Bad news has been good news for the markets for a long time now. The basic premise has been bad news spells more liquidity as the authorities fight any and all negative notions.
We may be entering a new stretch where the market (and the CBs) are finally able to feel better about life. When good news starts spelling bad news for the markets, this will be the sign that the market is calming down and beginning to clear, ie. equalize valuations.
Showing posts with label valuations. Show all posts
Showing posts with label valuations. Show all posts
Tuesday, June 2, 2015
Wednesday, April 15, 2015
Graham and Dodd tactical allocation rules based on market PE
From Kitces and Pfau in AAII.
Though there are a multitude of ways to define an undervalued or overvalued market, we rely on the switching rules developed long ago by Graham and Dodd (“Security Analysis: The Classic 1940 Second Edition,” McGraw-Hill, 1940). They suggested maintaining the neutral asset allocation when valuations fall within a range between two-thirds and four-thirds of their historical average value. Graham and Dodd increase the stock allocation when valuations are less than two-thirds of their average, and decrease the stock allocation when valuations are more than four-thirds of their average. These numerical bounds correspond to evolving CAPE values of approximately 10 and 21 over time. Given the volatility of the CAPE ratio, these bounds also roughly correspond with the bottom and top quintiles of the historical valuation distribution, which are CAPE values of 11.1 and 21.2 (see Figure 1).
These results suggest that the valuation-based approach is generally superior to the rising equity glide path approach and the fixed equity allocation portfolios, as the valuation-based scenarios produce comparable-to-slightly-better results across the board.
Though there are a multitude of ways to define an undervalued or overvalued market, we rely on the switching rules developed long ago by Graham and Dodd (“Security Analysis: The Classic 1940 Second Edition,” McGraw-Hill, 1940). They suggested maintaining the neutral asset allocation when valuations fall within a range between two-thirds and four-thirds of their historical average value. Graham and Dodd increase the stock allocation when valuations are less than two-thirds of their average, and decrease the stock allocation when valuations are more than four-thirds of their average. These numerical bounds correspond to evolving CAPE values of approximately 10 and 21 over time. Given the volatility of the CAPE ratio, these bounds also roughly correspond with the bottom and top quintiles of the historical valuation distribution, which are CAPE values of 11.1 and 21.2 (see Figure 1).
These results suggest that the valuation-based approach is generally superior to the rising equity glide path approach and the fixed equity allocation portfolios, as the valuation-based scenarios produce comparable-to-slightly-better results across the board.
Friday, April 10, 2015
Average Market Multiple and Its Standard Deviation
Was playing around with Shiller's CAPE database and was curious what the standard deviation of the market multiple was.
Arbitrarily choosing the period 1965 to 2015 the long term average CAPE was 19.7x with a standard deviation of 8.2 (hi = 44.2x, lo = 6.4x).
Using the same period but using a naive PE (ie. non-smoothed), the average market multiple over the period was 18.9x with a standard deviation of 12.6 (hi = 123.7x, lo = 6.8x).
Breaking the period into 5 yr, 7 yr and 10 year rolling periods to simulate various cycles the PE and standard deviations came out to:
Arbitrarily choosing the period 1965 to 2015 the long term average CAPE was 19.7x with a standard deviation of 8.2 (hi = 44.2x, lo = 6.4x).
Using the same period but using a naive PE (ie. non-smoothed), the average market multiple over the period was 18.9x with a standard deviation of 12.6 (hi = 123.7x, lo = 6.8x).
Breaking the period into 5 yr, 7 yr and 10 year rolling periods to simulate various cycles the PE and standard deviations came out to:
| CAPE | Naïve PE | ||||||
| 5 Year | 7 Year | 10 Year | 5 Year | 7 Year | 10 Year | ||
| Average | 19.29 | 19.26 | 19.20 | 19.05 | 18.82 | 18.49 | |
| Standard Deviation | 7.83 | 7.71 | 7.52 | 7.64 | 7.08 | 6.80 | |
| Hi | 36.50 | 33.48 | 31.10 | 33.16 | 30.76 | 31.43 | |
| Lo | 8.59 | 8.87 | 9.39 | 8.10 | 8.81 | 9.37 |
Monday, April 6, 2015
Is The Market Efficient?
