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Walking the High Wire

July 9, 2013

Walking the High Wire

Many of the world’s equity market indices are near, or have recently set all-time highs. These developments have been well-documented in the media, with most references containing cautionary tales of the declines that occurred each time markets had previously reached these levels. This has left some investors questioning whether owning equities at such “lofty” levels is still wise. Should we take our profits now and avoid the inevitable declines? As you can well guess after reading our previous article, we would council to maintain course due to the inability of mere humans to predict future short term moves.

We also feel strongly that the old saying “Price is what you pay, but Value is what you get” applies very well to this market.

A chart of the S&P/TSX Composite Index or any other equity index provides a visual tool to summarize past and present price movements but it reveals nothing about the attractiveness or investment merit of the companies that comprise the index. To do that, most investment managers build forward-looking estimates of the level of cash flow that each company in your portfolio can generate. This, rather than a stock chart, becomes their tool to assess whether companies are trading at attractive or excessive values.

This focus on future cash flow or future earnings (a more common metric reported in the media) is strangely absent from much of the current coverage on the record-breaking index levels. For example, the S&P 500 in the U.S. has recently surpassed its value during the market peak in 2000. At that time, the 500 companies in the S&P 500 were trading at about 25 times their next years earnings. Today, that ratio is closer to 15. Put another way, the current value of these 500 companies is about the same as the value in 2000, but these companies are now generating earnings that are approximately 66% higher.

When was the last time you read a headline noting the record-breaking level of earnings and that companies are now earning almost 2/3 more in profits than they were 10 years ago?

We aren’t suggesting that equities won’t suffer a pullback from current levels; any number of developments will be the catalyst for the next healthy correction. But in the long-run, the attractiveness of any given company is not related to what it looks like on an historical chart, but is correlated to its current valuation and its ability to generate future cash flow for shareholders. We would encourage investors to stay focused on these metrics and not historical charts if they want to better understand their holdings and why it has always been better for longer term investors to be owners of great companies rather than loaners to these companies.

It is our strong belief that to be successful in reaching your goals it is necessary to have a plan in place and to follow a process. That is, to make your life and financial decisions not by accident but by design.

Remember, successful people ACT towards the future they want!

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