Dow Jones Fair Value November 2011

Current Assessment: the Dow Jones is approximately at fair value, with some downside risk.

This Dow Jones Composite Value Index is an aggregation of the 30 companies that make up the Dow Jones Industrial Average.

The aggregation is an approach which effectively combines all companies and treats them as if they were a single entity. Once that is achieved, it is possible to view the Dow companies in totality; measuring:

• combined value versus price – to help determine likely market movements up or down
• the primary valuation technique is on the basis of profitability and does not consider PE ratios, which I believe to be ineffective
• earnings trends, including incorporating leading economic indicators to measure against consensus earnings estimates
• profitability, cash flows, debt levels and financing activities, free cash flows (fundamental stats)
• sentiment indicators are included to provide an additional view of direction or risks
• two value metrics are used: valuation based on consensus earnings forecasts and valuation based on the earnings indicator using economic indicators

Value is a moving target. It is my view that markets are relatively efficient in aggregate over the medium term, but are not efficient at all times over all time-frames. It is also my view that markets are frequently relatively inefficient on an individual company basis over the short to medium term.

Value is a moving target – it is not static. Given that the economy and financial markets are dynamic and constantly forward-looking, value should change frequently. The reason for this is that I judge value not on what happened in the past, but what is happening in the future. Therefore expectations of earnings, and the probability of those earnings being met, are vital to driving perceptions of current value.

Note that this is not a value versus growth perspective. There is no such thing. Prices should generally move towards value, but value can be increasing or decreasing at any point of time. Therefore, there should not be such a thing as a ‘value investor’ or ‘growth investor’. Value is a consideration of what price should be paid on the basis of value heading either upwards or downwards. Situations where price materially diverges from value are likely to be bubbles on the basis of price. From an investment point of view, it is generally the right idea to invest at prices below value and sell at prices above value (with a margin), whilst having consideration as to whether value is increasing or decreasing.

Two companies out of the 30 are excluded – namely the banks JP Morgan and Bank of America. The reason for this is that they skew the fundamental data and reduce clarity of the dynamics of the other companies that are included.