I have asked this question a time or two before. But I have thought about it in a different way and have decided for today that the market is not efficient. At least not efficient in the sense that it adheres to some average valuation level.
The problem is the market is overvalued and undervalued for long periods of time. It is hard for an investor to know when it will revert to the mean, and in all likelihood overshoot on the other side.
Overshoot and undershoot are a structural aesthetic of the market. The duration and magnitude of overshoot or undershoot is not well understood.
I would say the market is virtually never efficient. At least not from a valuation perspective.
It seems to me that there are times when the market is overvalued. The implication is market participants are expecting better things in the future. And there are times when the market is undervalued. The implication being market participants are expecting worse things in the future. But throughout, regime changes and overshoot are a function of changing expectations, money flows, fear/greed levels, and liquidity.
Over and undervaluation point to correlated mistakes. Paul Samuelson said something to the effect, markets are macro inefficient but micro efficient. That is probably right although it doesn't make much sense.
Just as correlations and assumptions of normal distributions are non-stationary and change over time, so to does the market average valuation line. With that being the case, one would presume that more recent data (valuation levels) would be more relevant for ascertaining the "modern" average valuation level as compared to a longer term mean. This may or may not be a good assumption to make. Only time will tell ('tis the answer to everything).
The problem is the market is overvalued and undervalued for long periods of time. It is hard for an investor to know when it will revert to the mean, and in all likelihood overshoot on the other side.
Overshoot and undershoot are a structural aesthetic of the market. The duration and magnitude of overshoot or undershoot is not well understood.
I would say the market is virtually never efficient. At least not from a valuation perspective.
It seems to me that there are times when the market is overvalued. The implication is market participants are expecting better things in the future. And there are times when the market is undervalued. The implication being market participants are expecting worse things in the future. But throughout, regime changes and overshoot are a function of changing expectations, money flows, fear/greed levels, and liquidity.
Over and undervaluation point to correlated mistakes. Paul Samuelson said something to the effect, markets are macro inefficient but micro efficient. That is probably right although it doesn't make much sense.
Just as correlations and assumptions of normal distributions are non-stationary and change over time, so to does the market average valuation line. With that being the case, one would presume that more recent data (valuation levels) would be more relevant for ascertaining the "modern" average valuation level as compared to a longer term mean. This may or may not be a good assumption to make. Only time will tell ('tis the answer to everything).
Monday, February 23, 2015
Plenty of Room for the Major Indexes to Go Higher
In homage to Herman's Hermits, "2nd verse, same as the first..." (this was the same case I made in March 2014)
With large cap tech trading at middling multiples (15x) there is still room for the major large cap indices to go higher.
If large cap tech were to play catch-up (moving from 15x to 18x) it would also likely underpin the rest of the market (maybe even add a little to their valuations) and could see the general market indexes rise another 15%-30%.
Last year at this time we saw the high beta momentum plays get hung drawn and quartered even as large cap tech underpinned the "broader" strength in the market. I say "broader" because breadth actually deteriorated significantly (small-mid caps were hammered) but this was not so evident from the large cap major indices.
With large cap tech trading at middling multiples (15x) there is still room for the major large cap indices to go higher.
If large cap tech were to play catch-up (moving from 15x to 18x) it would also likely underpin the rest of the market (maybe even add a little to their valuations) and could see the general market indexes rise another 15%-30%.
Last year at this time we saw the high beta momentum plays get hung drawn and quartered even as large cap tech underpinned the "broader" strength in the market. I say "broader" because breadth actually deteriorated significantly (small-mid caps were hammered) but this was not so evident from the large cap major indices.
Saturday, September 6, 2014
The Conceit of Value Investing
Value investors rightly argue that if you focus on acquiring undervalued assets, ie. assets trading below intrinic value (whatever that is...certainly no objective measure...a post for another day), then the market will eventually come around to recognizing the firm is worth more than what it is currently and start bidding up the price.
The irony or conceit of value investing is that it is generally in a bullish (positive growth) economic environment that either the company's fortunes turnaround or the market has pushed the value of growth and momentum names so high that it is now looking for valuation arbs and comes down to the value end of the market to find those opportunities. A positive economic environment gives the market the confidence to take a punt on a distressed asset and time is the healer of all things (which is why value performs best at the end of a cycle - it is playing catch-up).
