Market Valuation

The following article first appeared in  Alan Kohler’s Eureka Report on December 9, 2009.

Stocks in aggregate are no longer cheap. They were much earlier in the year, but based on the present levels of profitability they are not cheap any more. Those buying today are doing so in a patently perfunctory manner or are simply motivated by the fear of continuing to miss out. In the short term, losses rather than profits are more likely to ensue for those buying today.
Before you go selling your holdings in a fit of panic, remember there are always at least two views about the market’s short-term direction.

In one corner are the bulls, who say that the equity market’s recent strength is the beginning of a multi-year rally that owes its ongoing support to the fact that looming inflation will deliver negative returns from cash, which, combined with the massive expansion of the monetary base, represents a free, low-doc loan from the government.

In this environment many suggest that asset class inflation is assured. Indeed, just under $20 billion a week has been creeping out of the bomb shelters and into assets such as shares and gold.

In the other corner sit the economic bears, such as Nouriel Roubini, David Rosenberg and Marc Faber, who say the same inflationary and expansionary balance sheet policies of the West have given the US dollar an intrinsic value of zero, which will bankrupt America and produce a complete horror show that makes the last downturn look like a picnic.

Yield Curves.

So who was it that said two people looking at the same set of facts could not arrive at vastly different conclusions? Listening to and reading the apologetics and protestations of these extraordinarily successful investors must make the morning chat with your broker about whether AMP is paying too much for AXA seem inane. (Postscript:  AMP was paying too much for AXA – Nab’s purchase is even more ridiculous).

Perhaps more importantly, to whom do you listen? You cannot base that decision on who is smarter because both groups have geniuses in their ranks; nor can you base your decisions on previous successes because both groups have extremely wealthy proponents.

The answer does not lie with replicating the financial and reputational bets taken by the economists, strategists and traders. Indeed, it lies in not taking a view at all but allowing an entirely different group of facts to dictate your actions.

Those facts are the book values or the equity of companies on a per-share basis, the anticipated profitability of those book values, the manner in which profits are currently retained and distributed (in others words, capital allocation by management) and a reasonable required rate of return.

On these measures most companies are no longer cheap and many are downright expensive. This has occurred for two reasons, that combined, reflect the typical short-term focus of both professional and amateur investors.

The first reason is that share prices have obviously risen. They have risen because Australia has sidestepped a recession, interest rates remain accommodative, our output is in demand and overseas markets have recovered.

The second reason is that shareholders who may have stayed on the sidelines, have pumped money into attractively priced dividend reinvestment plans, placements and rights issues as many of Australia’s largest companies collectively raised $90 billion in the 2009 financial year.

And who can blame the investor who bought shares in Wesfarmers at $29 for wanting to bring down their average price and participate in an entitlement offer to buy three more shares at $13.50 when the rest of the shares they own are trading at $16?

But while the reduction of debt, associated strengthening of balance sheets and stag profits are attractive, there is a nasty downside to all of this.

If I have a company with $100 of equity on the balance sheet and 100 shares on issue, each share is entitled to $1 of the net book value of the assets. If, however, my company’s shares are trading at 10¢ because of the global financial crisis and my bankers ask me to reduce my $100 of debt to $50, I may choose to issue 500 shares at 10¢ to raise the required $50.

The first thing that happens of course is that company equity rises by $50 but more disturbing is that there are now 600 shares on issue. Where once each shareholder owned $1 of equity for every share they held, they now own just 25¢ worth of equity.

And if you are a small shareholder from whom the company couldn’t conveniently raise money, your holding has just been diluted because the institutions got the lion’s share of the placement.

Further, the money raised went to pay down debt rather than investment, so the earnings will only increase by the post-tax interest saved. As a result, the return on equity declines as well and because the true value of a company is inextricably related to the profitability of its book value, company valuations decline.

Valuations have thus declined and yet share prices have risen. As Benjamin Graham said, in the short term the market is indeed a voting machine. And I am not talking about one tiny or obscure corner of the market. Rights issues and placements, according to Paterson’s research, now account for more than 6.5% of total market capitalization: the highest level in more than 20 years.  (Postscript:  figures compiled by trade-futures.com show that 80% of small traders are bullish – the same level as when the market peaked in November 2007).

In the current environment, many value investors will succumb to temptation and their lack of discipline and reduce their discount rates. In doing so they try and keep their valuations from looking out of touch with ever-increasing share prices but really they’re playing catch-up. And when share prices fall slightly, value apparently and suddenly appears.

