Wealth Accumulated

By D J Thomas, a large-cap stock market value investor and financial writer

News flow

How to value the S&P 500 like an expert in 3 easy steps

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How to value the S&P 500

Valuing the S&P 500 is integral to successful global large-cap stock market value investing.

It’s one of the first modules we teach in the Value Investor School because the S&P 500 is the most followed and written about stock market index in the world.

That makes it the simplest index in the world to research and invest in.

Just look at the top ten largest stocks by market capitalisation (at the time of writing).

Market capitalisation refers to the total dollar value of ALL the company’s shares combined.

It reads like a who’s who of the most well-known global businesses:

  • Apple (AAPL)
  • Microsoft (MSFT)
  • Amazon (AMZN)
  • Tesla (TSLA)
  • Alphabet Class A (GOOGL)
  • Alphabet Class C (GOOG)
  • Berkshire Hathaway Class B (BRK.B)
  • UnitedHealth Group (UNH)
  • Johnson & Johnson (JNJ)
  • Exxon Mobil (XOM)

The top five of these stocks represent 20% of the total value of the S&P 500 and some of these names are in the financial press on a daily basis.

So it pays to get to grips with the value of the S&P 500 on a regular basis to either invest in it directly with an index fund or to get a sense of general market valuation.

The importance of valuing the S&P 500 from a value investing perspective

Type the words stock market into your browser or favoured social media channels and you’re bombarded with a thousand opinions on what you should or should do with your money. Sometimes you’ll get stories of the latest stock to collapse in value.

When we come across headlines and news articles from the financial press, they almost always sensationalise the truth as to what is happening to stocks day to day.

How the stock market works in context with macroeconomic events, and how your individual stocks can be affected by rising or declining market values is an important skill set to develop.

The constant wall of noise can be confusing as we’re drawn to seek out ‘expert opinion’ in times of uncertainty whether stocks are rising or falling.

There must be an intellectual safety net out there somewhere.

Luckily, the value approach is an intellectual safety net based on your own balanced, independent research. It is a far better judge as to what to do in any given market scenario than the noise machine from Wall Street.

Financial publications get paid by making you click through to their articles.

Pay yourself first with underpriced value by determining when the S&P 500 is undervalued.

#1 Find out the PE ratio of the S&P 500

A lot of investors balk at the idea of valuing stocks with the PE ratio relegating it to a prehistoric has-been.

The manipulation of earnings by unscrupulous managements and the sometimes lumpy earnings successful businesses produce, yo-yo-ing up and down like no tomorrow, make it difficult to get an accurate valuation of a stock or index based on its earnings.

Or so they say.

Yes, there is also a heavy earnings bias toward the largest capitalised stocks; much of the earnings are concentrated in the top 10 stocks due to their enormous size and global sales.

But I’ve got news for you: nothing is ever perfect in the world of investing.

Successful investors understand that reasoning based on the most accurate information available is better preparation for successful, profitable investing than relying on the opinion of almost everyone.

The number one resource I use for finding out the PE ratio of the S&P 500 is multpl.com, from Rober Shiller, Professor of Economics at Yale University.

When you click through you’ll get a nice chart showing the PE ratio of the S&P 500 from about 1870 to the present day.

#2 Compare the current PE ratio of the S&P 500 to the historical PE ratio of the S&P 500

One thing you’ll notice from the chart is the wild swings in value the S&P 500 has had over the years, especially since the massive liquidity manipulations starting in the 1980s.

Ultimately, your task is to compare the current PE ratio to its historical value.

You do that by noting where the S&P 500 PE ratio is now and where it has bottomed in the past.

The last bottom was in 1980 at 7 and the PE ratio has since made only two major bottoms of 17 in 2006, and 14 in 2011/12.

Put another way, the S&P 500 PE ratio has been bottoming at around 15 over the last 40 years.

Pro tip: on each of those occasions, the Federal Reserve put a floor in and artificially inflated the value of the S&P 500 with quantitative easing and cutting interest rates.

