Once again the stock market has confounded conventional wisdom, this time by rallying during the traditionally weak period of August and September. Many market observers felt that the quiet period during August was the calm before the September storm. But the market has kept rallying. Now the experts say this was due to anticipation and realization of more quantitative easing by the Federal Reserve. Fair enough. But there may be more going on as well. Some of the rally is probably attributable to a very justifiable expansion in PE multiples. Many stocks are still valued at ratios that are close to those at the market bottom in 2008-09. In other words, while earnings have expanded, valuation metrics have not. These low valuations are arguably due to an under-allocation by both individuals and institutions to stocks. Many retail investors have stepped back from “the stock market” because they cannot afford another 2008, but in so doing they ignore the fact that it is a market of stocks. Many institutions have made significant cutbacks in their exposure to stocks during the past decade in the interest of broader diversification. Negative investor sentiment creates opportunity.
We have done well in this rally. Most of the stocks that I complained about last quarter staged nice rebounds. The S&P 500 returned 6.35% for the quarter while your account returned 6.85%.*
I’m not suggesting that maintaining near-full exposure in stocks is easy. A bear would say that valuations are cheap because current earnings are not sustainable in light of the economic problems in Europe and China, as well as our own debt problems. Our view is valuation focused; we cannot predict the future. When something is cheap based on historical metrics, it creates a favorable risk/reward situation. Our analysis includes an examination of the earnings patterns of individual companies during economic downturns. We invest accordingly, while attempting to appropriately define our risk parameters. Whether the downside is fully priced in is the great unknown. A stock that seems cheap at a PE ratio of 10 can drop to a PE ratio of 8 – which implies a 20 percent loss.
The market is still difficult to navigate. Stocks have been unusually correlated with one another, so that cheap and richly valued companies are trading more in tandem than is justified by fundamentals. Careful research has not produced outsized rewards this year, but should over time. So we continue to look for stocks where the growth in earnings and revenue is strong, where the price seems cheap relative to estimated earnings, and where valuations seem to be at the low end of the range for the past decade or more based on historical and current earnings.
Here are some examples. United Theapeutics (UTHR) is a $3 billion drug company that addresses heart disease, cancer, and infectious diseases. Value Line says that its appreciation potential is “well above average”. It has been growing earnings and cash flow at a rate of nearly 60% compounded annually over the past five years and yet trades at a PE ratio of only 12. Although earnings dipped in the last recession, revenue per share did not.
MasTec, Inc. (MTZ) is a $1.5 billion company that builds and maintains communications, energy and utility infrastructure. Analysts are looking for an acceleration of earnings this year which would produce a doubling of earnings in six years. Yet the multiple of price-to-cash flow is just above where it was at the 2009 low. Of course, earnings could confound the analysts and tank, but earnings dipped only slightly in the 2009 recession while revenues and cash flow continued to grow. Given what we know, this stock is still reasonably cheap even though it was up 31% for the quarter.
Avis Budget Group (CAR) has a volatile earnings pattern but it is in a sharp upswing at present, and the stock has a PE ratio under 7. My system says that if it can grow earnings at a relatively modest 12% annually, the expected annual return on the stock would be north of 25%. Value Line agrees; they expect average annual appreciation of between 18 and 32 percent over the next 3-5 years. This stock also shows that our methodology is hardly foolproof; the stock has been choppier than I had hoped and we’ve dialed back our exposure a bit.
Other travel-related firms seem cheap as well. Airlines are notoriously volatile and subject both to changes in the broad economy and in oil prices. For example, Hawaiian Airlines traded at over 4x cash flow until 2009 and now trades at only 2.3x cash flow – not far from the lowest valuation it had during early 2009. Earnings are volatile. Ironically, they peaked during the recession in 2009. They are now estimated at $1.25 on a $5 stock. It’s an airline, and airline stocks can always go lower – but if we’re ever going to try, it is at a valuation like this.
Another stock that seems cheap is Owens Illinois, a maker of glass containers. In 2007 it earned $2.89 a share and traded at $50. In 2012 its earnings will be roughly that same $2.89 – but now the stock is trading at only $19. Arguably the 2007 price was too high; the current price seems too low. Earnings and revenues indeed declined during the 2009 recession, and there is no ignoring the cyclicality in this company’s fortunes.
