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The Market May Be Cheaper Than It Looks
August 2, 2010
It never ceases to amaze us how fast market expectations can change. Back in May, we argued that investor expectations had gotten ahead of the fundamentals and the market had become overvalued. At the time, investors seemed to believe that the global economy was well on its way to a V-shaped recovery and that Greece's problems were a minor issue. However, as we went to print with the May issue, the market's opinion changed. Investors were suddenly concerned that Greece was the "canary in the coal mine" of a larger sovereign debt problem within the EU, and they were also coming to grips with the massive scale of BP's gusher in the Gulf of Mexico. Optimism waned as the potential economic consequences of both scenarios became quite frightening.
According to indicators such as the P/E10¹, or Cyclically Adjusted Price Earnings ratio (CAPE), the market is still moderately overvalued — although much cheaper than three months ago. Despite this, we continue to find high-quality businesses selling at attractive prices. So how is it that, even with the P/E10 flashing red, there appears to be an abundance of cheap stocks in today's market?
Potentially Understated Inflation
Given that inflation estimates play an influential role in the calculation of the P/E10, it is important to investigate the assumptions behind the calculation of inflation. Traditionally, inflation is measured using the Consumer Price Index (CPI) provided by the Bureau of Labor Statistics (BLS). The CPI estimates inflation by measuring fluctuations in the average price of a basket of consumer goods and services that is deemed to be typical of the average urban consumer. However, due to a variety of reasons, largely political, the methodology used to calculate CPI has undergone many changes in the past 10 to 20 years. One of the most controversial changes was to alter the composition of the basket to reflect changes in consumer behavior over time.
In doing so, the BLS hoped to remove biases that cause the CPI to overstate the true inflation rate. Former chairman of the Federal Reserve Alan Greenspan advocated this alternative methodology, arguing that if the price of steak went up, consumers would choose to eat more hamburger meat instead.² He therefore concluded that unless hamburger meat replaced steak in the basket, inflation would be overstated because consumers were not actually spending more money. Skeptics view these changes as government manipulation, the purpose of which is to understate the true inflation rate, as well as the wage and other rate increases indexed to it (think Social Security).
Over time this recalibration of the CPI has produced lower inflation estimates than the "old school" method. In fact, the discrepancy has become rather large, as illustrated in the chart at right. Unlike Mr. Greenspan, however, we prefer steak to hamburger meat. Accordingly, we tend to believe the truth lies somewhere in between the BLS's CPI and the Shadow Government Statistics' (SGS) Alternate CPI.
The wide gap between the government-sanctioned CPI and the Shadow Government CPI presents a competing set of assumptions about how to measure the effect of rising prices on the average consumer and the market as a whole. The relevance to investment analysts is that higher inflation figures can have a dramatic impact on the current P/E10 ratio. For example, if inflation is assumed to be 5% annually, $1 in nominal earnings from 10 years ago would be worth approximately $1.63 in today's dollars. At 10% annually, $1 in nominal earnings from 10 years ago would be worth about $2.59 today. Using a higher inflation estimate therefore increases average real earnings over the 10-year period, and thus lowers the P/E10 ratio. If we assume the SGS figures are correct, then the current P/E10 based on the average closing price during the month of June is about 14x (see chart below). This ratio is much lower than the current P/E10 of near 20x using traditional CPI figures.
The Corporate Cash Stash
While a P/E ratio is a useful tool to measure how expensive or cheap a company's stock is based on its earnings, it tells us nothing about a company's capitalization, which is a large determinant of a company's value. Consider the following scenario: Company ABC generates $1 in earnings per share (EPS) a year, has $5 per share in cash, no debt, and can be purchased for $14 per share or 14x earnings. On the other hand, Company XYZ also generates $1 in EPS a year, has $1 per share in cash, $5 per share in debt, and can also be purchased for $14 per share or 14x earnings. Which company would you rather own? Even though the companies sport the same P/E ratio of 14x earnings, ABC is clearly the better investment, holding all qualitative factors equal.
Corporations today have some of the strongest balance sheets we have seen in many decades. The Federal Reserve recently reported that, as of the end of the first quarter 2010, U.S. Nonfarm Nonfinancial Corporate Businesses had slightly more than $1.84 trillion of cash and cash equivalents on their balance sheets, up 26% from one year ago. As a percentage of total assets, this is the highest level since 1963 (see chart below). As a percentage of total debt, this is the second highest level since the late 1960s.
Source: Federal Reserve Statistical Release, "Flow of Funds Accounts of the United States"
This growing stash of corporate cash cannot be explained by reductions in net working capital (e.g., reduced inventory, reduced receivables, or increased payables) or by increased debt issuance, as both have remained virtually flat since 2007. Rather, corporations that eliminated dividend payments or stock repurchase programs — both methods of returning value to shareholders — during the peak of the financial crisis have yet to fully reinstate such programs. Corporations have also drastically cut back on capital expenditures and investments, with total capital expenditures still roughly 15% off their peak in 2008. U.S. merger and acquistion (M&A) activity has picked up somewhat recently, but it still remains quite depressed. It seems businesses remain reluctant to invest in growth initiatives or return cash to shareholders amid a highly uncertain economic, political, and regulatory environment. In short, companies are hunkered down in survival mode and hoarding cash.
What does all this mean for the investor? Given the incredibly strong balance sheets and large cash holdings of U.S. Nonfarm Nonfinancial Businesses, now is not the time to rely solely on P/E-based methodology to measure intrinsic value. Large cash holdings not only contribute to intrinsic value, they also have the potential to serve as a catalyst for higher market valuations if companies begin deploying them to increase dividend payments, share repurchases, capital investment, and/or M&A activity. Last month, Noble Corporation (NYSE: NE) provided one such example. The company deployed its large cash hoard in the highly accretive acquisition of Frontier Drilling, which served as a positive catalyst for its stock price.
We also continue to find value in companies such as Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG), and EMCOR (NYSE: EME), whose massive holdings of cash and cash equivalents amount to roughly 19%, 15%, and 33% of their respective share prices. With iron-clad balance sheets like these, the market just might be cheaper than it looks.
Copyright 2010 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 4 · No. 8
¹ The P/E10 takes an average of the index's real earnings over the past ten years, offsetting both inflated and depressed results. The current price (or historical real price) is then divided by the average real earnings of the previous ten years to arrive at the P/E10 ratio. (See Saturna's May Market Navigator, "Pricey Market Poses Challenges To Index Investors" for further explanation.)
² Williams, Walter J. "Government Economic Reports: Things You've Suspected But Were Afraid to Ask!" October 1, 2006. http://www.shadowstats.com/article/consumer_price_index
³ "SGS Alternative CPI" estimated by Shadow Government Statistics, American Business Analytics & Research LLC (www.ShadowStats.com) using the methodologies from 1980.
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