Wednesday, December 27, 2006


Charles Dow, who gave his name to the Dow Jones Average and was also the longtime publisher of the Wall Street Journal, the most indispensible publication anywhere, famously remarked that to understand the movement of the stock markets, it was key to understand changes in valuation of stocks. As I look at valuations, unfortunately, they seem mighty high.

High Valuations

With corporate profits at all time highs, the market trades at 18 times (trailing 12 months) earnings. Bulls suggest that on a forward earnings basis this is more like 15 times, which is historic. They are right and wrong. Forward earnings are obviously more important than past earnings (only assets still held by the company that are available for distribution to shareholders count, but more on this in a bit), and 15 times earnings is a historically accurate figure (but for trailing, and not forward, earnings on which basis stocks have have valued closer to 13.8 times).

John Mauldin (check out his website from my links at right) notes that at profit margins from the 1990s(!) stocks would be trading at earnings of 25 times. Margins have improved primarily from two things, one, lower borrowing costs and two lower tax rates. That is, net income has increased from reductions in non-operating expense. Thus, businesses aren't really better today, external factors have aligned to reduce their costs.

Slowing earnings growth

In my last post, I talked about the expecations of relatively low growth in the earnings of assets in the future. The rates anticipated by Buffett and Gross are significantly lower than either the recent rates growth in earnings (the US economy is now in something like its 18th straight quarter of double digit earnings growth), nor anticipation of future earnings (which continue to call for double digit growth for some time, followed by high single digit growth). Some companies, of course, will experience strong growth in earnings like this, but as noted in my last post, all companies cannot grow earnings (corporate income) faster than overall income (GDP) beyond a few years.

Business have used low interest rates and lower tax rates to improve their balance sheets by refinancing and retiring debt, and by retiring equity in the form of stock buybacks. These conditions are often mistaken by bulls to mean that future earnings and cashflows should be much higher. In fact, business decisions are indicative of a very negative investing climate. Rather than use cheap credit to expand operations, they are using cheap credit to alter their capital structure. This is not a bad thing, per se, but it means that rather than borrow to acquire more assets to scale up and increase business activities, it means that they feel their current level of assets is adquate, and that they would rather reduce the claims on those assets. This may help earnings per share, but not earnings.

Their logic goes something like this. Say you are 10 years into a 30 year mortgage. If you take advantage of lower interest rates to refinance your mortgage and stretch payments out over a longer horizon, back to 30 years - and with cheap money why wouldn't you - you now have much higher cashflows than you had before. You have lower interest cost each month (because the balance is now financed at a lower rate, plus, you have smaller principal payments every month, because you are now going to amortize the principal over 30 years instead of 20). The question is what do you do with those cashflows? To keep this example representative, we have to assume that the property on which the mortgage is held is an investment property, and that it is profitably rented.

If all else remains equal - rent collected, etc - as a result of this change, your income will go up (because your interest expense will go down). But the logical thing to do, if the real estate business looks promising, is actually to relever the property by using the lower interest rate and longer payment horizon to keep the same payment, but take money out and use that money to purchase more real estate (thereby expanding operations and earning more money). If you aren't investing in more real estate in that environment, what does that say about business prospects? Might they be worsening? Might that mean that you would have lower income going forward? Even if interest rates remain low, maybe overbuilding or other conditions mean that rents in your area are falling (or are likely to fall, which is why you aren't committing to expanding your holdings).

Instead, businesses are using that higher income to either pay of other debts, increase cash (which improves balance sheet liquidity) or buy out partners (by repurchasing stock). Now, the stock repurchases are mostly a good idea. They reduce capital and assets, and thereby improve returns on equity (assuming that there is no impact on the business, the remaining shareholders should get more money, because the pie can be cut into fewer pieces).

Understand - this is NOT BULLISH!!! If interest rates are falling, why would you pay off debts, unless returns on capital are falling at least as fast? Think of it this way, if you used borrow at 3% and earn 6% on that money, and did so happily, and now you can borrow at 1%, why wouldn't you try and borrow more, even if you could only earn 5%, your margin would be greater. Plus, as you borrowed more and leveraged up, your returns on equity would improve (just like buying back stock). If instead you simply refi-ed your existing loans and took the extra cashflow and bought out your partners, what does that say about your expectation of growth prospects?

