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CHAPTER 11: Using the RPF Model for Inve... > Beware of RPF Shifts - Pg. 137

Using the RPF Model for Investment and Business Strategy 137 were set to change. The key to applying the model lies in assessing the inputs and applying appropriate factors. These examples illustrate how the RPF Model can be used as a predictive tool. The articles illustrate my thought process in analyzing the situation at the time, without benefit of hindsight. In this case, the model clearly showed that S&P 500 Index was undervalued relative to Treasury yields and current earnings, but could isolate the cause. Since earnings appeared reasonable, the cause of the divergence could be narrowed to either index price or Treasury yield as the cause. As it turned out, the gap between predicted and actual was closed in equal parts by a rise in yield and increase in price of the index. BEWARE OF RPF SHIFTS As discussed in Chapter 2, the RPF can shift. It shifted in 1981 and in 2002, both in response to major economic events. Surprisingly, it did not appear to have shifted during the 2008 to 2009 crisis--as we've seen it still explains the market. The fact that the past shifts were 20 years apart does not mean it will shift every 20 years. It is an important number, and you need to be aware that it can change. A shift in the RPF can cause it to appear that either a bubble has formed or a buying opportunity is present when the deviation of predicted from actual values was actually caused by the RPF shift. For example, in mid-2002 the market appeared to be significantly undervalued, when the RPF had actually jumped from 0.90 to 1.48. It was not clear that this was a permanent shift until later. However, as described in Chapter 2, an analysis of events at that time, including enactment of Sarbanes-Oxley and the start of the war in Iraq, could have provided a clue. INVESTING IN INDIVIDUAL COMPANIES Investing in individual companies is not for dilettantes. Professionals who manage investment funds spend huge amounts of money to learn about their targets. These are smart people who are paid well to do nothing but study companies. In order to compete, you need to do some work. When it comes to evaluating individual companies, the RPF Model does not provide absolute answers, but helps identify opportunities where companies may be mispriced relative to the market or peers and suggests where further analysis can be leveraged. It is ironic that executives will spend a huge number of hours analyzing (or directing their subordinates to analyze) relatively small investments, yet manage their portfolios without having nearly the same level of diligence.