I’ve just updated my Keeping Score page, for the first weak month we’ve had in a long time. Sector performance is not completely what I would have expected.
One part of this is easy.
PE is industry jargon. It’s a shorthand way of expressing the value of an individual stock, an industry group or a whole stock market, in terms of how many times one year’s earnings we’d be willing to pay to own whichever it is.
On the face of it, a low PE, say, 4x, would seem to be good; a high PE, say, 50x, bad.
But how do we know? What factors enter into determining a PE?
A point that I’m maybe too fond of making is that, strictly speaking, there’s no demand for stocks. There is demand for liquid investments, though (for most people in the US, it’s so they can save to send their children to college and to retire). Bonds and cash are the other two big categories of liquid investments. The apparent hair-splitting distinction is important, however, because each fixed income markets is much larger in size than stocks. They’re also less risky. The potential returns on these alternatives have a deep influence on what people are willing to pay for stocks. In fact, academics turn the PE upside down (1/PE) to get what they call the earnings yield on stocks. If you make the assumption that $1 in earnings in the hands of company management is more or less the equivalent as $1 in interest paid to you by the US Treasury, then the yield on Treasury bonds should (and virtually always does) have a powerful influence on what the earnings yield, and PE of stocks should be. Why pay 20x for stocks if bonds are yielding 10%?
As I’m writing this, the 10-year Treasury bond is yielding 2.68%. That’s the equivalent of a PE of 37. This compares with a PE of 26 on the S&P 500, based on current earnings. So either stocks are cheap or bonds are overpriced.
Today’s situation is very unusual, given that the financial meltdown in 2007-08 compelled the Federal Reserve to push interest rates down to intensive-care lows. The consensus judgment of financial professionals, which I think is correct, is that bonds are unusually expensive today, not that stocks are dirt cheap. If the 10-year is on the way to a 3.5% yield as the Fed returns rates to normal over the next year or two, then the equivalent PE on the S&P would be 28.5x.
That’s about where US stocks are now priced vs. bonds, which suggests that stocks are fully valued if we factor in the likely course of the Fed. This suggests that only new positive information will move the overall market higher.
Now the going gets harder.
The second important point is the the stock market is a futures market. That is, it is always pricing in tomorrow’s prospects as well as current earnings. Willingness to pay for future earnings ebbs and flows with the business cycle, however. During recessions, investors play their cards very close to the chest and look at most a few months into the future when pricing stocks. In normal times, the market begins to price in the following year’s earnings in June or July. In a very buoyant market, investors may pay for earnings two or three years into the future.
A third consideration, related to the second, and applying to individual stocks, is the rate of earnings growth. The importance of this factor changes from time to time. But a useful general rule is that the PE based on this year’s earnings can reach as high as the long-term growth rate of the company. In other words, if earnings per share are growing at a 50% annual clip–and will likely continue to do so for the next several years (or at least there’s no easily visible bar to growth like this)–then the PE can be as high as 50x.
Generally speaking, the US economy can probably grow at about 4%-5% a year in nominal terms (meaning, including inflation). If so, publicly traded companies, which are arguably the cream of the crop, will grow earnings per share by about 8% – 10% annually. All other things being equal, this latter figure should be the trend growth for stocks in general.Put a different way, a company that can sustain growth of 50% a year in an economic environment like this must have something extra special going for it.
This rule of thumb doesn’t work for many “value” stocks, since no growth/earnings declines would imply a zero multiple–which in most (academics would say “all”) cases is clearly wrong (Academics say every stock retains at least a kind of option value).
It looks as if the top Federal corporate tax rate will be declining from the current world-high 35% to a more median-ish 20% or so. The consensus guess, which I think is as good as any, is that this change will mean about a 15% one-time increase in profits reported by S&P 500 stocks next year.
However, Wall Street has held the strong belief for a long time that this would happen in a Trump administration. Arguably (and this is my opinion, too), one big reason for the strength in US publicly traded stocks this year has been that the benefits of corporate tax reform are being steadily, and increasingly, factored into stock quotes. The action of computers reading news reports about passage is likely, I think, to be the last gasp of tax news bolstering stocks. And even that bump is likely to be relatively mild.
