Morningstar Magazine - October/November 2017 - 48

Strategies

Hello CATY
A novel valuation ratio for
predicting returns.

Tax Wise
52

When to Use Charitable Remainder Trusts

54

Investing Over the Lifecycle, Part I

58

Equity: Market Underestimates Nuclear's
ESG Benefits
Credit: Fannie and Freddie's Risk Transfers

RESEARCH

Philip U. Straehl and Roger G. Ibbotson

Quant U

Investment Research

64

Best Ideas
66
68
70

Manager: Contrarian and Concentrated
Passive: Value Giants
Equity: Driving Forward

Over the two decades since the publication of
Campbell and Shiller's seminal paper on
"Valuation Ratios and the Long-Run Stock Market
Outlook" (1998), the cyclically-adjusted price/
earnings ratio, or CAPE ratio, has emerged as the
investment industry's preferred valuation ratio.
The CAPE ratio, which traces its intellectual
roots as far back as Benjamin Graham and David
Dodd's 1934 book Security Analysis, provides
a simple shorthand for investors to assess
a stock market's valuation. While 10-year average
real earnings-the denominator in the CAPE
ratio-are merely a crude proxy of a stock's
intrinsic value, the ratio has performed remarkably
well as a predictor of changes in expected
returns over multidecade sample periods,
propelling its adaption by the investment industry.
Yet, increasingly researchers have raised
questions about the reliability of the CAPE ratio as
a long-term valuation measure. Most recently,
Siegel (2016) suggested that changes in generally
accepted accounting principles have depressed
reported earnings in recent decades, leading
to current CAPE ratios that are too high compared
with historical levels, thus understating
prospective returns. Rather than proposing yet
another fix to the CAPE ratio, we offer a novel
long-run valuation ratio: the cyclically-adjusted
total yield, or CATY. Straehl and Ibbotson
(2017) provided initial evidence on CATY as a
valuation measure, and this article takes a closer
look at the merits of CATY as a predictor of
future returns. We show that CATY is a viable
alternative to CAPE, with stronger predictive power
especially over more recent decades.

48

Morningstar October/November 2017

Earnings vs. Payouts

The debate over earnings or payouts (e.g.,
dividends) as the better measure of the value of a
stock is as old as the modern investment field
itself. John Burr Williams, who invented the
theory of stock valuation as a Harvard University
Ph.D. student, argued in The Theory of Investment
Value (1938) that earnings are only a means
to an end and that investors ought to focus
on dividends (payouts) instead. His definition of
the intrinsic value of a stock was linked
to payouts, not earnings: "A stock is worth the
present value of all the dividends ever to be
paid upon it, no more, no less ... Present earnings,
outlook, financial condition, and capitalization
should bear upon the price of a stock only
as they assist buyers and sellers in estimating
future dividends."
Benjamin Graham, the father of value investing,
was sympathetic to Williams' viewpoint,
arguing in this 1939 book review of The Theory
of Investment Value: "The emphasis on the
primacy of dividends and the insistence that the
value of reinvested earnings is to be found
only in increased dividends sound a much-needed
warning to Wall Streeters."
Why then, do many popular valuation measures,
including the CAPE ratio, use earnings as the main
representative of fundamental value?
Investors tend to use earnings, or net income,
because of accrual-based accounting, where
revenues and expenses are booked when
they occur, not when the cash is received or spent.
This timely matching of revenues and expenses
paints a smoother, more accurate picture
of a firm's finances at any time. A manufacturing
business that collects cash from its customers



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