#3 Decide whether the S&P 500 is overvalued, undervalued, or at fair value

For simplicity, I use three gauges of stock market valuation to help them value stocks:

  • Overvalued
  • Fair value
  • Undervalued

You can see why it’s a popular method.

But you can’t get to decide where the S&P 500 is on the value gauge until you’ve done the work and the work tells us that as of the publication of this post, the PE ratio for the S&P 500 is 20 which means it is around fair value.

Why fair value?

Remember the average PE ratio bottom range of 15-17, that is the undervalued range.

It makes sense that 18-20 is fair value range and anything above 20 is overvalued.

Why is 20 overvalued?

Because a rock solid principle of value investing is that we buy stocks and index funds at a discount to intrinsic value (fair value).

One thing to note is that these ranges are not absolutes. They change with economic times such as the recent central bank and government manipulations of stocks since the 1980s.

Ranges play an important role of placing the value of the S&P 500 in context to historical values.

For even greater context, the S&P 500 is heading towards undervalued because the Federal Reserve is in a monetary tightening cycle (raising interest rates and shrinking its balance sheet) and the US is already in a technical recession.

The White House and The Federal Reserve have both tried to redefine what a recession is for political reasons but the truth is that GDP has declined for two back-to-back quarters in a row.

The Federal Reserve also strenuously maintains that rates will rise well into 2023 and well-known financial institutions predicting a global recession in 2023.

Based on the history of how stock market prices perform under similar conditions, the S&P 500 is likely heading lower.

How much lower?

Nobody knows.

That said, you’re job is not to second guess the President, The Federal Reserve, or even where stock prices are heading in the future.

From a value investing perspective, you’re simply defining what the value of the S&P 500 is now whilst taking into consideration the macroeconomic environment of the global stock market.

Publicly available interest rates and GDP data help you with this task.

Over time as you regularly interpret financial markets news flow within the context of a value-first approach, you’ll develop a deeper understanding of how the stock market actually works not from a day-to-day perspective, but from a long-term, low-risk perspective that most market participants do not consider.

You have my permission to take ownership of your own financial success.

Need some help with becoming a smarter investor?

A value-first approach to investing creates a mind free of distractions that’s hard to beat.

Sometimes value investing can still seem bewildering given the never-ending stream of headlines and financial jargon, especially in times of uncertainty.

You may even have struggled with some of the terminology in this post.

That’s okay.

The good news is that you do not have to choose between a financial dictionary and interpreting 1000 opinions a day to become a truly successful, long-term investor.

You can use a value investing framework that respects your time, common sense, and appreciation of what actually matters in financial markets in plain English.

If you want to learn more about making successful value-orientated investments, check out the online stock market investing course.

Q3 2022 performance report

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The Q3 2022 performance report for the Wealth Accumulated Portfolio is compiled from broker quarterly statements and publicly available information of the quarterly performance of the S&P 500.

Results for the Wealth Accumulated portfolio for the third quarter of 2022 are as follows:

  • The Wealth Accumulated Portfolio: -1.04%
  • S&P 500 -5.28%

The Wealth Accumulated performance is net of expenses.

Towards the end of 2021, just after Christmas, all portfolio positions were liquidated.

Throughout most of 2022, the portfolio has held cash which has been an unfortunate but necessary position to be in.

News flows became increasingly negative throughout this year and journalists have not stopped sharing their gloomy outlook for global financial markets.

Having dry powder in the form of cash is one thing, actually holding on for so long with it is extremely trying, especially as bargains are more prevalent each week.

Clearly, stocks have had a very poor year which has led to the Wealth Accumulated portfolio doing better than the stock market averages due its large cash position.

When the time comes, the Wealth Accumulated portfolio will be purchasing a combination of index funds and carefully selected undervalued large caps.

Outlook

My general view of global large-cap stocks – the type in which I invest – is that they are at fair value.

The PE ratio of the S&P 500, my preferred approximation of market value, is 19.07 as of the date of this post.

Before the massive liquidity events, that started in the 1980s and were exacerbated in 2008 and 2020, a PE ratio of 20 for the S&P 500 would have signaled the top of the market.

The current economic environment means we factor in central bank and government interventions.