In fact, one effect of the increased economic stimulus that may come from lower domestic corporate taxes is that the Federal Reserve will feel freer to lean against this strength by moving interest rates up from the current emergency-room lows more quickly than the consensus expects. Although weening the economy from the addiction to very low-cost borrowing is an unambiguous long-term positive, the increasing attractiveness of fixed income will serve as a brake on nearer-term enthusiasm for stocks.
What I do find very bullish for stocks, though, is the surprising strength of consumer spending, both online and in physical stores, this holiday season. We are now nine years past the worst of the recession, which saw deeply frightening and scarring events–bank failures, massive layoffs, the collapse of world trade. It seems to me that the consumer spending we are now seeing in the US means that, after almost a decade, people are seeing recession in the rear view mirror for the first time. I think this has very positive implications for the Consumer discretionary sector–and retail in particular–in 2018.
I’ve been reading a lot of commentary recently that maintains stocks are generally expensive. Sometimes the commentators even recommend selling, although in true Wall Street strategist style, they’re not very specific about how much to sell or how deep they think the downside risk is.
The standard argument is that if you compare the PE ratio of the S&P today with its past, the current number, just about 25x, is unusually high.
What I haven’t see anyone do, however, is consider the price of stocks against the price of alternative liquid investments–cash and bonds. That would tell you what to do with the money if you sell stocks. It would also tell you that bonds are much more expensive than stocks.
The yield on the 10-year Treasury is currently 2.23%. That’s the equivalent of a PE of about 44x. The return on cash is worse. Cash, however, protects principal from capital loss, except in the most dire circumstances–ones where you’re thinking you should have bought canned goods and a cabin in the woods..
In addition, I think the most likely course for interest rates in the US is for them to rise. When this has happened in the past, bond prices have fallen while stocks have gone basically sideways. There’s no guarantee this will happen with stocks again. But rising rates are always bad news for bonds.
What is surprising to me about current market movements is that stocks continue to be so strong during a time of typical seasonal weakness.
DIS shares went on a fabulous run after the company acquired Marvel in late 2009, moving from $26 a share to $120 in early 2015. Since then, however, the stock has been moving sideways to down–despite rising, consensus estimate-beating earnings reports in a stock market that has generally been rising.
What’s going on?
The basic thing to understand about analyzing a conglomerate like DIS is that aggregate earnings and earnings growth matter far less than evaluating each business in the conglomerate by itself and assembling a sum of the parts valuation, including synergies, of course.
In the case of DIS, the company consists of ESPN + television; theme parks; movies; merchandising related mostly to parks and movies; and odds and ends–which analysts typically ignore.
In late 2009, something like 2/3 of the company’s overall earnings and, in my view, 80%+ of the DIS market value came from ESPN.
At that time, ex Pixar, the movie business was hit and miss; the theme parks, always very sensitive to the business cycle, were at their lows; because of this, merchandise sales were similarly in the doldrums. ESPN, on the other hand, was a secular growth business, with expanding reach in the global sports world and, consequently, dependably expanding profits.
ESPN profits not only made up the majority of the DIS conglomerate’s earnings, the market also awarded those profits the highest PE multiple among the DIS businesses.
At the time, I thought that if truth in labeling were an issue, the company should rename itself ESPN–although that would probably have detracted from the value of the remaining, Disney-branded, business lines.
Then 2012 rolled around.
Long-time readers may recall that I became interested in DIS in late 2009, the company acquired Marvel Entertainment, a stock I held, for stock and cash.
I hadn’t looked at DIS for years before that. I quickly learned that DIS was a conglomerate, that is, a type of company where the most useful analysis comes taking the sum of its constituent parts.
I knew the company’s movie business had been struggling for some time and the theme parks were being hit hard by recession. Still, I was more than mildly surprised that ESPN (plus other media that we can safely ignore) made up somewhere between 2/3 and 3/4 of DIS’s operating earnings. Why did they still call it Disney?
Given that the parks are a highly cyclical business and movies moderately so–meaning the PE applied to those earnings should be relatively low–and that ESPN was showing all the characteristics of a secular growth business–meaning high PE–I thought that ESPN represented at least 80% of the market capitalization of DIS. (That’s despite the fact that the market would apply a higher than normal multiple to cyclically depressed results).
So DIS was basically ESPN with bells and whistles.
ESPN’s turning point
In 2012, ESPN made a major effort to enter the UK sports entertainment market. To my mind, this wasn’t a particularly good sign, since it implied ESPN believed the domestic market was maturing. Worse, ESPN lost the bidding, closing out its path to growth through geographic expansion.