But the margin of safety is illusory and with returns from stocks unlikely to sustain returns so far out of whack from everything else, real value is some distance below. Only a demonstrated track record can prove otherwise.

Posted by Roger Montgomery, 9 December 2009

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Has the market’s enthusiasm eroded all the safety out of buying stocks? I think so. In fact, for a few weeks now I have been saying that there are very few (read 1 or 2) quality stocks that are cheap. Equity markets are now selling off as investors get nervous again and start thinking about risk. It does appear to me that the rally has not been justified by the economic fundamentals, but more about the US economy in a minut

If you don’t already know, I have no use for P/E ratios. Let me explain why.

Suppose three companies each have $10 of equity per share, each returns 20 percent on that equity and each is trading on a P/E of 10, which equates to $20. The only difference is that the first company is paying out 100 percent of its earnings as a dividend, the second is paying out 50 percent and the third is paying no dividends. If you were to assume that you could buy and sell the shares at the same P/E of ten, the first company would return 10 percent per annum over any number of years, the second would return 15 percent and third will return 20 percent per annum. The third is clearly the cheapest and yet all three had the same P/E of 10. P/E’s can’t tell you very much about valu

There are however times when P/E’s are at such extremes that they provide support to my preferred analysis of the spread between price and value. This is one of those occasions and so, without recognising the validity of P/E’s, I will provide those of you who use P/E’s with the fix that you need.

By definition, if the US economy is recovering, then we recently experienced the last month of the US recession. It would be worthwhile examining the P/E ratio for the S&P/500 Index on the previous occasions that represented the last month of a recession.

Let me start by noting that currently, the trailing P/E is 27. This seems extreme and out of nine recessions since 1954, it is the highest trailing P/E at the last month of a recession, with the exception of November 2001. The other eight observations ranged from a trailing P/E of 8.3 in July 1980 to 17.2 in March 1991. Now some of the years in which the P/E’s were very low were also years of very high inflation, but even if those years are removed today’s trailing P/E is comparatively high.

Many of you will correctly point out that it makes no sense to use trailing P/E’s if we are coming out of a recession because the trailing ‘E’ is unusually low. In such situations, analysts focus on forward P/E’s. (Of course you know my view; if P/E’s are nonsense, then forward P/E’s, sector average P/E’s and the like are simply nonsense squared).

Nevertheless, on one-year forward estimates, the P/E ratio is at 16 times. This is the highest it has been since 2003. Even at the peak of October 2007, the forward P/E was about 14 and the highest it has ever been is 15.4 times.

But while it seems that multiples have, in six months, surged from historic lows to all-time highs, and while conventional wisdom would suggest that P/E’s are at levels normally reserved for the late stages of a bull market, there is a counter argument; at market peaks, such as October 2007, analysts are unusually bullish about the future, while after a recession analysts will be overly cautious about their forecasts. The result is low relative forward P/E’s at peaks and apparently high P/E’s coming out of a recession.

Confused? I am. That’s why I don’t use P/E’s, because they try to predict what the predictors will predict.

What do I really think? I think the stock market has got ahead of itself and the high quality businesses that I look at are now trading above their current valuations and are trading at their valuations two years out. Based on trailing and forward P/E’s (did I tell you I can’t stand P/E’s?) the US market has behaved as if it is in the late stages of a recovery and yet there is still debate about whether the recession is over. US inflation at this stage does not appear to be a threat. Indeed Target and Walmart have started their sales early… that sounds like deflation to me. In the US, rent, restaurant prices, airfares and the prices for personal care products, education, household appliances and tools, hardware and outdoor equipment, confectionary and soft drinks are all plunging. For the week of October 23rd, mortgage applications fell 12.3%! And this was on top of a 13.7%(!) slide the week before. On top of the fact that the Federal Reserve’s Beige Book has indicated that consumer spending remains weak. as does residential construction, architectural billings and commercial construction activity, this suggests that the market has cast its shadow too far forwar

Imagine what the US economy would look like without a $2 trillion injection!

By Roger Montgomery, 29 October 2009

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The US stimulus may have been great for global markets, including our own, but have the benefits to the ‘real’ economy been just as dramatic?

The impact of stimulus packages on the real world appears to be wearing off. By the end of September next year, 70 per cent of the 2009 American Recovery and Reinvestment Act’s $787 billion will have been spent.

According to economics forecaster Moody’s, US stimulus packages contributed ¼% in the first quarter of calendar 2009, 3% in the second quarter, 3.5% in the third quarter (now), and is forecast to contribute ¾% in the next quarter, 1½% in the first quarter of calendar 2010 and ¾% in the second quarter of 2010.