Value investors will also argue that value investing works in down markets because you have purchased assets at depressed prices and that provides a cushion (margin of safety) relative to the high priced (multiple) growth and momentum names that have led the market. That has not generally been my experience. In a large market pullback all names seem to fall together.
Value names tend to outperform at the beginning (inflexion point) in a market cycle and toward the middle-end of a market cycle. Growth and momentum names dominate (or lead) the market through the middle of a cycle.
The irony or conceit of value investing is that it is generally in a bullish (positive growth) economic environment that either the company's fortunes turnaround or the market has pushed the value of growth and momentum names so high that it is now looking for valuation arbs and comes down to the value end of the market to find those opportunities. A positive economic environment gives the market the confidence to take a punt on a distressed asset and time is the healer of all things (which is why value performs best at the end of a cycle - it is playing catch-up).
Value investors will also argue that value investing works in down markets because you have purchased assets at depressed prices and that provides a cushion (margin of safety) relative to the high priced (multiple) growth and momentum names that have led the market. That has not generally been my experience. In a large market pullback all names seem to fall together.
Value names tend to outperform at the beginning (inflexion point) in a market cycle and toward the middle-end of a market cycle. Growth and momentum names dominate (or lead) the market through the middle of a cycle.
Tuesday, September 2, 2014
Keep It Simple - The Crux of Value Investing
I don't think you have to do fancy algorithms or deep quant or anything else to uncover deep value. You only have to be patient and be willing to pick-up a good company when the market has discarded it to the side of the road.
I call this value investing. In order to do it you have to have some gumption as to what you think the company is worth. The reason and the cause of the 'fall from grace' are important because you have to discern that it is a temporary setback.
The aforementioned is a company specific self-inflicted own goal or some sort.
The other major time when 'value' investing can work healthily is when the market itself has got itself in a panic and is casting everything out with the bathwater.
Contrarianism is ingrained deep within the process.
Both instances call for a gauge of intrinsic value, conviction, courage and patience. Those are the most important elements to being and becoming a better investor.
I call this value investing. In order to do it you have to have some gumption as to what you think the company is worth. The reason and the cause of the 'fall from grace' are important because you have to discern that it is a temporary setback.
The aforementioned is a company specific self-inflicted own goal or some sort.
The other major time when 'value' investing can work healthily is when the market itself has got itself in a panic and is casting everything out with the bathwater.
Contrarianism is ingrained deep within the process.
Both instances call for a gauge of intrinsic value, conviction, courage and patience. Those are the most important elements to being and becoming a better investor.
Saturday, March 8, 2014
Why and how the market can keep going up as breadth disintegrates
The S&P 500 is at 1878. It is up 1.61% YTD, 23.7% 1 yr, 31% since January 2013, 62.5% since October 2011.
The Nasdaq Composite is at 4,336. It is up 3.2% YTD, 36.8% 1 yr, 42% since January 2013, 75% since October 2011.
Those are all big numbers. Especially in the context of an anemic economy and being toward the end of a regular market cycle.
Earnings growth has been substantial. The S&P is trading at 15x forward earnings. The Nasdaq is trading at 18x forward earnings. Valuation is above average but by no means extreme or even stretched. It could also be argued that with rates low and expected to be low for a long time, multiples could be substantially higher. The march higher has been broad based, lead by small and mid caps.
Beyond the aggregate data, I think there is another catalyst that I have not seen talked about that could easily see the major benchmarks substantially higher (even as the broader market and market breadth falls away).
That catalyst is the low relative valuation of the benchmarks major components. The top 10 companies in the S&P 500 comprise 18% of the benchmark weighting. The top 10 companies of the Nasdaq Composite comprise 32% of the benchmarket weighting. Those companies look to me to be substantially undervalued relative to the benchmarks smaller components. If their multiple were to rise from an undervalued average of 13x to a more normal 15x, then that could easily propel the indexes much higher (throw in earnings growth and dividend yield for added support), even as breadth trails off.