It seemed to me that DIS management, which I regard as excellent, understood clearly what was happening. It began to redirect corporate cash flow away from ESPN and toward the movie and theme park business, which had better growth prospects, and where it has since had unusually good success.
Over the past two fiscal years (DIS’s accounting year ends in September), the company’s line of business results look like this:
ESPN + revenues up by +11.9%, operating earnings by +6%
parks revenues up by +12%, op earnings +24%
movies revenues up by +30%, op earnings +74%
merchandise revenues up by +4.6%, op earnings +33%.
the valuation issue
ESPN has gone ex growth. This implies these earnings no longer deserve a premium PE multiple. To me, the fact that ESPN now treats WWE as a sport (!!) just underlines its troubles.
The other businesses are booming. But they’re also cyclical. So while improving efficiency implies multiple expansion, earnings approaching a cyclical high note implies at least some multiple contraction.
Because the two businesses are so different, I think Wall Street is making a mistake in treating earnings from the two as more or less equal.
DIS will most likely earn $6 a share or so this fiscal year. That will be something like $3 from ESPN and $3 from the rest.
Take the parks… first. Let’s say I’d be willing to pay 18x earnings for their earnings. If that’s the right number, then these businesses make up $54 a share in DIS value.
Now ESPN. If we assume that the worst is over for ESPN in terms of subscriber and revenue-per-subscriber losses, we can argue that the future earnings stream looks like a bond’s. If we think that ESPN should yield, say, 5% (a 20x earnings multiple), that would mean ESPN is worth $60 of DIS’s market cap. If we’d still on the downslope, that figure could be a lot too high.
$54 + $60 = $114. Current stock price: $109.
my bottom line
My back of the envelope calculation for the parks… segment may be a bit too low. I could also be persuaded that my figure for ESPN is too rich, but it would take a lot to make me want to move the needle higher for it.
Yes, most of DIS’s earnings are US-sourced, so the company could be a big winner from domestic income tax reform.
But if I were to be holding a fully valued stock on the idea of a tax reform boost, I’d prefer one with more solid underpinnings. At $90, maybe the stock is interesting. But I think ESPN–the multiple as much as the future earnings–remains a significant risk.
MSFT reported a strong 1Q17 after the close last night.
Revenue was up +3% (non-GAAP) year on year. Operating income was flat, on the same basis, and net up +6%. EPS was up by +9%, at $.76, exceeding the high end of the expectations of the thirty-odd professional sell side analysts who follow the company.
Growth businesses, like the cloud or the Surface line of laptop/tablet hybrids, were up strongly. Legacy businesses held their own. Guidance is for a flattish 2Q17.
In many ways, the MSFT report is similar to the Intel (INTC) results from the night before. Guidance for both companies appeared roughly the same, as well–more or less flat quarter on quarter performance, during a period that’s typically seasonally strong.
The reaction in the press and in the stock price for MSFT, however, was strongly positive. The stock was up by 4%+ when the results were made public …and by more than that after the conference call. As I’m writing this on Friday afternoon, MSFT is holding onto almost all of its after-hours gain during a down day on Wall Street.
INTC, in contrast, fell at all three waypoints–announcement, conference call, next-day trading.
Part of the contrast in stock performance has to do with the differing nature of the two companies’ businesses, hardware vs. software. Part is a function of the greater speed at which MSFT has been able to demonstrate that it is turning itself around.
On the other hand, I find it noteworthy that there should be a 10% relative performance difference in two days between the two behemoths who were once the constituents of the former Wintel alliance–and on bottom lines that, if we removed the company names, don’t look all that different.
The rest, of course, must represent two different sets of expectations. I hold both stocks, which I’ve been studying for over a quarter century (and which I find a little scary). My expectations aren’t that different.
I’m not simply grousing about being wrong aobut INTC. I think of investing in the stock market as somewhat like playing a game whose rules each player has to figure out as play progresses. I’ve often likened the difference between investing in, say, the UK or Japan vs. the US as like that between playing checkers or Sorry and playing chess.
I have a hunch that in reports like these we’re seeing evidence of a change in how the stock market game will be played in the US in the future. If so, it will be important to catch on to the new state of things as soon as possible.