process? Can you determine the correctness of each step?
* What creative thinking techniques can you use to generate ideas? How many different techniques?
* Can you see the result? How many different kinds of results can you see?
* How many different ways have you tried to solve the problem?
* What have others done?
* Can you intuit the solution? Can you check the result?
* What should be done? How should it be done?
* Where should it be done?
* When should it be done?
* Who should do it?
* What do you need to do at this time?
* Who will be responsible for what?
* Can you use this problem to solve some other problem?
* What is the unique set of qualities that makes this problem what it is and none other?
* What milestones can best mark your progress?
* How will you know when you are successful?


source: http://bbh-labs.com/how-the-cia-define-problems-plan-solutions-the-phoenix-checklist

High Performance Teams

High-performance teams (HPT’s) provide more than just financial rewards for organizations; they can influence processes and raise performance levels for individuals, teams and even upper management. High performance teams gain EFFICIENCIES in the Hard Systems (i.e. work flows, tasks, objectives, measures of performance, controls); they gain superstar PRODUCTIVITY from the Soft Systems (i.e. leadership, communication, motivation, commitment, and trust) and tend to be SUSTAINABLE through Organizational Culture (i.e. organizational alignments and adaptability).

The Alignment Principle

One of the most important principles I've learned is to make sure that stakeholder interests are aligned to a common objective. One, it's the right thing to do. Two, it's a powerful motivator when everyone is working towards the same goal. Three, it fosters productivity, and four it helps reduce the cost of human capital management. Ultimately, alignment occurs when the critical parts of your company are aligned with (ie support) its strategy (Owen Darbishire). It's about making sure that you, company management, and investors are always working toward the same goal.

Performance Hypotheses states that the more highly aligned a firm’s organization is with its strategy, the more effectively it will execute its strategy and the better it will perform (DiOL module 3). Evidence suggests that the benefits of alignment are not just additive. Exponential benefits are triggered through consistency across multiple dimensions – “reinforcement” (Owen Darbishire, DiOL)

Well structured teams show up to work, they meet deadlines, accomplish their tasks and meet their goals. High performance teams are essentially the same effective system; however, their performance outputs are a function of soft factors. High Performance Teams excel in: commitment, trust, communication, responsibilities (purpose), collaboration (problem solving + knowledge brokering), involvement and continuous improvement.

Successful Private Investors...

"Successful private investors are people who value a holistic approach to business. They figure out how to ask the right questions in the right order. They value intellectual honesty and let facts speak for themselves. They do not let emotions cloud their decisions. Their ability to be self-critical, reflective, and adaptive is the lifeblood of their livelihoods. They see companies not as mere numbers on a balance sheet but as living entities that need support and encouragement to survive." ~ The Masters of Private Equity and Venture Capital pg8