The Nasdaq Composite is at 4,336. It is up 3.2% YTD, 36.8% 1 yr, 42% since January 2013, 75% since October 2011.
Those are all big numbers. Especially in the context of an anemic economy and being toward the end of a regular market cycle.
Earnings growth has been substantial. The S&P is trading at 15x forward earnings. The Nasdaq is trading at 18x forward earnings. Valuation is above average but by no means extreme or even stretched. It could also be argued that with rates low and expected to be low for a long time, multiples could be substantially higher. The march higher has been broad based, lead by small and mid caps.
Beyond the aggregate data, I think there is another catalyst that I have not seen talked about that could easily see the major benchmarks substantially higher (even as the broader market and market breadth falls away).
That catalyst is the low relative valuation of the benchmarks major components. The top 10 companies in the S&P 500 comprise 18% of the benchmark weighting. The top 10 companies of the Nasdaq Composite comprise 32% of the benchmarket weighting. Those companies look to me to be substantially undervalued relative to the benchmarks smaller components. If their multiple were to rise from an undervalued average of 13x to a more normal 15x, then that could easily propel the indexes much higher (throw in earnings growth and dividend yield for added support), even as breadth trails off.
A "bubble" in growth
The market has experienced a massive run over the past year and a half. Much of that is due to the economic/political clouds clearing, confidence repairing, earnings coming through and ZIRP (and all its manifestations, eg. Bernanke Put, etc.) supporting a one-way trade.
But there is no doubt in my mind we are experiencing a growth bubble not too dissimilar to the internet bubble (which granted was a great deal more diffuse) in a number of places. These companies are characterized by rapid revenue growth, low to no profit, and the prospect/hope of future leveraged profitability - sound familiar. What is scary to me is that like the internet bubble it kept going and going until finally you threw in the towel and drank the kool-aid yourself. There are no signs of multiple expansion declining. No signs of a prick.
We will wake-up one day, two weeks, three weeks, four weeks past the peak and realize the game is up. For me that will mean watching the aftermath. I am hopeless at chasing. I will likely have been burned badly fighting it on the way up only to have capitulated and failed to have a position (or worse had a position but failed to have the conviction/patience to let the position ride) to capitalize on the bursting.
There will no doubt come a time when the market will once again focus on long term sustainable profitability with a degree of scepticism toward these sectors (which will likely result in overshoot on the downside). The scales will fall and the reckoning will begin.
Main areas where a bubble burst in valuation will be felt: SaaS, big data, analytics, cloud, biotech, social media.
But there is no doubt in my mind we are experiencing a growth bubble not too dissimilar to the internet bubble (which granted was a great deal more diffuse) in a number of places. These companies are characterized by rapid revenue growth, low to no profit, and the prospect/hope of future leveraged profitability - sound familiar. What is scary to me is that like the internet bubble it kept going and going until finally you threw in the towel and drank the kool-aid yourself. There are no signs of multiple expansion declining. No signs of a prick.
We will wake-up one day, two weeks, three weeks, four weeks past the peak and realize the game is up. For me that will mean watching the aftermath. I am hopeless at chasing. I will likely have been burned badly fighting it on the way up only to have capitulated and failed to have a position (or worse had a position but failed to have the conviction/patience to let the position ride) to capitalize on the bursting.
There will no doubt come a time when the market will once again focus on long term sustainable profitability with a degree of scepticism toward these sectors (which will likely result in overshoot on the downside). The scales will fall and the reckoning will begin.
Main areas where a bubble burst in valuation will be felt: SaaS, big data, analytics, cloud, biotech, social media.
Friday, February 21, 2014
WhatsApp and Facebook = Jump the Shark
The smart money is using the fleeting money (high stock valuations) to hit the exits.
Whether it is Facebook using its funny money (stock) to buy WhatsApp for $19b, or the raft of other mega-valuation names (LNKD, TWTR, CSOD, NOW, P, AMZN, WDAY, CNQR, SPLK, DDD, SSYS, etc.) who are hitting the market market with secondaries and/or convertibles or debt of some sort, I think the smart guys are taking money off the table.
We are moving into the 2Q doldrums so I think this is probably a good time to shorten up as well. The market hasn't broken yet, but when it does there will be lots of regret. The writing was on the wall.
