Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

MUTUAL FUNDS

Part I

MUTUAL FUNDS 1

PART I

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STOCK VALUATION

Ultimately, people buy stocks to own a piece of a corporation’s earnings. If the XYZ

Widget Company earns $5 a share and its stock sells for $100 a share, it has a P/E

ratio of 20; an investor is paying $20 for every $1 of earnings. As a broad generality, a

company in a seasoned industry group selling at a 30 P/E is said to be expensive; one

selling at a 10 P/E is said to be cheap. The market meltdown of 2008 and 2009 may or

may not alter these historical numerical guidelines.

Unfortunately, company earnings are not particularly stable. It is easy for corporate

accountants to “fiddle” with reported earnings to the point where they are almost

meaningless. For these reasons, P/E has only limited value. Ben Graham pointed out

that corporate earnings provide useful information only when averaged over several

years. Publicly traded companies have two P/E ratios: “trailing” and “estimated.”

The trailing P/E is most commonly used and represents a corporation’s actual earnings

over the past 12 months; estimated earnings are a forecast for 12 months in the future.

Unless otherwise noted, all P/E figures shown are trailing.

Over the past 80 years, the stock market’s P/E ratio has ranged from a negative number

(the Great Depression) to over 45 (early 2002). By historical standards, when the mar-

ket’s P/E is about 7, it is definitely cheap; when it is greater than 20, it is expensive. The table below shows year-end price/earnings ratios for the S&P 500 and Dow (sources:

S&P and Barron’s Online). As of March 2012, the Dow’s trailing P/E was 14 (15.5 for

the S&P 500).

Year-End P/E Ratios: S&P 500 and DJIA

Year S&P DJIA Year S&P DJIA

2011 15.6 14.4 2001 46.5 27.1

2010 18.0 14.8 2000 26.4 22.2

2009 20.6 14.1 1999 29.1 24.1

2008 18.8 13.3 1998 32.6 24.0

2007 16.8 17.0 1997 24.4 20.2

2006 17.4 17.1 1996 19.1 18.2

2005 17.9 22.5 1995 18.1 16.4

2004 20.7 18.3 1994 15.0 15.0

2003 22.8 20.1 1993 21.3 25.6

2002 31.9 21.6 1992 22.8 30.5

MUTUAL FUNDS 2

PART I

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The P/E ratio shows how long it would take to earn back (through current earnings) the

price paid to acquire 100% of a company. For example, On February 12th

, 2012, Mi-

crosoft had a P/E of 11. If someone bought 100% of all Microsoft stock (thereby becom-

ing the sole owner), it would take just 11 years for the investor to recover 100% of the

purchase price—based on Microsoft’s current earnings (no projection for increased earn-

ings, which would lower the number of years).

Phrased another way, it would be impossible to duplicate Microsoft’s presence, market

share, reputation, product line and research in 11 years (note: it would be highly unlikely

such a feat could be done in 20 years—meaning Microsoft stock is a bargain based on its

current P/E ratio). A number of blue-chip companies in 2008 and 2009 reported negative

earnings—no earnings or a loss means a non-existent or negative P/E ratio.

A company may not have any earnings but all companies have a book value. This indica-

tor can be thought of as the net value of a company’s total assets. A stock with a P/B of

less than 1 is said to be cheap; one with a P/B of more than 5 is expensive, at least

relative to its book value. The book value of a stock is considered to be very stable.

The price-to-book value ratio (P/B) represents the recent closing stock price divided by

the theoretical dollar amount per common share one might expect to receive from a com-

pany's tangible book assets should liquidation take place. Some studies suggesting a low

price-to-book can lead to a strong stock price rise in the future. Price-to-book generally

does not measure financial services stocks well because of the nature of the financial ser-

vices business.

Over the past 80 years, the stock market’s P/B has ranged from less than 1 to 8

(both numbers are exceptions); it has averaged about 1.6. During 1999, the P/B ratio

for U.S. stocks was just below 6 (vs. 4 for European stocks). The ratio has declined since

then, leveling off to 2.2 beginning in the middle of 2002 through 2009. The S&P 500 had

a P/B ratio of 3.9 as of February 2012 (vs. 3.5 for the Russell 2000).

MUTUAL FUNDS 3

PART I

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BOND PERFORMANCE

The table below shows total return figures for U.S. Government securities and inflation.

Over the past 10 years (2002-2011), the Barclays 20+ Year Treasury Index averaged

9.2% (11% for five years).

U.S. Government Bond Performance By Decade [1970-2011]

U.S. Government 1970s 1980s 1990s 2000s 2002-2011*

Long-term (20 year) 5.5% 12.6% 8.8% 7.7% 8.9%

Med-term (5 year) 7.0 11.9 7.2 6.2 4.8

T-bill (1 month) 6.3 8.9 4.9 2.8 3.2**

Inflation (CPI) 7.4 5.1 2.9 2.5 --

* mutual fund categories, net of expense ratios / ** short-term government bond funds

The returns fixed-income securities enjoyed during the 1980s, 1990s, and up through

2004 were partially due to a falling interest rate environment. As an example, the prime

interest rate peaked briefly at 21.5% during the first half of 1981 and pretty much fell

from there. Even in 2005-2012, interest rates were historically low.

