ArnoldScottConversation6 1 10EditedTranscript

The following is an edited transcript of the video‐taped conversation that took place in
Century Management’s Austin, Texas office on Tuesday, June 1, 2010, between Scott and
Arnold Van Den Berg. The video can be seen on our website at www.centman.com. A DVD
of this presentation is also available upon request.
SCOTT: Good afternoon, everyone. My name is Scott Van Den Berg, and I am one of three vice presidents
here at Century Management. I am joined here today with my father and company president, Arnold Van
Den Berg. This afternoon we are going to take the opportunity to answer the frequently asked questions that
many of you have asked over the last month or two. Let’s get started with our first question:
Question 1
SCOTT: Many investors are worried that the market could go back down and test the lows that we
saw in March 2009. Arnold, can you share your thoughts on this concern?
ARNOLD: Well Scott, I think that anything is possible in this kind of an environment, although I believe
that the risk of the stock market going back to the March 2009 bottom, which was around 670 on the S&P
500, is very low. There are several reasons why I feel this way. First of all, as the financial crisis was taking
place, I had never seen in my 40 years in the business companies react as quickly as they did to cutting costs,
reducing payroll, cutting dividends, cutting capital spending, and just getting everything honed down. And
because of this rapid reaction to the crisis, probably due to the fear that was going on at that time, many
companies have been able to really get themselves in good financial shape. As a matter of fact, the balance
sheets of America’s corporations have the most cash relative to assets that they have had in years. According
to the Federal Reserve, cash now makes up about 7% of all U.S. non-financial company assets, including
factories and financial investments. This is the highest level since 1963.
Second, profit margins are improving dramatically. While it’s hard to believe, the profit margins are almost
as high as they were in 2007, which was a record year. Just to give you an example, on Chart 1, in 2007,
corporate America earned about $1.4 trillion. It got as low as $1.1 trillion in 2009. Now, in 2010, earnings
are projected to go back to $1.4 trillion, which is not quite as high as 2007 when you run out the decimals,
but it’s 95% there. So we had this tremendous decline in economic activities, a decline in profits, and two
and a half to three years later they are almost back up to their previous highs. As a matter of fact, when you
measure GDP (Gross Domestic Product –a measure of the country’s overall economic output), it is actually
higher now than it was in 2007.
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Chart 1:
Gross Domestic Product (GDP)
Therefore, when you take the fundamentals, earnings are back up and sales (GDP) are back up. So you can
see that the market doesn’t have any reason to go down to the March 2009 lows given these fundamentals.
The third reason I do not believe the market will go back to the March 2009 low is due to the valuation of the
market. On Chart 2, I want to introduce a price to book chart for the S&P 500 (our proxy for the general
market). Now we know that most companies have sales, they have earnings, they have cash flow, and they
have a book value. (Book value is simply the net asset value of the company.) If we take the S&P 500 as an
index, and we measure its book value, we can get an idea of what its price should be. Usually you use sales,
earnings, yield, cash flow, or free cash flow, but I am choosing to use price to book value (P/BV) and price
to sales (P/S) because these are two of the more stable metrics. In other words, they don’t move around as
much as the cash flow or earnings. If you take the very low periods from 1990 to present, and we all know
that stock prices fluctuate around interest rates, all of the interest rates were below 9.25%.
SCOTT: What interest rates are you referring to?
ARNOLD: I am using the Moody’s Baa rate (equivalent to the Standard and Poor’s BBB rating), which
represents good quality / medium risk investment grade corporate bonds. I have found that the market
usually trades in a relationship to these bonds. For example, in March 2009, when the average Moody’s Baa
corporate bond got to a yield of 8.24%, (15% higher than the 80-year average of 7.11%), the S&P 500 index
was trading at 1.52 times book. There is only one other time in the last 21 years when the price to book ratio
got that low. In October 1990, when the average Baa corporate bond had a yield of 10.80%, the index was
trading at 1.72 times book.
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Chart 2:
S&P 500 Price to Book Ratio
Source: Bloomberg, LLP
As you can see on Chart 2, out of the last 20 years, the price to book ratio has only been below 2.00 times
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However, what is most important to remember is that when you look at how extreme the market sold off in
comparison to the last 20 years, we knew it was oversold as the S&P 500 had only spent 1.5 out of the 20
years in that low valuation zone.