Whether it is Facebook using its funny money (stock) to buy WhatsApp for $19b, or the raft of other mega-valuation names (LNKD, TWTR, CSOD, NOW, P, AMZN, WDAY, CNQR, SPLK, DDD, SSYS, etc.) who are hitting the market market with secondaries and/or convertibles or debt of some sort, I think the smart guys are taking money off the table.
We are moving into the 2Q doldrums so I think this is probably a good time to shorten up as well. The market hasn't broken yet, but when it does there will be lots of regret. The writing was on the wall.
Wednesday, October 2, 2013
Megacap Tech on Sale
Hard to really understand why the megacap techs trade at such a large discount to the market, their history and their fundamentals in an environment where everything else (with the exception of materials/cyclicals) are going through the roof.
The market is essentially saying that it thinks these pseudo monopolists are essentially dead men walking. It sees the young upstarts as the future, and the old lions as history.
The contrast is stark and amazing:
MSFT v CRM
ORCL v N
SAP v WDAY
INTC v LNKD
AAPL v ARMH
CSCO v RAX
HMC v TSLA
The market is essentially saying that it thinks these pseudo monopolists are essentially dead men walking. It sees the young upstarts as the future, and the old lions as history.
The contrast is stark and amazing:
MSFT v CRM
ORCL v N
SAP v WDAY
INTC v LNKD
AAPL v ARMH
CSCO v RAX
HMC v TSLA
Thursday, August 1, 2013
The Cloud Bubble
There is nothing more irksome than the smugness of some momentum guy who dismisses valuation as irrelevant.
The current hot air craze is with "cloud" companies:
Amazon
LinkedIn
Netsuite
Workday
Salesforce.com
Concur Technologies
Commvault Systems
All these companies have solid topline growth, but there are minimal cashflows relative to their market value. The market is incorporating an awful lot of future unknown growth into present valuations.
For example, Workday (WDAY): $12b cap, $11b EV, 38x P/Sales, 750x TTM cash flow, 15% short interest, TTM sales are $308m, topline growth rate is 61%. The firm hasn't gone FCF positive yet, but is at the inflection point. What size do revenues need to be to justify a $12b market cap in the competitive tech industry? I would say a reasonable multiple is 4x-5x sales. 5x sales assumes revenues of $2.4b - that equates to a 50% CAGR rate over the next 5 years. Is that possible? Yes. Is it likely? Probably not (unless they are the next incarnation of Microsoft or Dell...but their addressable markets are much smaller and their competition much greater). Assuming 30% operating margins, then $2.4b in revenues produces $720m in EBITDA. That translates to the current stock price trading at 15.27x 5 yr EV/EBITDA. That is not todays EV/EBITDA multiple. That is 5 years from now, which assumes an awful lot has gone right. And if there is one thing we know from the tech world, 5 years is an eternity to techdom.
The most likely scenario is that these names will continue to trade at high multiples reflecting their leadership positions in high growth areas, but at some point in the future a transition or transposing of sentiment will take place and the tyranny of multiple compression will weigh down future appreciation. They may continue to grow like weeds and they may become obscenely profitable, but they will be paid less and less for those returns. In the case of dotcom leaders (CSCO, EBAY, INTC, MSFT, ORCL, EMC) they grew their earnings substantially but shareholder returns were highly muted by multiple compression.
The current hot air craze is with "cloud" companies:
Amazon
Netsuite
Workday
Salesforce.com
Concur Technologies
Commvault Systems
All these companies have solid topline growth, but there are minimal cashflows relative to their market value. The market is incorporating an awful lot of future unknown growth into present valuations.
For example, Workday (WDAY): $12b cap, $11b EV, 38x P/Sales, 750x TTM cash flow, 15% short interest, TTM sales are $308m, topline growth rate is 61%. The firm hasn't gone FCF positive yet, but is at the inflection point. What size do revenues need to be to justify a $12b market cap in the competitive tech industry? I would say a reasonable multiple is 4x-5x sales. 5x sales assumes revenues of $2.4b - that equates to a 50% CAGR rate over the next 5 years. Is that possible? Yes. Is it likely? Probably not (unless they are the next incarnation of Microsoft or Dell...but their addressable markets are much smaller and their competition much greater). Assuming 30% operating margins, then $2.4b in revenues produces $720m in EBITDA. That translates to the current stock price trading at 15.27x 5 yr EV/EBITDA. That is not todays EV/EBITDA multiple. That is 5 years from now, which assumes an awful lot has gone right. And if there is one thing we know from the tech world, 5 years is an eternity to techdom.