Translation? The Obama stimulus package is having its maximum impact on the ‘real’ economy right now. Data showing the recovery taking root is simply a function of this stimulus. According to Moody’s, this quarter is as good as it will get. The bad news is that from here-on-in, the stimulus will start to wear off.

Now, I am no economist. But there are several prominent experts, like Jim Rogers, who are warning another slowdown is about to occur that will make the recession the US just experienced look like a picnic.

I am equally poor at forecasting stock markets – you will discover over time that it just hasn’t been an essential ingredient in my own investing. But a friend of mine who picked the last market high and low to within a couple of days (please don’t ask me who he is or how he does it), tells me that markets have just seen their medium term highs and have begun another sell-off. This may or may not transpire of course, but he has always impressed me with his uncanny ability to get it right.

So we have some economic forecasters saying be careful, we have a market forecaster saying watch out and now here is my contribution…

I can tell you what a business is worth. I can also tell you that in the short run the stock market is a popularity contest, but in the long run share prices follow values. That’s why it is essential you know the value of the companies you are buying shares in.

When I aggregate all the company values I have estimated, I arrive at an estimated valuation for the All Ordinaries Index of just under 4000 points. This compares to a market that is 600 points, or 15 per cent, higher. That alone however doesn’t mean the market is going down. Valuing a company is not the same as predicting its price, and the reality is that Australia has over 3000 funds chasing less than 2000 stocks. This has the effect of creating a ‘normal’ state that sees the market above its valuation.

But above its valuation it is. So while I am very optimistic about Australia’s future and will never let short-term concerns about the economy or the market stop me from buying shares of great businesses when they are offered at attractive prices, right now I can’t find many great companies that are cheap enough to buy. And some people I have great respect for suggest I should be even more cautious in my optimism. Perhaps you should too.

By Roger Montgomery, 6 October 2009

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One of the most common questions asked by investors, aside from what stock to buy, is; “is the market cheap or expensive?”

So how can investors estimate what the true value of the market is today and where it might be heading in the future?

Who you ask will determine the answer you receive. Some market commentators, experts, advisers and other ‘helpers’ use the P/E Ratio as their measure of fair value, some use charts to show support and resistance levels and some just make an ‘educated’ guess. It is easy to see why many investors become confused and lose confidence in the views of financial professionals, particularly since the aforementioned approaches have such a poor track record of reliability.

Just as I estimate the values of businesses, you can estimate the value of the All Ordinaries Index. That’s because an index is simply a collection of businesses weighted by their market capitalisation.

Applying the same methodology that I consistently use to value individual businesses to the All Ordinaries Index, I get a fair value for the market of around 4,100 points. At the current market price of around 4,510 points, I conclude that the market is not extremely expensive at 10 percent above fair value but nor is it a bargain.

Knowing this doesn’t help me predict where the market is going to go.  Placing a value on the market or any business for that matter is not the same as predicting its price but without a valuation you’re flying blind and merely hoping the shares you buy don’t go down.  That’s not investing, that’s speculating.

Knowledge of what the All Ordinaries might reasonably be worth today provides confidence about how to act.  If the news is plastered with stories of losses in the stock market and all looks like doom and gloom, and if the price of the All Ordinaries index is substantially lower than its estimated value, its probably time to buy.

By Roger Montgomery, 1 September 2009

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Massive windfalls have indeed been doled out to the institutional shareholders of almost half of the top 200 companies in the last act of a scripted and predictable pattern of debt fuelled overpriced acquisitions, followed by rising interest rates, tightening credit conditions and inevitable asset writedowns. Its our very own cash for clunkers scheme!

The next act however is one that shareholders should watch carefully, lest they fall into the trap of paying too high a price themselves.

Giving a company more money irrespective of whether it is through a rights issue, a placement or most other forms of capital raising is akin to putting more money in a bank account; the end result should be more earnings. And so a company that is the recipient of a billion dollars should – if it is going to beat a bank account – deliver an increase in its earnings of at least 5 percent. If the risks associated with businesses and the stock market as well as the dilution that occurs from issuing additional shares are taken into account the increase should be greater still.

Failure to increase earnings means shareholders have gone backwards.

Of course at next year’s beauty pageant (earnings reporting season), companies that boast about record earnings or otherwise substantial increases, should be reminded by reporters, journalists, shareholders and analysts of the vast sums of additional funds they were given. They should also be told that earnings can increase substantially with little more than a bank account, a generous benefactor and a rocking chair.

By Roger Montgomery, 1 September 2009

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