SCOTT: You mean below 2.00 times book?
ARNOLD: Yes, below 2.00 times book. In other words, in 1990 and in 2009, the S&P 500 traded below
2.00 times book value, each time lasting no more than nine months at this level for a total of 1.5 years.
However, 1.5 out of 20 years is just 7.5% of the time. So that is where my statement comes from. I just do
not believe the market (S&P 500) will go down that low today. But again, even if it did, I do not believe it
would stay there very long—just like it hasn’t over the last 20 years.
SCOTT: Now currently, our CM Value 1 Composite, which represents our average account, has a
price/book ratio of 2.12 times book value. So based on what you just said, that would suggest there is a lot of
value and upside in the companies we are holding.
ARNOLD: Relative to values over the past 20 years, 2.12 times book is about as low a price/book ratio as
we have had on our portfolios, except for those two periods (1990 and 2009). Furthermore, when compared
to the S&P 500 at 2.25 times book, our typical portfolio is actually cheaper today than the broader market.
Now I would like to introduce another chart (Chart 3)that shows a price to sales ratio. It basically
tells the same story as the price to book value. However, we like to show this ratio as well, since some
people relate better to sales than book value. Moreover, the price to sales ratio is a good measurement as
sales do not typically fluctuate as widely as the earnings.
By looking at the price to sales ratio on Chart 3, you can see the real cheap points in the market were
in September of 1990 (just like it showed when we looked at the price to book value ratio) at 0.63 times
sales, and again in March 2009, when the market traded at 0.68 times sales. Today, the S&P 500 is just over
1.10 times sales. This is very low relative to most other periods over the last 20 years, except that period in
1990 when the average Baa corporate bond had a yield (interest rate) of 10.75%.
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Chart 3
S&P 500 Price to Sales Ratio
Source: Bloomberg, LLP
SCOTT: This is the price/sales ratio for the S&P 500?
ARNOLD: That is correct.
SCOTT: The average price to sales ratio for our CM Value 1 Composite today is 0.75 times sales. As you
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Now the only reason I can see that would cause the S&P 500 (i.e. the market) to go below 1.52 times
book (see Chart 2) or 0.75 times sales, is if the earnings went down sharply like they did in 2008 and 2009,
and at the same time interest rates (as measured by the Moody’s Baa corporate bond yield)
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With so many bids coming in at deeply discounted values (20 to 50 cents on the dollar), many banks
were forced to lower the value of their mortgage pools, as well as other assets, to the value that was being set
by lowball bids. The lowering of these assets’ values even had to take place on mortgage pools that were still
in good shape and performing as scheduled (because in theory if they wanted to sell that pool of loans they
would have to take a loss). However, as long as the bank did not need to sell these mortgage pools to raise
money, there was really no need to write them down as a loss. However, this is what mark-to-market
accounting requires, and at market extremes it can add fuel to the fire by forcing banks to write down the
value of their mortgages and other assets, even if they are performing, all because recent sales of those assets
are showing lower comparable prices. This amounted to huge losses for the banks.
I believe this is one of the main reasons that Lehman Brothers, Bear Stearns, and many banks went
bankrupt; they had to mark their assets down to the current market levels even though they were depressed.
There were illiquid assets that might have been worth 100 cents on the dollar in normal times, but due to the
sharp and rapid decline in offer prices, those assets might have been selling for 25 cents—they had to take
the losses, and there went their balance sheets.
Looking back at the history of mark-to-market accounting helps put this issue into perspective.
Mark-to-market accounting existed during The Great Depression. Economist Milton Freedman wrote about
this issue in his book, A Monetary History of the United States 1867-1960, and said that he felt that mark-to-
market accounting was one of the main reasons there were so many bank failures in 1929. In other words, the
banks would not have been nearly as bad off if they would have been able to value their mortgages at the
prices they were selling for and the number of foreclosures they had; but because they had to mark them
down due to this accounting rule, there were tremendous bank failures. They finally got rid of mark-to-
market accounting in 1938, and it is no coincidence that after 1938 the economy, along with everything else,
began to pick up, gathered steam, and did much better. During this period, 1938 until 2007, we never had the
kind of wide swings in the economy that we did before The Great Depression. Before The Great Depression,
every recession seemed to be more of a boom and bust cycle. Part of the reason was caused by some of these
rules. Then when they eliminated this mark-to-market accounting rule, from 1938 to 2007, the extreme boom
to bust swings in the market were eliminated.