The most likely scenario is that these names will continue to trade at high multiples reflecting their leadership positions in high growth areas, but at some point in the future a transition or transposing of sentiment will take place and the tyranny of multiple compression will weigh down future appreciation. They may continue to grow like weeds and they may become obscenely profitable, but they will be paid less and less for those returns. In the case of dotcom leaders (CSCO, EBAY, INTC, MSFT, ORCL, EMC) they grew their earnings substantially but shareholder returns were highly muted by multiple compression.
Thursday, May 16, 2013
Don't Be Fooled By The Present
A good rule of thumb when modeling firms and valuing equities is not to be fooled by the present. Normalizing growth rates, margins and discount rates attempts to estimate the value of a firm over a cycle.
Here is the problem.
In accord with financial theory, market practitioners are using the 10 yr Treasury bond (or even the 5 yr) as the risk free proxy in their DCF models. When you extrapolate linear topline growth based on the recent past (ie. the recovery out of the pit) throw in a little margin expansion (a lot actually because they are universally optimistic) and then discount the future expected cash flows at basically 1% or 2%, then a lot stocks are going to look awfully attractive. And that is where we are at right now. That is what QE does. It distorts the lens through which value is assessed.
I model with a normalized risk free rate of 5% (that assumes a real return of 3% and 2% inflation). The result is drastically different from the current consensus.
If and when the economy and markets normalize (and I think they are well on their way to doing that now) and analysts start putting higher risk free rates into their weighted average cost of capital calculations, then you are going to see large headwinds for valuations (ie. target prices). That doesn't even take into account the cost of rising interest rates on the actual cash flows of a business funding off shorter term debt.
It has been a free ride for a while, but you want to get off that train before it jumps the tracks. With the Fed on hold until at least 2014 and maybe into 2015 (depending upon economic activity and the level of unemployment), then it might still be a while before that transition takes place. Having said that, the market will in all likelihood anticipate the future rise of rates and begin factoring it into models before we see the actual change.
Here is the problem.
In accord with financial theory, market practitioners are using the 10 yr Treasury bond (or even the 5 yr) as the risk free proxy in their DCF models. When you extrapolate linear topline growth based on the recent past (ie. the recovery out of the pit) throw in a little margin expansion (a lot actually because they are universally optimistic) and then discount the future expected cash flows at basically 1% or 2%, then a lot stocks are going to look awfully attractive. And that is where we are at right now. That is what QE does. It distorts the lens through which value is assessed.
I model with a normalized risk free rate of 5% (that assumes a real return of 3% and 2% inflation). The result is drastically different from the current consensus.
If and when the economy and markets normalize (and I think they are well on their way to doing that now) and analysts start putting higher risk free rates into their weighted average cost of capital calculations, then you are going to see large headwinds for valuations (ie. target prices). That doesn't even take into account the cost of rising interest rates on the actual cash flows of a business funding off shorter term debt.
It has been a free ride for a while, but you want to get off that train before it jumps the tracks. With the Fed on hold until at least 2014 and maybe into 2015 (depending upon economic activity and the level of unemployment), then it might still be a while before that transition takes place. Having said that, the market will in all likelihood anticipate the future rise of rates and begin factoring it into models before we see the actual change.
Friday, February 11, 2011
A Back of the Envelope on the Pullback
I've been concerned that the mega caps haven't participated in the rally, and their playing catch-up will in fact drive the market higher (even as we get a rotation out of smid caps).
Consequently, when you look at the Naz and S&P 500 I'm not expecting them to fall too much. Doing a back of the envelope of the major indexes:
* 50%+ of each index is comprised of stodgy mega-caps trading at an average of about 15x forward earnings (even when you include Apple and Google and Amazon).