Policymakers have artificially inflated the prices of assets leading to inflation and crises in the global economy.

Their extremely small set of tools means that it is almost certain they will be forced to use inflation-causing tools again, most likely when a financial crash is imminent, or is already underway.

Right now I believe stock prices will be heading lower until well into 2023.

This belief is not a prediction or some type of forecast.

The Federal Reserve’s commitment to fighting inflation has been more robust than in recent years and interest rates are its only current weapon of choice.

Historically, investors despise interest rates and dump assets as a show of force against the rising cost of credit.

But it does mean the market is getting cheaper every day.

So far in 2022 stock prices have declined by -22.83% as measured by the S&P 500.

The US is already in a recession despite policymakers trying to redefine what a recession is and at the same time, the Fed is tightening the money supply.

Inflation has plateaued at historical highs and we are yet to see any sign that the war in Ukraine will end any time soon.

My policy of stock purchases is firmly rooted in the value investing school, with an emphasis on buying them at a discount to their intrinsic value.

Under these conditions, I do not see any advantage in deploying capital into stocks at this time and possibly into 2023.

Q3 2022 performance report: what happened in the third quarter?

The portfolio added one FTSE 100 position in the third quarter of 2022 after a disastrous news report citing a potential lawsuit that could result in a hefty fine for the business.

It is a well-established stalwart of the FTSE 100 and remains in the top 10 largest companies by market cap on the London Stock Exchange.

At the time of purchase in mid-August, the dividend yield stood at 6.54% and price to earnings 11.09.

They have since paid a dividend and the share price has declined slightly since the initial purchase.

The price decline is the reason for the portfolio’s negative returns of -1.04% this quarter.

I’m not overly concerned about short-term price fluctuations, especially from such a large well-established company that pays a handsome dividend.

The purchase represents 10% of the portfolio whilst cash is at a staggering 90%.

My main concern is the continuing fall in general prices which has forced me to maintain a large cash position.

The staying invested v inflation eating away at the value of cash debate is of no concern when losses from declining stock prices also devalue portfolios.

A double-whammy if you will. I’d rather a single-whammy.

In the current environment, the only sensible course of action is to hold cash whilst policymakers work to bring down inflation an unintended consequence of which is to wash up bargains stocks.

Conclusion

Hopefully, I’ve been able to communicate more about the Wealth Accumulated investment approach in this inaugural quarterly report without reference to specific stocks.

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The most profitable stock market investing strategy of all time

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Profitable stock market investing

I’ve talked for years about how Benjamin Graham, the father of value investing, taught the public a profitable stock market investing strategy without relying on Wall Street or The City to do it for you.

One advantage of a DIY approach to stock market investing is that you will cut out the fees professional money managers will charge you.

They will often charge you fees even when they lose you money in bear markets or they are simply unable to beat the S&P 500, which most of them cannot.

You can simply buy a low-cost S&P 500 index fund in your broker account and make more money over the long term than the vast majority of professional money managers.

But you’re here because you’d like to understand how a more sophisticated approach to making money from the stock market can yield even better results over a long-term time frame.

The Relatively Unpopular Large Company

The Relatively Unpopular Large Company is the name Benjamin Graham gave to a value investing strategy that is simple to understand so that you can start using it once you get to grips with it.

Graham described the strategy as ‘conservative and promising’:

The key requirement here is that the enterprising investor concentrate on the large companies that are going through a period of unpopularity

Benjamin Graham, The Intelligent Investor

The key skill you’ll need to develop is determining that the period of unpopularity is temporary.

But more on that later.

Let’s break down how this strategy works.

Concentrate on large-cap stocks for profitable stock market investing

Concentration on the largest of stock market listed companies ensures that over time, you’ll develop an intuition, a sixth sense within the large-cap space.

Familiarity does not breed contempt in this situation.

Trying to invest in stocks of all shapes and sizes can be done, but we are here to develop a niche skillset in the ‘safest’ part of the market.

For one thing, large caps are the most talked about, followed, analysed, and written about stocks in the world.

This means that your research process on individual stocks going through a period of unpopularity begins with a simple Google search.