At the top of the market back in November 2007, they reinstated the mark-to-market accounting Rule
157. Then, as the crisis developed, they realized that Rule 157 was adding fuel to the fire and they needed to
remove it. Just one week before the market bottomed, they made a statement that they were going to review
mark-to-market accounting. On March 12, 2009, the House Financial Services subcommittee met, and on
April 2, 2009, they officially changed the rule. This was right at the market bottom and I believe, outside of
the fact that the market was dirt cheap, removing this rule was a key part to the market turning around when
it did. The main reason the market reversed course is that people realized that if the banks don’t have to use
mark-to-market accounting and they could work out their problems over the long-run, just like we did
through every other recession, they would not have to deal with the extreme write downs and losses. With
that in mind, the market took off.
So to summarize the question, “why do I believe there is a low probability the market will get back
down to the March 2009 level?”, it’s because corporations have rebuilt their balance sheets, margins are
higher, the valuation of the market itself in March 2009, an extreme that should have never happened, and
more importantly, the elimination of mark-to-market accounting. Now they have just suspended this
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accounting rule; but they have not eliminated it all together. If they were to reintroduce Rule 157, I think that
would increase the downside risk of this market, and we would react accordingly. So when you sum up these
reasons, we have reason to be optimistic that that is not going to happen.
Question 2
SCOTT: Clients have asked about Greece, Spain, and other European countries, and they would like
to know what the short-term and long-term impacts these economies might have on the U.S. stock
market?
ARNOLD: I think the economic crisis in Greece, as well as throughout Europe, is getting a lot of headlines.
This is the unfortunate thing about just listening to the press, or the mainstream media, because they are
trying to sell their wares and in doing so they often exaggerate and overemphasize things to grab attention.
But if you really look at the situation from a factual standpoint, you frequently find that the facts are a little
different than what the headlines would lead you to believe. Facts are a stubborn thing and they have a way
of surfacing if you just look for them.
For example, let’s take a look at Greece. Now I don't know how many newspaper headlines I have
seen where Greece is at the top of the news, not only in the business sections, but all over the media. This is
where it’s important to put what you read and what you hear into perspective. The world’s GDP (Gross
Domestic Product), i.e. the world’s total economic activity, is $61 trillion. This is the total pie—$61 trillion.
Then you have Greece, which is $356 billion. In other words, Greece is just 0.58% of the world’s GDP. Just
to put this into perspective, the GDP of Massachusetts makes approximately the same economic contribution
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Now when you put this into its proper economic perspective and then compare it to the headlines or
even the impact it has had on the financial markets, it seems like the amount of energy and attention being
spent on just one-half of one percent of the world’s GDP is more than
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bit of money, you are a lender; when you lend him a lot of money, you are his partner. In other words, if he
goes down, you go down. Well, in China, roughly 37% of its GDP are exports. According to China’s
National Bureau of Statistics (2008), 8.8% of its GDP are exports to the United States and 6.5% of its GDP
are exports to Europe. In April 2010, the Peoples Bank of China reported that China has $2.5 trillion in
foreign exchange reserves. Now, from an enlightened point of view, not from an altruistic point of view—I
will never make the suggestion that China is going to do anything altruistic—but from an enlightened, self-
interest point of view, China is going to do what it can to help bail out Europe because Europe is
approximately 24% of China’s exports. When you depend that heavily on those customers, you are going to
want to do everything you can to prop them up and help make them work over the long-run.
While it might take some money to shore them up in the short-run, over the long-run they will be
excellent customers. Besides, at 24% of your exports, you really don’t have a choice, you are going to do
what you can. Just like we in the U.S. do what we can to bail out other countries. It’s not always because of
our altruistic reasons, but rather our own enlightened self-interest. So it’s in China’s interest as well the rest
of the world to keep Europe going because according to the latest data (2008) from the World Bank, Europe
is 22% of world GDP, and overall that is significant.
SCOTT: If something does happen to the Euro, or it continues to fall, that could impact a lot of U.S.
multinational companies, and we own a lot of large, blue chip multinational companies. How do you think
this would impact their sales and earnings?