* It seems obvious to me that the large caps are undervalued relative to the smid caps. Smid caps are trading at roughly 18x forward earnings (and that might be understating it).
* When the "risk on" trade expires and the "risk off" trade returns, it is easy to see a little pullback and rotation along the following lines. Large cap multiple compression from 15x to 14x (6%-7% decline), smid cap multiple compression from 18x to 15x (16%-17% decline)....translates to a 10% market decline (assuming a 60/40 large cap/smid cap breakdown - in fact the breakdown is closer to 88/12).
In the absence of any serious weakness in earnings (and the economy), it is highly unlikely that we will see much more than a 10% correction, unless PEs were to compress due to some major risk factor.
Consequently, when you look at the Naz and S&P 500 I'm not expecting them to fall too much. Doing a back of the envelope of the major indexes:
* 50%+ of each index is comprised of stodgy mega-caps trading at an average of about 15x forward earnings (even when you include Apple and Google and Amazon).
* It seems obvious to me that the large caps are undervalued relative to the smid caps. Smid caps are trading at roughly 18x forward earnings (and that might be understating it).
* When the "risk on" trade expires and the "risk off" trade returns, it is easy to see a little pullback and rotation along the following lines. Large cap multiple compression from 15x to 14x (6%-7% decline), smid cap multiple compression from 18x to 15x (16%-17% decline)....translates to a 10% market decline (assuming a 60/40 large cap/smid cap breakdown - in fact the breakdown is closer to 88/12).
In the absence of any serious weakness in earnings (and the economy), it is highly unlikely that we will see much more than a 10% correction, unless PEs were to compress due to some major risk factor.
Saturday, June 20, 2009
What A "New Normal" Might Look Like
I'm a 'new normal' kind of guy and I was just musing what a 'new normal' might look like. Here is what it might look like from an investment perspective in a generalized example:
T-5 T-4 T-3 T-2 T-1 Reset T+1 T+2 T+3 T+4 T+5
Revs ($m) 80 85 90 95 100 70 80 83.5 87 91 95
Profit Margin (%) 20% 20% 20% 20% 20% 5% 10% 10% 10% 10% 10%
P/S multiple (x) 2.5 2.5 2.5 2.5 2.5 1.5 1.8 1.8 1.8 1.8 1.8
Firm Value ($m)* 200 212.5 225 237.5 250 105 144 150.3 156.6 163.8 171
Return 6.25% 5.88% 5.56% 5.26% -58.00% 37.14% 4.38% 4.19% 4.60% 4.40%
*Firm value = Revs x P/S multiple
The table above assumes a 'new normal' world, ie. lower growth rates, lower multiples (higher risk premium), and lower margins - much of the 'new normal' hypothesis depends upon growth rates failing to return to normal (due to consumer deleveraging and increased taxes). Here are a couple of takeaways: (1) We experienced a 58% asset reset last year, reflecting an 80%+ decline in reported profits (I consider that the first wave of deflation), (2) We get a bounce gain of around 37% after the reset (already had it), (3) Firm value will take a long time to recover (hard to get back wealth losses if we're going into a 'new normal'), (4) To reduce the damage of the asset reset, you absolutely needed to stay in the market to capture the bounce.
I was astounded by the implications of the 'new normal' world wrt the loss of wealth (or firm value), but the biggest takeaway from this example is the fact that when you reset asset prices by 58%, long term expected returns are pretty good.
I could have used PE instead of PS for valuation purposes (I prefer PS, especially in a period like the present), and it would have conveyed the same sense.
P.S. Sorry the table looks bad. You'll have to bear with me on that one.