A number of blue chip stocks also seem cheap. Microsoft might seem an unlikely example. Nevertheless, the company’s compound earnings growth rate was 13.9% over the past five years, and this was supported by a revenue growth rate of 10% annually. Even so, the stock trades at a PE ratio of only 10. Nothing says that this PE can’t continue to decline, as it has done for most of the past decade. Moreover, even Microsoft was not immune to a minor earnings dip in 2009. I think that part of the reason for the stock’s cheap valuation is that CEO Steve Ballmer seems busier protecting Microsoft’s existing turf rather than encouraging creativity or new growth. In 2006, the stock closed the year at $29.86 while earning $1.20 per share. In fiscal year 2013 the company is expected to be nearly triple that with $3.01 in per share earnings, but it is still trading at nearly the same price. It may have been too rich in 2006 but Microsoft’s PE ratio is now below the realized growth rate of its earnings. Nothing says that the stock cannot get cheaper still, but a 2.6% dividend yield should cushion any decline.
Oracle also seems cheap. They have grown earnings each year despite the recession at an average annual rate of 16%. Yet the stock trades at a PE of only 13. Based on PE and price-to-cash flow measures, this stock is as cheap as it was at the end of 2008. My system projects a compound annual return of 13% on this stock; Value Line projects 9.5 to 15% annually.
Again, I stress that none of this is foolproof. Intel is earning about twice what it earned in 2005 and yet the stock price is roughly the same. It has grown earnings at 16% and cash flow at 14% compounded annually and yet the PE on the stock is only 10.5 and the stock had a return of negative 14% for the quarter. I have articles from 20 years ago where analysts were predicting the end of Intel (see, eg, Business Week 11/1/1993).
Like Microsoft, GE is another stock that is underpinned by a good dividend – now at 3%. The stock got beat up during the financial crisis but has de-leveraged and its industrial side is growing nicely. Since 2009, it has grown earnings at an average of nearly 15% annually. My system projects an average annual return on the stock of 9%; Value Line has an even more optimistic projection of 14 – 25% annually. It returned 9.8% for the quarter.
We’ve discussed Apple enough in past letters, but the stock has a low PE ratio and continues to grow earnings at rates well above 50% annually. It ended the quarter at $667 and is expected to earn $44.36 this fiscal year (ending now) and $53.30 for fiscal year 2013, for a current PE of 15 and a forward PE of 12.5. Earnings growth of over 50% can’t last forever, and some analysts point out that competitors are producing better products at lower prices. Although branding and valuation are still working in Apple’s favor, I sense that management is risking the brand for the first time by doing stupid things like eliminating Google maps – i.e., not putting the customer first.
The list goes on. There is a huge disconnect between the price of gold bullion and the price of gold mining stocks. Consider Barrick Gold (ABX). It has been growing earnings steadily over the past five years at a rate of about 20% annually. But it trades at a PE of 9. The stock has gone from $51 at the end of 2007 (with earnings then of $1.27) to about $38 today (with likely earnings of $4.25 for this year). Buying the dips in gold stocks has not been a winning move, but at some point that is likely to change. We think now is a good time to make that bet; gold has moved to new highs and Barrick recently moved above its 200 day moving average for the first time in six months.
Not all blue chips stocks are cheap. Consider Proctor and Gamble. It is a stable company with a 3.2% dividend yield. But the company has grown revenues and earnings at less than 5% on average annually over the past five years, and it still trades at a PE ratio of 18. The stock is rich in part because the earnings are very stable, so it remains a good alternative to fixed income holdings. But we think that the odds of much capital appreciation are slim. There are many stocks with similarly rich valuations. We tend to underweight them, particularly when there is little or no dividend yield to underpin the stock.
Some people have waded back into the market by investing only in high dividend stocks. This trade has gotten too crowded, and dividend stocks in general did not have a great quarter. Our utility stocks were basically flat this quarter. Verizon is fully priced by most valuation measures, but still returned 3.7% for the quarter.
We’ve experienced a period of low volatility and strong returns this quarter. We wish it would always be like this. But we are bound to have scares and corrections related to Europe, China, the fiscal cliff, and whatever else. One never knows how far such moves might carry, so we do our best to manage risk during market declines. There seems to be an expectation baked into stock prices that Congress will timely address the fiscal cliff issues; we think there is some possibility of a deadlock with negative consequences. We are mindful of the selloff that occurred during the debt limit standoff a year ago. Thus we will continue to monitor markets and news very carefully. There is some concern that the authorities do not have many tools left to deal with a substantial reversal in the market or the economy – another reason to remain vigilant. But the bottom line is that if we can continue to buy good companies at good valuations, we should continue to do well. Thank you for your continued confidence.
* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers include all actively managed equity accounts and reflect the reinvestment of dividends and deduction of all fees. As one can not invest in an actual index, for comparative purposes we show returns and other statistics of the Vanguard 500 Index Fund, a mutual fund that very effectively tracks the performance of the Standard & Poor’s 500 Index.