ARNOLD: Europe has slowed down, just like we did in the recession, and so the multinational companies
have already suffered some erosion of sales and profits. I would say as the Euro goes down, it will actually
improve their earnings as their products and services will become more competitive (i.e. their products will
be cheaper relative to the dollar and other currencies). One of the things I love about the multinational
companies in our portfolio is that we are not only diversified in America, but roughly 50% or more of their
sales come from Asia, Europe, and countries all over the world. We basically have a call on world GDP. So
even though Europe’s growth has slowed, China’s GDP has been growing at 8% to 10%. Now I am not
saying that 8% to 10% growth is necessarily sustainable, but through owning companies with multinational
exposure, we have the benefit of participating in faster growing economies as well as slower ones. But I
think with the Euro going down, long-term—not short-term—long-term that is going to be positive for
European sales and profits, and it will be profitable for our multinational companies. It may be that by the
time Europe is picking up, China may be slowing down. We don’t know. But we like having a diversified
income stream from all over the world. Now a lot of people invest directly in other countries. The way we
get our global diversification is by investing in U.S. based multinational companies. And by the way, in our
opinion, for the past two years, many of the large U.S. multinational companies have been some of the best
values in the market. Furthermore, relative to interest rates and fundamentals, we believe they are as cheap as
they have been in 25 or 30 years.
SCOTT: So these large cap stocks are as cheap as you have seen them in 25 to 30 years?
ARNOLD: Not as cheap as they have been in an absolute sense, but when compared to interest rates, yes,
they are that cheap. On a fundamental basis they have been about this cheap three other times over the past
30 years, but they have not been this cheap when you compare them to interest rates. So they are a true value
today. Currently, they represent about 60-63% of our typical portfolio, but this really depends on the client.
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Question 3
SCOTT: There have been a lot of clients who have called and asked about inflation. There is concern
that with all the government spending and stimulus that either now or somewhere, sooner or later we
are going to see inflation come into the economy. But we also have calls from clients asking about
deflation. Can you give us your thoughts on the inflation/deflation argument?
ARNOLD: This is probably a good time to introduce the principle of loss. Most people think when you talk
about a loss in capital, they think about the fact that when the market goes down their portfolios go down.
However, this is rarely a permanent loss, or at least it does not have to be if you are holding good values. Of
all the bear markets over the last 135 years, only one did not achieve the previous peak within 6 years. As a
matter of fact, of the last 14 bear markets, on average, the market recovered and reached a new peak within
3.3 years. Even in 1932, the return off the bottom was 372% over 4.75 years. So with most recoveries taking
place within a few years, a permanent loss of capital is not as big of an issue as most people think. Rather,
the main issue should be how one handles a one to two-year, and in the rare case, a three-year decline in
market values. o 1 84 A0 1trs,whiple people think that
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For example, if you take an average person at age 65 with $1 million in cash, and assume an inflation
rate of 4%, by age 85 (20 years later), this $1 million dollars in cash would have the purchasing power of
only $442,002 due to inflation. This is a total decline of 56%, and it’s permanent. So there is a huge risk due
to inflation, even during normal times. But if you’re speaking about higher inflation periods, like the
runaway inflation that some people are concerned about, well then obviously the decline in purchasing
power will be even greater.
Chart 5
Permanent Loss of Purchasing Power Caused by Inflation
Starting Value $1,000,000 $1,000,000 $1,000,000 $1,000,000
Inflation Rate 3% 4% 7% 10%
Years 20 20 20 20
Future Value $543,794 $442,002 $234,239 $121,577
Source: Century Management
Let’s take the inflation argument first. The reason that people believe there is going to be a large
amount of inflation, more than the normal 3.5% to 4%, is because the government has expanded its balance
sheet almost two to three times above normal. Some people call that printing money. I think you have got to
distinguish between printing money and creating credit. What the federal government has done is they have
created reserves to put into the banks so that they will have the ability to lend it out, and as it goes through
the banking system (i.e. the fractional reserve system) it expands and thus boosts the economy and
eventually get things going. If they print the money, like they did in Germany during the 1920’s, where they
literally printed it on the presses and distributed it to the public, then you’re going to have very serious
inflation. Our government is not printing money—they are creating reserves to extend credit. But if people
don’t borrow that money, then it’s not going to expand at the rate they’re supplying it.