More importantly, large-cap stocks and the businesses behind them employ the brightest minds in the world.

That intellectual capital is what Ben Graham was relying on when he said of this strategy:

The large companies thus have a double advtange over the others. First, they have the resources and capital in brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.

Benjamin Graham, The Intelligent Investor

Look for stocks with a market capitalisation of at least $10 billion, many of them being household names familiar to you.

Yahoo Finance, Google Finance, and many other free services will give you this information.

If you’re a European investor then indexes like the FTSE 100 in the UK, the CAC 40 in France or the DAX in Germany offer convenient lists of large caps to research from.

Determine if the period of unpopularity is temporary

Guesswork will not do for this or any aspect of the strategy.

You will need to do some research if all of a sudden your news-feed flashes the headline ‘XYZ large-cap stock has collapsed in price today’.

Here is a starter list of questions you’ll need to answer to help you determine the timeline of unpopularity:

  • Why did it collapse in price?
  • How short-lived is the issue that caused the price collapse?
  • Does it have a strong balance sheet?
  • Has it hit 52-week or multi-year lows?
  • Is the general market in a bull or a bear market?
  • What is the long-term (10+ years) dividend record?
  • How likely will the company ‘turn itself around’ based on what management v what The Street says?
  • What is the PE ratio average over the past ten years (PE10) compared to the PE ratio over the last twelve months?
  • Has the long-term return on capital employed (ROCE) been historically high? (at least double digits).

Some of these questions are abstract and will have no definitive answer.

Some of these concepts like PE10 or ROCE will be new to you and are based on mathematics.

In both situations, the research process is about building a picture of the long-term success or otherwise of a business, where it sits in the current business environment, and how well based upon your research you think the business will turn itself around after a setback.

Learning about PE10, ROCE and other useful financial ratios is part of the process of becoming a better, intelligent, and enterprising investor.

It is the difference between dollar cost averaging with a low-cost S&P 500 tracker (set and forget) or seeking a higher reward for more work.

Sometimes you will not have a clear yes or no answer as to whether the unpopularity of a company will be temporary.

In this scenario, you should simply place the stock on a watchlist and monitor the news flow about the stock.

You would have already done the hard work of researching it, so it’s best not to waste that work.

Keep it on your radar, monitor news about it, and gain a better understanding of the business to determine when it’s time to buy.

Is investing in large-cap stocks a good fit for your mindset?

At the start of this article, I stated that the relatively unpopular large company strategy was the most profitable of all time.

Warren Buffett uses something close to this strategy, with a focus on large businesses that have shown consistent growth and a historically high return on capital employed (ROCE).

Buffett also buys businesses outright and has a vast pool of cash to play with, and combined with his reputation, he creates deals that we cannot.

That said, he is the wealthiest most successful stock market investor of all time and his investing mentor happened to be Benjamin Graham, the inventor of this strategy and the father of value investing.

But before you stride out there on your lonesome, a word of caution.

There are hundreds of articles, white papers, and books written about the best stock market investing strategies in the world.

What the vast majority of them lack is what I call a ‘mindset fit’.

This mindset fit is the distance between a stock market strategy and the way you think as an individual.

If you think you need charts, indicators, and a constant refresh of your broker’s app for stock market prices every 15 minutes then this strategy of relatively unpopular large companies is not for you.

You’ll likely need a short-term trading strategy based on technical analysis.

If you value your time to enjoy what the world offers without having to look at charts and stock prices all day then the relatively unpopular large company is for you.

Most of your time will be spent keeping abreast of financial market news rather than staring at charts and prices.

Value investing is by its very nature long-term orientated so when you actually purchase stock in a large cap undergoing a temporary period of unpopularity, the price may not rise straight away and may even go lower before going higher.

This is exceptionally difficult for most people to accept which is why they feel the need to check stock prices constantly.

Checking the news is a much better use of your time since large caps tend to pay dividends whilst they sort themselves out.

Subscribe to the newsletter so that you’ll not miss another article on large-cap stock market investing and follow along with my own portfolio news and performance because I use this very strategy to make money from large-cap stocks.