Worse yet, what if the favorable tax environment were to change ?

Thus, as investors, we have to assume lower earnings growth going forward. We also have to be willing to put a premium on quality earnings.

Options, the silent killer

So, values are high and earnings are set to slow down. When it comes to valuations there is one final issue - and that is options. If stock is repurchased, and prices rise, this helps option holders because as each share gets a greater portion of the pie, its value increases (and with it the value of the option). Worse, many of these options are not included in calculations of earnings per share (even diluted earnings per share often exclude significant amounts of options outstanding, because of an accounting convention that I will explain in a later post).

I have no detailed analysis on this, outside of the companies I follow, but I can tell you that P/E ratios on those stocks would be about 10% higher than they already are if all options were exercised. In the case of one stock I follow, complete dilution, including the effects of options and convertible prefered stock would push P/Es to above 30! Yikes! (I really should sell - Credit to the reader who figures out which stock it is).

As an investor, it is key to assume that all options will be excercised (even those that are "under water") because if the investment is a good one, price appreciation will almost certainly result. That is, nearly every good investment assumes that you are purchasing at a discount. The subsequent price rise will likely get options (at least those issued as compensation) above water. On that basis, if my experience is representative, then most companies have about 10% of their stock in options that are not counted in shares outstanding when diluted earnings per share are calculated and therefore the earnings per share is 10% lower than reported, and the P/E must therefore be 10& higher than reported. On a straight basis, that suggests that stocks are trading closer to 20 times earnings today, and on the John Mauldin 1990s margin basis, at 27.5 times.

No wonder finding good investments has been so damn hard.

Bill Gross on the Alpha/Beta Challenge

Well, I have just returned from beautiful and warm Thailand. Thai must mean "snacks" in Thai, because the country is literally full of them. I have to say, it was pretty interesting having 78 degrees (Fahrenheit, that's 24 degrees Celsius) on Christmas Day. I'm now in Munich again, where it's sunny (if only for a few hours a day), but -3 (Celsius, which is 26 degrees Fahrenheit. It is an adjustment).

Any event, with my return to broadband, I am also catching up on my back reading, which has been severely curtailed by vacation travelling and sightseeing, moving countries, leaving my former employer and gearing up for a year at the University of St Gallen in Switzerland, where we compress a 22 month degree (the MBA) into 12 months.

But to the topic of this article, Gualberto Diaz has written a post about the current arguments between bulls and bears. I just read a great assessment by Bill Gross, the Managing Director at Pacific Investment Management (PIMCO) about the dilemma that we as investors are facing, which also sheds some light on the issue of what sort of markets to expect going forward. He describes it as the Alpha/Beta anemia. It's implications are far-reaching for investing strategy.

Start with a basic (and correct) assumption. Since GDP measures the overall income from domestic sources (domestic assets), over long periods, returns on assets are likely to rise in lock-step with growth in (nominal) GDP. Many investors still long for the "good old days" when double digit investing returns were common. This was due to the fact that from 1970-1985, nominal GDP increased in double digit amounts. (In the 1970s, asset price returns - which can diverge sharply from the growth of the underlying business income - lagged overall GDP growth, setting the stage for asset price growth stronger than GDP growth in later years to restore the correlation), and the period after 1993, when real GDP grew at 4-5% per year for most of a decade. While nominal GDP increased around 8%, any selectivity in investment choices meant that returns above 8% were easily obtained (and were easily magnified by using financial leverage, i.e. buying on margin).

Unfortunately, from one perspective, those days are over, at least, it would appear so. Economic growth (GDP by another name), is averaging much closer to 2.5%, with inflation matching that figure for a nominal GDP rate of 5% or so per year. Assets should return, therefore, something like that figure. Applying financial leverage (debt) might enable investors to push that up by 1 or 2%. Since asset price levels (in the very long term) reflect earning power of the underlying assets, asset prices (investor returns) are likely to be in this range. Incidentally Warren Buffett wrote an article in Fortune a few years back, and said about the same thing - he expected 6% returns going forward.

Are you still with me? In short, what Gross is saying is, asset income growth should be between five and six percent in the future, with the opportunity to use debt to improve returns on equity to six to seven percent per year. This figure, also called "beta" which describes how much of an investment's price movements can be correlated to market price movements (a basket of stocks with perfect market correlation has a beta of 1.0) is simply too anemic for most investors.

