Investing At A Different Market High
Fresh all-time highs from various indexes along with bullish commentators attempting to one-up each other with higher and higher price targets might have more cautious investors wondering where the bargains are.
If an investor is going to risk principal on an equity stake in a business, it is highly beneficial to value the company based on the full business cycle, including recessions. Looking at gauges of full-cycle and forward earnings estimates uncovers a wide range of valuations, from extremely undervalued and defensive to significantly over-valued and cyclical. This is a marked difference from the across-the-board lofty valuations of 2007, and reminiscent of the disparity value investors exploited to great success in 2000 and 2001.
Most cyclical companies hide their business cycle risk if you value them only on the past twelve months of earnings. This is how every commonly quoted P/E ratio is calculated. Forward earnings estimates almost always extrapolate the recent past into the future, and the last few years have been slow and steady growth. Both of these assumptions suffer painful breakdowns when the business cycle peaks and enters a recessionary phase.
Although global stock markets are flashing green, numerous major global economies are already in recession. The international earnings sources of American domiciled companies as well as the connectivity between nations are respectable sources for caution. Should an investor then flee the stock market? Absolutely not! However indexing at this juncture could prove hazardous. Some simple analysis can both prevent investment in cyclically-exposed names, as well as transition a portfolio into undervalued, high quality, all-weather names.
Instead of looking at last year's earnings and analysts' forward earnings estimates, stress-test your stocks by looking at their annual reports from 2009 and 2010. If you see major declines from 2008 to 2009 and/or 2009 to 2010, you are looking at a cyclical business. Most consumer discretionary, energy, materials, and financial companies are cyclical. Importantly, just because a company continues its steady growth in a recession does not mean it is an automatic buy, nor does a cyclical business negate all potential future returns. The key to profitable investing in both types of companies is valuation. This is where today's market looks eerily like 2000 to 2001.
The tech bubble of the late 1990's popped in early 2000. At the peak, it is widely remembered that valuations for tech stocks reached well into outer-space, with some cash flow negative companies trading at hundreds of times their revenue.
Simultaneously, amongst the silliness, stalwart businesses traded at discounts were so steep both relative to the market and on an absolute basis that stable companies could be purchased at prices that discounted recession! Value investors suffered underperformance during the bubble by avoiding tech stocks and buying these low valuation non-cyclical companies, but in the aftermath the discipline and quantitative analysis paid off immensely, causing many value investors to breeze through the bear market and recession of 2001-2002 posting great relative and absolute.
Today's market offers similar opportunities. Although the market in its entirety is trading at a lower PE than in the year 2000, there are still large pockets of over-valued companies that are in dangerous territory, especially when one considers an inevitable end to the current business cycle. Quixotically, keeping the market average PE lower are some of the best names, and ironically, many of these names are in the large cap technology space including Microsoft and Computer Associates.
There are numerous defensive names that grew throughout the recession of 2008-2009 and yet are currently trading below the market multiple. This disparity alone should make a fundamentally-focused investor jump for joy but the story gets even sweeter. Imagine if the economy were to slow and you are invested in a high-multiple, cyclical name.
The earnings of your company will plummet, making the multiple look even worse relative to the market, but since the growth is gone and markets can be fickle, you will suffer twice as the price crashes back to a more reasonable number. On the other side, a value manager holding a company with a low valuation that grows earnings will win twice, with trading multiple expanding and earnings increasing. As we saw in 2000-2001 the change can occur suddenly and without warning.
Though the markets are breaking records and investors are exuberant, it is a tough time for prudent investors because of the relative underperformance of value names. Using history as a guide, those looking at the fundamentals of defensive names have a lot to be optimistic about, and value investors can greatly benefit by focusing on the low-valuation, non-cyclical names that are overlooked in the excitement.
Exactly when the market turns is unknown, but it is far better to be positioned early for this change rather than late.
Brian Frank is president of Frank Capital and portfolio manager of the Frank Value Fund.