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.

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