Faced with these returns, however, investors are essentially saying, "that's fine for other people, but I need at least nine or 10 percent". There are several reasons for this, Gross mentions only one, which is the fact that six or seven percent returns will not be adequate to fund future liabilities. He does not specify which liabilities he means but my sense is that he means healthcare and retirement expenses. This blog has said as much many times over (see retirment crisis).

As a result, investors are instead seeking out riskier investments, those that tend to have higher "alpha" which is the additional "reward" that riskier investments should offer. But with that effort to find higher return investments (like small-cap stocks, a favorite of "foolish" investors, particulalry right now), the ususal price discounts that these investments offer in return for their high risk (the risk premium) has diminished. In fact, small cap stocks, far from trading at a discount to large issues, trade at a substantial price premium (which, to some degree may be mitigated by the potential for faster growth, but this is what these alpha-seeking investors are all assuming).

You know what happens when people are lining up to buy something, particularly something that is sold at an auction (which is the case with stocks!), buyers overpay.

In short, what has happened is that the price of risk, the risk premium, has declined substantially. The implications are significant. First, periods of significant stability can actually create risk, because over long periods investors become accustomed to being rewarded for making ever riskier bets, until, unfortunately, they aren't. When the tide turns, many investors will find they have been "swimming naked" in the words of Buffett.

Worse, systemmic underpricing of risk means that index-weighted portfolios (which are weighted in large part based on price levels) will always over-invest in over-priced assets, and under-invest in (risk-adjusted) underpriced assets, as the overpriced assets have higher market capitalization relative to earning potential, and underpriced assets, by definition, have low capitalization relalitve to earning potential. Indexers, in other words, far from being protected by "diversification" will discover that diversification has them overinvesting in today's high priced assets. While their losses might not be as spectactular as those of an investor who was 100% invested in "optical networking" stocks in 2000-2001, losses of 30-50% in diversified porfolios will be little comfort.

Gross suggests, I believe rightly, that the only thing an investor can do is seek to concentrate his money in the single few best investments he can find. Those that offer opportunities to earn superior (and here he means 7%) returns with comparably little risk.

He does not believe that assuming addtional financial leverage is a smart move at this point. Basically, there are two options, the first is that the Fed will renew vigilance with respect to inflation and again raise interest rates. This will reduce financial leverage in the system, which _should_ make things safer, but might also lead to a collapse in certain overvalued asset prices, thereby provoking the crisis that the Fed hopes to prevent. Or, the Fed can allow higher inflation, which, while it will prevent (at least in the short term) a credit crisis, inflation also generally leads to lower asset prices as the twin effects of taxes and higher discount rates reduce present values of assets thereby leading to price declines or stagnation (like the 1970s).

Finally, unmentioned by Bill Gross, but mentioned by Gualberto, most businesses are at peak earning cycles. corporate profits' share of GDP is at all time highs (which is one way that asset prices have outstripped GDP growth over the past three years). The trend of business income increasing faster than overall income cannot continue indefinately. Tax levels linger near post-war lows as (unrecognized) government liabilities pile up on balance sheets, which foretells of greater tax burdens in the future; corporate income, already at high levels, is a natural target for revenue raising.

Finally, we have the issue of those other pesky liabilities for which assets earning six or seven percent - the ones I call the Boomer-Lifestyle Liabilities. These are the costs associated with retiring in the style the Boomers imagine themselves living. Let me make this clear, Boomers, as a group, will live a retirment lifestyle well below that which they are living now. There are various ways that they can help to reduce the gap - they can continue to work in retirement (or not retire), they can pick really great investments (but not all of them can) and they can win the lottery (again, not all can do this either), which means that Boomer consumption will begin declining.

Lower consumption (and higher savings) means more money chasing assets of declining quality (less consumption means lower business income). I don't have to tell you where that leads.

What does this all mean? Most of the bull arguments I have seen are really trader/herder mentality. It amounts to "ride the wave", with a focus on recent economic reports and stock market price level movements as a reason to invest. I will not tell anyone not to ride the wave. But I will ask, what happens when the tide turns, as it will, maybe next year, maybe 2009. Are your assets good enough to survive a major change? Even good enough to survive a tsunami? As Thais can tell you, bad things can happen even when the weather seems perfect at the beach.