Minyan Mailbag: The Problem With Q-Ratios
the goal is not to be bullish, bearish, or neutral...
My Dad, a perma-bear owing to his birth during the Hoover Administration, loves to cite three statistics over and over when he implores me to liquidate my equity holdings: Historical P/E ratios, historical dividend ratios, and his very favorite, the Q Ratio. No bear worth his fur is ever without these weapons in justifying their negative view that the market must fall, either today, next month, next year, etc.
I see you trotted out the Q Ratio yesterday and noted "pictures tell a thousand words" and therefore anyone who thinks stocks are cheap on a long-term basis "may want to rethink (their) position."
Before I submit a counter argument for the Minyanville readership, I diverge for a second. The Professors, Todd and John Succo in particular, seem genuinely stumped about why everyone thinks they in particular and the site in general are so bearish. I believe it's posts like yours that result in Minyanville getting painted with that brush. (To that end I commend Todd for his publishing of the mailbag this week that took him to task for his oft-repeated mantra that "perception doesn't match reality" concerning volatility readings. While Todd has much too much intellectual and emotional capital tied up in that opinion to abandon it, it still takes courage to address a hostile point of view, and he certainly did that. That's truly a community of value.)
Here's the problem with citing historical Q ratios: Return on Assets is not mean reverting. Although Tobin's Q Ratio measures the entire market, we don't have to look any further than the Dow 30 to understand why. The heart of the Q Ratio thesis is that balance sheet assets reflect their replacement value. That may have been true as early as a generation ago. But, brace yourself, it is different this time. Very different.
Our economy has morphed from industrial based to service based and as a result it's fair to say we've traded up. We are an economy made up of intellectual capital and brands, not steel plants and manufacturers. From a brand standpoint the operating metrics like Return on Assets of my father's retailers like Woolworth and Sears (SHLD) are embarrassing next to Wal-Mart (WMT) and Home Depot (HD) (and non-Dow company Target (TGT))-- just ask Mr. Macke about that.) From a brains standpoint, there is no way in the world you can replace the brainpower at Merck (MRK), Johnson & Johnson (JNJ), Intel (INTC) and Microsoft (MSFT) by replicating their balance sheets.
In short ownership of today's companies in the U.S. means you own extremely valuable intangible and intellectual properties not ridiculously capital intensive assets like steel mills, coal mines, and factories. Of course the old companies will have better Q Ratios. The old companies are laden with capital-intensive less profitable assets.
You, Messers, Tobin and Napier, and of course my father may think the book values of Microsoft and J&J are comparable to Anaconda Copper and International Nickel but I would gently suggest you may want to rethink your position.
Thank you for your well thought out remarks. First, a bit of background on my personal investment philosophy: Todd's, John's, and my thoughts are distinctly our own. I have spent 26 years attempting to build a methodology that focuses on catching most the upside market volatility and missing most of the downside volatility, or drawdowns. It is, as you know, more of an art than a science, although there are many numbers that we must crunch to ultimately decide how to risk our own (or in my case, my clients' assets).
My goal is not to be bullish, bearish, or neutral. My goal is to observe the facts of the markets and to react to them as I see prudent. I agree with you that we have changed dramatically as a nation since the first bull signal in 1921. We ARE a service based (leveraged and dependant on others) which is where I do respectfully disagree with your analysis. If you note on the chart, the absolute peak of silliness in the Q ratio was in the year 2000. I believe that is when companies like Walmart, Target, Home Depot, Merck, JNJ, Intel and Mr. Softie were making highs not seen since. It was 'different that time' too as I recall, and I am glad to have had the discipline to use 'tried and true' methods like P/E ratios, dividend yields, price/book, price/sales, price/cash flow, Q ratios and others to save myself and clients' valuable capital.
The fact that we think the same for the most part when it comes to the big picture (Todd, Succo and myself) is because we are all prudent, not perma-bears. If I am painted that way, so be it, but as guardian of my clients' hard-earned assets, I will never, ever subscribe to 'it's different this time.' If it works for you, I wish you the very best of luck. It just doesn't work for me. Incidentally, you may find the book a good read. There is much more to it than just the Q ratio.
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