We recently came across an interview Jon Shayne did with Forbes back in October. Although we have not yet met his acquaintance, Mr. Shayne would seem to be pretty close to Broyhill, both in his investment philosophy and in his investment locale, based in Nashville, TN. The full article is a quick enjoyable read, available here, along with four frustrations of today’s value investors, highlighted by Shayne below:
I. Stock prices are high compared to companies’ overall earning power. Check out the striking chart below, compiled by Smithers & Co., a London research firm.
The red line tracks “CAPE” – the “Cyclically Adjusted Price-to-Earnings Multiple” of the S&P 500. Here, CAPE is plotted to its own average meaning that, relative to its historical performance, every point above the “0” line suggests the market is overvalued, while anything beneath means it is undervalued, calculated by Yale Economist Robert Shiller.
The blue line confirms that Shiller was onto something – and that prices indeed look quite lofty. The line plots a nifty metric called “q” – “q” measures the value of the market divided by the amount that investors would have to pay to replace all of the assets held by all of those companies. The notion here: If the replacement value is significantly below public market value, then eventually investors will choose to start their own companies rather than buy overpriced slivers of ones that already exist! The beauty of CAPE and “q” is that they are highly correlated though mathematically unrelated.
II. Profit margins are way above their historical average. Price-to-earnings multiples only tell you so much. To really understand how badly prices are out of whack with reality, you have to take a closer look at the “E” in P/E.
Since 1881, the S&P 500 has traded at an average P/E of 15.2. As of mid-October, the market P/E had crept up to 21.5. Meanwhile, profit-margins, adjusted for inflation, are notably high, as shown in the chart below, also compiled by Smithers.
Aside from a brief stint during the latest crisis, the chart shows that corporate profits as a slice of overall economic output have hovered above their historical average for the last 17 years. Since the crisis, those profit margins have soared to 20% above the red trend line. In short: We are in overheated territory and it would take scorching growth to support these price levels going forward. Again: Relative to history, both the overall market P/E and corporate profits are abnormally high.
III. Government intervention masks the true health of the economy. The U.S. government has racked up trillion-dollar deficits four years in a row. The Federal Reserve has printed trillions of dollars to keep interest rates low and charge up the economy. Think about where things would be if these things hadn’t happened. Profits would be lower. Asset values would be lower. And these things cannot be sustained indefinitely.
IV. No Safe Haven. Theenvironment is more difficult than it has been because it is more uncomfortable to hold cash. Welcome to a hard-core value guy’s perfect storm: historically high P/E multiples and profit margins, massive market-propping stimulus programs and flimsy protection against creeping inflation.
We plan to more thoroughly review the outlook for US market valuations and profit margins in a coming Broyhill Letter. In the meantime, Jon Shayne provides us with a nice intro to a difficult topic for investors to accept – it seems that the consensus today is unwilling to accept the historical evidence that profits are mean reverting and normalized valuations have much greater predictive power than those based on a single year of earnings. For regular readers, this is nothing new. We discussed this almost two years ago in a post titled, At What Price?
Andrew Smithers, best characterizes our frustrations, in Wall Street Revalued:
“Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth. The more they achieve their aim the greater is their success at creating confusion rather than helping our understanding . . . The reason why current PEs provide no guide to value is that profits are highly volatile and rotate around their equilibrium level. If profits are at their equilibrium level, and only if they are, then the ratio of the current to average PE will provide a valid estimate of the market’s value.”
Laymen’s interpretation: PEs calculated on one year of earnings are virtually meaningless. It is absurd to value the stock market on current or predicted PEs when profits and margins are near peak levels. It is equally absurd to undervalue the market when profits are depressed. For example, at the end of 1932, after a near 90% fall in stock prices, the market PE was about 25% above average. Anyone care to argue that stocks were expensive at this level?