T-5 T-4 T-3 T-2 T-1 Reset T+1 T+2 T+3 T+4 T+5
Revs ($m) 80 85 90 95 100 70 80 83.5 87 91 95
Profit Margin (%) 20% 20% 20% 20% 20% 5% 10% 10% 10% 10% 10%
P/S multiple (x) 2.5 2.5 2.5 2.5 2.5 1.5 1.8 1.8 1.8 1.8 1.8
Firm Value ($m)* 200 212.5 225 237.5 250 105 144 150.3 156.6 163.8 171
Return 6.25% 5.88% 5.56% 5.26% -58.00% 37.14% 4.38% 4.19% 4.60% 4.40%
*Firm value = Revs x P/S multiple
The table above assumes a 'new normal' world, ie. lower growth rates, lower multiples (higher risk premium), and lower margins - much of the 'new normal' hypothesis depends upon growth rates failing to return to normal (due to consumer deleveraging and increased taxes). Here are a couple of takeaways: (1) We experienced a 58% asset reset last year, reflecting an 80%+ decline in reported profits (I consider that the first wave of deflation), (2) We get a bounce gain of around 37% after the reset (already had it), (3) Firm value will take a long time to recover (hard to get back wealth losses if we're going into a 'new normal'), (4) To reduce the damage of the asset reset, you absolutely needed to stay in the market to capture the bounce.
I was astounded by the implications of the 'new normal' world wrt the loss of wealth (or firm value), but the biggest takeaway from this example is the fact that when you reset asset prices by 58%, long term expected returns are pretty good.
I could have used PE instead of PS for valuation purposes (I prefer PS, especially in a period like the present), and it would have conveyed the same sense.
P.S. Sorry the table looks bad. You'll have to bear with me on that one.
Thursday, April 30, 2009
PacSun (PSUN) Getting a Makeover
I had Pacific Sun (PSUN) on a solid balance sheet, low P/Sales screen, but failed to act on it as other retailers with similar characteristics started moving (CHS, CHIC). But a little bit belatedly, PSUN has been getting a re-rating lately. It has gone from $1.39 on April 8th to a high of $4.25 today (205%).
Unlike Talbots which rallied inexplicably last year when it got a little debt relief (but who was going to buy their lousy clothes) and provided a decent short opportunity, the same is not necessarily true for PSUN because it has a better balance sheet.
But having a decent balance sheet in the retail space is no guarantee that hard times won't catch you out. Select Comfort (SCSS) is a great example of a once "market darling" with a little bit of cash set aside for a rainy day, failing to provision sufficiently for when the rains came. It was amazing how quickly its financial position changed from one of relative strength to one of "where's the cash going to come from."
Incidentally, SCSS has had a nice rally from $0.19 to as high as $1.40 (636%) - wow, wish I had been on that one.
Disclosure: No personal or professional position in any stocks mentioned.
Unlike Talbots which rallied inexplicably last year when it got a little debt relief (but who was going to buy their lousy clothes) and provided a decent short opportunity, the same is not necessarily true for PSUN because it has a better balance sheet.
But having a decent balance sheet in the retail space is no guarantee that hard times won't catch you out. Select Comfort (SCSS) is a great example of a once "market darling" with a little bit of cash set aside for a rainy day, failing to provision sufficiently for when the rains came. It was amazing how quickly its financial position changed from one of relative strength to one of "where's the cash going to come from."
Incidentally, SCSS has had a nice rally from $0.19 to as high as $1.40 (636%) - wow, wish I had been on that one.
Disclosure: No personal or professional position in any stocks mentioned.
Monday, April 27, 2009
One of many dilemmas
One dilemma I have been wrestling with is to what extent is the future economic performance of the economy factored into current equity/asset valuations. With equity prices off over 58% at their lows, an awful lot of future bad news was being factored in. This largest decline since the Depression made sense to me because we were dealing with the largest economic decline since the Depression (in addition to a financial crisis of global proportions). But the question is did we overshoot on the downside and what is a reasonable level for equities given interest rates, growth prospects and a greater appreciation for risk. I do a lot of back of the envelope calculations in order to gauge perspective and am a great believer in normalizing things, especially in the midst of an extreme event. As such back in January when I put pen to paper and tried calculating a ballpark fair value number for the Standard & Poors 500, I came up with normalized EPS of $65 and a normalized PE multiple of about 15 to arrive at a ballpark fair value of somewhere between 900-975 [Note: this calculation was done in the midst of downward earnings revisions taking S&P 500 earnings to $40 and multiples of 8 being thrown around as reasonable - pointing to levels of 320-500 on the Standard & Poors].
P.S. The divergence between all the positive information coming out of China and the performance of the FXI recently may be telling of something. Keep an eye on that.
Disclaimer: I have a personal position in the FXI.
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