BONDHOLDER’S TOTAL RETURN

Suppose you buy a 10% coupon bond at par, or $1,000. The investment pays annual inter-

est and matures in 25 years. You hold it to maturity. Would you realize a 10% yield to

maturity, also known as the true compound rate of return? The answer depends on what

you do with the interest payments, which total $2,500 over the 25 years ($100 per year

times 25). Here is an analysis of the case:

1. If you spent your interest checks when received, your y-t-m (yield to maturity)

would not even come close to 10%. It would be 5.1%.

2. Instead, suppose you reinvested in a passbook account at 4%. You would accumulate

$4,165 in interest, but your realized yield to maturity would be only 6.8%.

3. To earn the full 10% y-t-m, you would have to reinvest each payment at 10%. The

accumulated interest would amount to $9,835.

The track record of professional rate forecasters is mediocre at best. The smart strategy

for most investors is simply to use bond funds to meet liquidity, preservation of capital,

and income needs.

MUTUAL FUNDS 4

PART I

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TARGET RETIREMENT FUNDS

Sometimes referred to as life-cycle funds, target retirement mutual funds are being

promoted as “one investment choice for a lifetime.” Each fund is identified with a spe-

cific retirement year, such as 2020 or 2025. As the target date approaches, the allocation

becomes more conservative, favoring bonds and cash. After the target date passes, most

of these funds either merge into a retirement income fund or adopt an allocation that pre-

serves purchasing power. There are a number of problems with these types of funds.

First, the objectives of people with a similar target date can be quite different. Someone

age 65 and in poor health may need more money each year. Second, most target funds

are based on 10-year intervals instead of five. Third, some fund groups increase the ex-

pense ratios for these “fund of funds.” Fourth, a number of the “sub” funds have track

records that are less than 10 years, making analysis somewhat limited. Fifth, some com-

panies offer their best funds, others use a mix of some of their good and some of their

not-so-good funds.

The Biggest Problems The greatest concern about target retirement funds is that their allocations are all over

the board. As an example, the AIG SunAmerica High Watermarket fund has a target

maturity of 2020 and a stock allocation of just over 86%. The Russell LifePoints Strategy

has the same target date of 2020, but its stock allocation is 50%. Similarly, the Seligman

TargETFund has a target date of 2025 with over a 94% allocation to stocks. The Van-

guard Target Retirement fund has the same 2025 target retirement date, but a stock allo-

cation of less than 57%.

A major contributing factor to the wide allocation variances is how the fund describes

“retirement.” A retirement fund’s objective could be an allocation policy until retirement

or it could be for life expectancy. Obviously a fund that “tacks on” an additional 18-25

years to its time horizon is going to be much more equity oriented. These funds offered

little protection during the 2008 meltdown (-38% vs. -38% for large cap blend

funds).

Target Retirement Funds [target date 2031-2035]

2011 2010 2009 3 Year* 5 Year* 10 year*

-4% 14% 30% 12.6% -1.0% n/a

* annualized (note: std. dev. over the past 3 years was 22% vs. 23% for large cap blend stock funds

MUTUAL FUNDS 5

PART I

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BEAR MARKET PERFORMANCE

Stock (S&P 500) and bond (Merrill Lynch U.S. Corporate and Government Master In-

dex) returns often move in different directions. The return figures below are cumulative

(sources: Lipper and Bloomberg).

Stocks vs. Bonds During Bear Markets [1977-2011]

Bear Market S&P 500 U.S. Bonds

Jan. ’77 — Feb. ‘78 -14.2% 3.2%

Dec. ’80 — July ‘82 -17.2% 21.0%

Sept. ’87 — Nov. ‘87 -29.6% 2.3%

June ’90 — Oct. ‘90 -14.7% 3.7%

May ’98 — Aug. ‘98 -13.4% 4.2%

Mar. 2000 — Dec. 2002 -33.0% 33.1%

Oct. 2007 — Mar. 2009 -56.2% 7.05%*

Average for Above -25.5% +12.4%

* total return for a 50/50 mix of 5-year and 20-year government bonds

THINGS TO DO

Your Practice

List the five investment and planning topics you know most about as well as five you would

like to know more about.

The Next Installment

Your next installment, Part II, covers five topics: REITs, investing in a house, bank loan

funds, rolling period returns, enhanced appreciation notes and long-short funds. You will re-

ceive Part II in a few days.

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business &

Finance (IBF) to learn about one of its five designations:

o Annuities – Certified Annuity Specialist® (CAS

®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o Taxes – Certified Tax Specialist™

(CTS™

)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For

more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.