What is important to remember here is that when the government lends money, they can also pull it
back out. Many people are not aware of this and thus feel we are going to have high inflation. Here is a
classic example of why it does not have to be that way. If you study Japan, in the 1990s they increased their
money supply by creating reserves. As you can see on Chart 6, the money supply went straight up during
2001 through 2002.
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Chart 6 - Japan’s Money Supply
Then it went sideways for a couple of years and then during 2005 and 2006, they drained virtually all
that excess credit back out of the system. Remember, they were able to drain the money out of the system
because they did not literally print the money. They created the money by expanding
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Therefore, the argument that because the Federal Reserve is expanding the money supply via
expanding credit we are going to have runaway inflation or very high inflation does not bear out with the
facts. Do I believe it is possible that we could have high rates of inflation, like some people worry about?
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manufacture without building new facilities, then they are able to raise their prices. We have neither of those
conditions now. Chart 8 shows the latest unemployment rate to be 9.7%, while Chart 9 shows U-6
unemployment, the most comprehensive unemployment metric, to be 16.9%, both of which are well above
their historical norms.
Chart 8 - Unemployment Rate
Chart 9 - U-6 Unemployment Rate (the broadest measure of unemployment)
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Based on today’s high unemployment rate and when you consider the slow pace that jobs are being
created, it could take three to five years, maybe longer, before you get back to a normal employment market.
The second major consideration for inflation to exist is a high factory
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next two years we have a greater chance of deflation than we do inflation. Over the long-run, I don’t think
deflation is a factor to be concerned about at all. Fortunately with the way the economy is recovering and
with the way many companies have repositioned themselves, we probably do not have to worry about serious
deflation.
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I have done a lot of thinking about this. A lot of people are rushing into bonds today. Now let me say
one thing. Bonds have a place in anybody’s portfolio that is concerned about the short-term. For example, if
you are worried about sending your kids to college in the next three or four years and you do not want to
worry about the volatility of the stock market, then bonds or even cash may be right for you. If you are
saving for another purchase or project such as a home or whatever it is that you have in mind that has a
short-term time horizon, bonds may be the right investment for you. In the business world, many companies
have pensions and insurance companies have other liabilities that they have to fund so bonds are an
appropriate investment. So depending on your own situation, personal circumstances, and time horizon, there
could certainly be a place for bonds in your investment portfolio.
With all of that said, it is important to note that the bond market has been in a bull market since 1981,
or 29 years. Inflation has gotten about as low as it’s going to get; maybe a little lower but not much. In
general, bonds have gotten about as highly priced as they are going to get. Typically, it takes almost one-
third of the time of the bull market to erase the excesses that have built up. Suffice it to say the bond market
is pretty richly priced today, especially if we’re going to have a little more inflation a few years out.
Let me just give you one example of what happened to bonds during the early 1970’s. In 1973, one
year before we started Century Management, inflation was running at 2.76%. By the end of the year it was
4.93%. That’s almost a doubling of the inflation rate in just one year. The following year inflation went from
4.93% to 11%. So in the space of two years (1973 to 1975), inflation went from 2.76% to 11%. In other
words, inflation quadrupled in two years. Now, if you want to know what happens to stocks or bonds during
inflation, you can look back at the bear market of 1973 and 1974 and that will answer your question. It was
disastrous. Remember, if you own bonds with a long maturity date and interest rates go up 1%, then that
bond will go down 10% in face value. Now if you have a short-term bond it doesn’t really matter too much
as it matures within a short period of time and you get your money back. But if you have a 30-year bond and
it goes down 10%, you would have to wait 30 years before it matures. If rates went up 4%, that same long-
term bond would go down 52%.
SCOTT: If the interest rates went up 4%, you could see a 40-50% decline in the long-term bond market.
ARNOLD: Yes. The point I am trying to make is that people have to manage their bond portfolios because
down the road when inflation does start to pick up, and if you did not make any adjustments, that bond
portfolio could go down very dramatically depending on how it is structured. If you’re in short-term bonds
you could wait until they mature and then roll the proceeds over to higher yielding bonds. I would say that if
you looked at the probability, as I said, I don’t believe we are going to have a lot of inflation for the next
three to four years. Now, having said that, we just made a trade in a long-term bond because at the price we
paid for the bond we deemed it to be a great value.
