Investors have many tools to use to pick investments. Four tool investors must know are:
- Sharpe ratio
- Information ratio,
- Sortino ratio
- Schiller PE10
The Sharpe, Information and Sortino ratios look at the relationships between risk and reward. They are based on historical fluctuations of share prices, so during a long term bubble the true risk does not show up in share price movements and at the same time investors are feeling too euphoric to think critically. These tools could be considered more of a “momentum” trader’s tools, instead of intrinsic value tools. Momentum investing means to gamble that you think the other guy will overpay for an asset thus making it go up even if you have no proof of its intrinsic value. It is known as the Keynesian beauty contest or the "Greater Fool Theory".
Is the market fairly priced?By contrast the Shiller PE 10 looks at intrinsic value and tries to estimate if the market is fairly priced.
Howard Marks wrote in his new investing book “The Most Important Thing” a chapter on risk and said that defining risk is an art. I agree. Trying to use historical data about share price fluctuations (embedded in Sharpe ratios, etc.) to estimate future risk is an art. A bubble can get bigger and can last for many years. So examining how much a share price has varied is not necessarily a good way to assess risk.
Do it like BuffetInstead I prefer to follow the attitude of Buffett who said one should buy a stock as if buying a business and one should assume the stock market will close for five years and they will be stuck with the investment. So in that case the standard deviation of the share prices in the past is not that important, instead the intrinsic value is important.
How to calculate intrinsic valueIntrinsic value is best calculated using cash flow or income method. Once the stream of income has been identified then a PE ratio is applied to determine if shares are priced below intrinsic value. Income is hard to suddenly increase by a huge percentage, especially if averaged over several years. Each day’s income is like a vote from a satisfied customer in a world full of competition. If the product is inadequate or overpriced then the business will receive less votes than before (less sales and less profits). Averaging income over ten years with each year adjusted for inflation is the best way to judge intrinsic value.
In addition one should examine the qualitative nature of the income. Does it come from a business protected by a corporate moat? Does it come from an industry that is becoming increasingly competitive with shrinking profit margins? Did the profit come because the R&D department was recently shut down? Did profit come from top line (sales) growth or from cutting expense items? Did it come from cutting costs with one-time write-off that was sent directly to the balance sheet without going through the income statement? Did the profit come from “discovering” a reserve account for losses was too strict and needed to be closed, thus boosting profits. Did revenues increase simply because a new company was acquired or did they increase because more sales occurred with no acquisitions.
By contrast, using balance sheet items such as assets and liabilities to estimate intrinsic is risky because the assets could be overvalued due to a bubble or suddenly drop in value due to obsolescence of assets. Also the company’s funds could be squandered on foolish acquisitions at the top of an industry bubble.