In this specific case we were able to buy a 30-year U.S. government coupon paying bond when it had
a yield to maturity of 4.75%. At present, with little to no inflation to speak of, we felt this would be a good
bet over the next few years, but I would not keep that bond over the long-run. So far, this trade is working in
our favor.
SCOTT: This long-bond strategy was more of a three to five year type of plan?
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ARNOLD: Yes, and probably even shorter. So the idea is if you are going to be in bonds, they still have to
be managed. If you are worried about deflation, you want to go out a little longer on the maturity date. If you
are worried about inflation, then you want to keep your maturity short so that you can keep rolling maturing
bonds over.
As our performance shows, we have done a very good job managing bonds over the past 35 years.
Just over four years ago, as you know, we even created a total return bond fund. Tom Siderewicz is our lead
manager of this fund. He has done a spectacular job of managing our bond portfolios over the past few years.
As you know, over the past three years our bond performance ranks as one of the top in the country. What
Tom is doing with bonds is the same thing we are doing with stocks and that is looking for values. Right now
our average bond portfolio is roughly 35% to 38% in cash. However, this figure will change depending on
each individual client, but it is an average. The reason we are holding so much cash in many of our bond
portfolios is that we believe many bonds are overpriced. However, we are continually looking for good
value opportunities for bonds just like we are for stocks.
If you are going to invest money in bonds, you still have to manage where you make your buys and
sells. For example, when you buy bonds you need to make sure they are cheap and when they become
overvalued you need to sell them because eventually they are going to be in a long-term bear market. Most
bond managers, especially those managing bond mutual funds, just keep themselves fully invested. If over
the next few years’ bonds begin to enter into a bear market and go down in value, being fully invested and
not actively managing the bonds might not serve your purpose. For example, if your bond has a coupon that
pays 4% but the bond goes down in value 4%, the decline in principal for the year will offset the income that
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I have studied this field for 40 years, I have racked my brains out, I have listened to all kinds of
arguments, and what it really gets down to is buying great values. That’s why I chose the value approach to
investing—it makes the most sense over the long-run. Most importantly, it is the only way I believe you can
truly protect yourself. Whether you are in stocks, bonds, or real estate, you have got to buy these assets when
they are cheap, and that usually means buying during uncertainty, when things don’t look as rosy, and then
be willing to sell them when they get overvalued and things are looking good.
For example, over the past year as our stock portfolios were going up and various individual positions
were going past their fair values, we reduced their weighting in the portfolios selling some positions in full.
As a result, our typical cash position peaked earlier this year between 22% and 30%, depending on the
portfolio. Then as the market has come down, we have invested about 4% to 8% of that cash because there
have been some bargains that surfaced.
If the market, or should I say individual stocks, continue to go down and get into our bargain zones,
we will continue to redeploy that cash. When their prices turn around and increase to the point where they
are above fair value and near their sell points, we will sell them out. Regarding our bond portfolios, we have
been doing very well. Today, our typical bond portfolio is holding roughly 35% to 38% cash. We may have
to sit in cash for six months to a year before we find more good values in bonds. We don’t know for sure,
but we will wait until we get the right kind of opportunity.
In summary, the only way you can truly protect yourself in different environments is to buy when
assets are out of favor and cheap. Then down the road when things are looking rosy and getting overvalued,
that’s when it’s time to sell. Furthermore, during periods where there are no values, you should just stay in
cash or short-term bonds, whichever one is the better value, and wait for the next great buying opportunity.
This has been our approach for more than 35 years.
Question 6
SCOTT: Where are we relative to fair value in the market today? Let’s use the S&P 500 as our proxy
for the market at-large, and then let’s answer the same question with regards to the average Century
Management portfolio.
ARNOLD: Okay, let’s start with the S&P 500. Wall Street uses a P/E ratio to arrive at fair value. However,
one of the problems with using Wall Street’s P/E ratio is that the “E” part of the ratio, that is, the earnings,
are typically based on projections for the next year. The problem is if their projections are over the norm they
will still use those numbers, and if their projections are under the norm the P/E goes up. So what we have
done in our methodology is we use normalized earnings. This helps to smooth out the extremes.
Over the past few months, I have seen various projections from Wall Street firms that put the S&P
500 earnings at $70 to $90. While it could generate $90 in earnings this year, we prefer to use normalized
earnings. After we run our three methodologies, we come up with a normalized $67 in earnings for this year.
This is a very conservative number, but we do that on purpose.
SCOTT: So $67 is our estimate of normalized earnings for the S&P 500 this year?
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ARNOLD: That is correct. The way we do that is we take the ten-year average P/E and add inflation. Yale
professor Robert Shiller has written extensively about this methodology. But we add a few other things to
double check it. We also take the normalized profit
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SCOTT: Earlier we talked about our CM Value 1 Composite (a proxy for our typical account) having a
price to book value ratio of 2.12 and a price to sales ratio of 0.75, which based on those metrics, like the P/E,
are on the lower end. In other words, our portfolios are selling at bargain levels.
ARNOLD: Yes. If you look at 0.75 of sales, that has only happened twice during our company’s 35-year
history. That was in 1990 with 10.75% interest rates, and it happened in 2009 at the bottom of the market. So
our portfolios, based on a price to sales ratio, are trading at a significant discount to the general market. This
is why we feel very good about our portfolios today. Regardless of any metric you want to use, price/sales,
price/book, whatever, it is at the lower end of valuations.
See Chart 12 on Following Page
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Chart 12
Price of S&P 500 Given $67 in Normalized Earnings x Various P/E Ratios
Normalized Earnings Valuation of S&P
Market Multiples
Power of S&P 500 500
LOW RANGE
11.00 X $67.00 = 737
11.25 X $67.00 = 754
11.50 X $67.00 = 771
11.75 X $67.00 = 787
12.00 X $67.00 = 804
12.25 X $67.00 = 821
12.50 X $67.00 = 838
12.75 X $67.00 = 854
13.00 X $67.00 = 871
13.25 X $67.00 = 888
13.50 X $67.00 = 905
13.75 X $67.00 = 921
FAIR VALUE RANGE
14.00 X $67.00 = 938
14.25 X $67.00 = 955
14.50 X $67.00 = 972
14.75 X $67.00 = 988
15.00 X $67.00 = 1005
15.25 X $67.00 = 1022
15.50 X $67.00 = 1039
15.75 X $67.00 = 1055
16.00 X $67.00 = 1072
16.25 X $67.00 = 1089
16.50 X $67.00 = 1106
16.75 X $67.00 = 1122
UPPER RANGE
17.00 X $67.00 = 1139
17.25 X $67.00 = 1156
17.50 X $67.00 = 1173
17.75 X $67.00 = 1189
18.00 X $67.00 = 1206
18.25 X $67.00 = 1223
18.50 X $67.00 = 1240
18.75 X $67.00 = 1256
19.00 X $67.00 = 1273
19.25 X $67.00 = 1290
19.50 X $67.00 = 1307
19.75 X $67.00 = 1323
20.00 X $67.00 = 1340
20.25 X $67.00 = 1357
20.50 X $67.00 = 1374
20.75 X $67.00 = 1390
21.00 X $67.00 = 1407
Source: Century Management
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SCOTT: We are always comparing the value of our portfolio to the value of bonds. In other words, if we
take a look at the earnings yield of our portfolio we come up with an earnings yield of just over 7%. Can you
explain why this earnings yield is a value today? (Note: 100 / 14.2 P/E = 7.04% earnings yield).
ARNOLD: One of the things that history will bear us out on is that there is competition between stocks and
bonds, and rightfully so. If you can make as much money in a bond as you can in a stock, then why would
you want to buy a stock where you have more volatility and risk? Bonds are certainly much safer and the
principal is more secure, although they will not protect you as well against inflation. When you take the
earnings yield, like you did (100 divided by 14 P/E = 7.14% earnings yield), we have a 7.14% earnings yield
on our typical portfolio. Currently, the Moody’s Baa (investment grade) bond yield is about 6.23%. When
we compare the earnings yield of the stocks to the earnings yield of the bonds, we can see that buying stocks,
even knowing that in today’s market they could go a little bit lower, is really a great value.
Any time you can buy stocks with an earnings yield as cheap as bonds and have the long-term growth
of the stocks, you are usually at a real good point of value. This makes sense, just think about it. If bonds are
yielding 6.23%, but at the same time you could by a stock with the same earnings yield plus get on average
of 5% to 6% earnings growth (average growth rate over the last 50 years), then you are getting all that
growth at no extra cost. Usually stocks sell at a higher earnings multiple (thus a lower earnings yield) than
bonds because they have that growth component. Well today, stocks are actually yielding more than bonds,
and you still have the growth component. Admittedly, over the next three to five years, you may have a
much slower growth rate than we did in the past, but you are still going to have some growth, and any
growth is basically gravy. The point I am trying to make is that whenever the earning yields on stocks is
equal to bond yields, stocks are a good value because you have the growth potential. You don’t have that
growth potential on bonds.
SCOTT: Would you say it’s fair to take that earnings yield of 7% and add it to a growth rate of 3-5% to get
an idea of our future return?
ARNOLD: That’s right. If you took your 7% earnings yield, especially if it was free cash flow (and by the
way, we spend more time talking about free cash flow, which is the real earnings in a company, but let’s just
use the P/E for this conversation). If the P/E was free cash flow, which for most of our companies it is, then
you could add the growth rate, whatever that may be. Historically, growth has been 5% or so, and that’s why
stocks have done better than bonds over time. When you take the earnings yield plus the growth rate, you can
have anywhere from 10% to 12% returns. It is no coincidence that these types of returns are consistent with
long-term historical market returns.
Now, if we take the current environment, where we may not have as much growth as we have had in
the past, it is likely that the total returns will be lower than the historical averages. However, I would also say
that after three to five years in a slow growth period, we could have much higher growth rates because of
many exciting things that I believe will be happening here in the U.S. and around the world. But the bottom
line is that you can take the earnings yield and add whatever growth rate you expect, whether it is 2%, 3%, or
5%, and that sum would be your projected return.
Page 24 of 27
Question 7
SCOTT: In closing, can you share your final thoughts?
ARNOLD: We hear a lot in the news about how strapped the consumer is, how much debt there is in this
country, how there is a lot of unfunded pension liabilities, and so forth, and
Page 25 of 27
Chart 13 - American Household Net Worth
Now if you want to talk about the future, here is the way I see it. As I look out over the next three to
five years, I think it’s going to be a very volatile market environment because our country is in the throes of
working out its problems. Sometimes it will look like things are going well like we saw in the early part of
the second quarter and the market will run up. Then there will be times when additional problems will
surface and the market will react and sell off. Even with all of the volatility, I believe the market will float
around its fair value. But once we are through these problems, and I think that over the next three to five
years we have a very good chance of working out the major issues— then when you look into the future, you
can’t have anything brighter than that.
Think about it, the $54 trillion of net worth Americans have today was largely created over the last 20
to 30 years with an average of 250-300 million people. Now we have China and India that combined have
more than 2.5 billion people. They are industrializing, they are innovating, and they are creating wealth at a
rate that is literally breathtaking. With China and India building a middle class that will have discretionary
income to spend at rates and levels we have never seen before, they are going to buy all the things that our
American companies sell. The growth rates that many of our U.S. companies will experience will be
fantastic.
We used to look at China and India for just low-cost labor as companies would have their products
produced overseas because it would simply cost less to produce, largely because the labor is less expensive.
But now-a-days, the Chinese and Indian people are at a point where they are creating a tremendous amount
of professional people. There are engineers being cranked out left and right, and all kinds of professionals are
coming to market. In many cases, they are actually starting to rival us in innovation. So, not only are these
Page 26 of 27
countries going to be good consumers, but they are going to help create productivity increases that are sure to
be breathtaking.
What has made our country so wealthy is the constant increase in technological processes and
productivity. When you increase productivity, you create profits. Can you imagine ov
Page 27 of 27

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SCOTT: What interest rates are you referring to?

Source: Bloomberg, LLP

SCOTT: You mean below 2.00 times book?

Source: Bloomberg, LLP

SCOTT: This is the price/sales ratio for the S&P 500?

ARNOLD: That is correct.

Chart 8 - Unemployment Rate

Chart 9 - U-6 Unemployment Rate (the broadest measure of unemployment)

See Chart 12 on Following Page

SCOTT: In closing, can you share your final thoughts?

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