Sunday, August 1, 2010 5 comments ++[ CLICK TO COMMENT ]++

Articles for a mid-summer night

I hate losing articles and such was the case with one I was typing up earlier this week grr :(

One area I have been researching lately is the historical behaviour of large-cap and mega-cap stocks. Some of you may have noticed it but I find it very bizarre that the market is pricing large-cap and mega-cap American stocks at relatively low valuations. In fact, depending on the measure you use, the market is pricing them lower than small-caps and mid-caps even. As an example, consider the P/E ratios of the following (I'm not recommending any; just picked some random big ones):

Microsoft has a forward P/E of 9.7 and a trailing P/E 12.3.
Intel (cyclical) has a forward P/E of 9.7 and a trailing P/E of 12.3.
IBM has a forward P/E of 10.4 and trailing P/E of 12.1.
ExxonMobil (cyclical) has a forward P/E of 8.8 and trailing of 13.4.
JP Morgan (vulernable to dervatives implosion) has a forward P/E of 8.8 and trailing of 11.9.
Pfizer (potential value trap) has a forward P/E of 6.7 and a trailing one of 14.

I just don't get why the market is pricing these widely followed, well understood, safer, bigger-moat, long-history companies at these valuations!!! These aren't in some dark corner of the investment universe; or ones that have been hammered after a big bubble or a panic. No; these are some of the most popular companies on the whole planet. Each of these companies have upwards of 20 knowledgeable, highly-paid, talented analysts following them. A company like Microsoft has 31 analysts following it (according to Yahoo! Finance) and it doesn't even include the foreign, European/Asian, analysts.

I have been trying to figure out why the market is pricing these companies as such and haven't developed any strong convictions. If you have some theories, feel free to leave a comment or fire off some e-mail to me.

It's almost at the point that, if the market isn't anticipating some huge macro risk—an example would be heavy taxation of large companies—then there is little reason for amateur investors to be dabbling in small-caps and mid-caps. These large-caps may end up generating 10%+ per year with much lower risk and better corporate governance.

While I'm at it, if anyone knows where I can get free historical information on small-cap and mid-cap indexes--basically looking for valuation measures like P/E but something like P/BV or P/CF is ok too--stretching back to the 1950's, please let me know. I'm trying to figure out if the market has priced large-caps at these valuations while keeping the smaller ones at higher valuations. For example, the DJIA hit a P/E of 8 in 1932 but I believe the whole market sold off (i.e. smaller companies also had a low P/E.) What is striking right now is that most of the low valuation is only with the large-caps and mega-caps.

Anyway, on to some articles (as usual not in any order)...

  • Li Lu, a future co-CIO of Berkshire Hathaway (The Wall Street Journal; h/t GuruFocus): The mainstream media finally catches up with a story widely discussed in value investing blogs many months ago. It looks like Li Lu will be one of the investment managers at Berkshire Hathaway. It looks like Li Lu's major investment success is BYD and I am still unsure of his skill with his other picks... in any case, Li Lu's character seems top-notch—anyone who demonstrates against the government for freedom is a good guy in my books.
  • FT Lunch with Alan Greenspan (Financial Times (may not be free); h/t Economist's View): Alan Greenspan is an interesting character. Started off as a hardcore Randian, heavily in favour of gold standard and distrustful of the state, became a popular conservative supporting Nixon and others, and ended up as a big proponent of the crony capitalism that is epitomized by the bailouts-for-all-capitalists thinking. Either he changed with age, or he was always a chameleon who changes stripes to suit the environment—kind of like those Afghani warlords who switch alliances at will, even in the middle of combat. Regardless of what one thinks of Alan Greenspan, he will go down as the most influential central banker of the last 20 years and possibly the last 50 (yes, he is even more infuential and had a greater impact on society than Paul Volker.)
  • US GDP comes in at 2.4% for Q2 (Calculated Risk): My forecast for the next few years is 2%, which is very bearish. I really hope I am wrong (people will suffer and even I may lose my job if its only 2%; who knows?) but I have a feeling we would be lucky to hit 3% for any sustained period over the next few years. Once the government stimulus is reduced, growth is going to be hard to come by. On top of the de-leveraging by consumers and financial institutions, the problem is that USA (Canada and others too) are shifting from a manufacturing society to some post-manufacturing economy. These things take time and the economy of the last 20 years will not resemble the future—at least in most developed countries.
  • (Highly Recommended) Accounting metrics to detect problem companies (MarketWatch): Anyone serious about fundamental analysis should actually read a book on this matter but, nevertheless, this is a good article that highlights some accounting items to watch. The article highlights the following red flags: inventories ("...inventories should rise at about the same pace as sales. If a company's inventories are growing faster than sales or expected sales growth, it's a clue that products aren't moving. In that case, gross margins could get squeezed."); free cash flow ("In 1999, the company [Worldcom] reported free cash flow of $2.3 billion. A year later, free cash flow was negative $3.8 billion. Such a large swing in free cash flow is a warning sign"); accounts receivable ("What you don't want to see is receivables rising at a much faster pace than sales. This suggests a company is shipping too much product into the channel and possibly extending collection payment terms.") Other red flags to watch include "always making the number" (GE under Jack Welch was notorious for this), "continual restructuring charges", "how thick the financial docs are" (I don't agree with this.)
  • John Mauldin's views on deflation (John Mauldin's Thoughts from the Frontline): A good overview of some numbers that seem to imply we are facing deflationary threats. Even one FedRes inflation hawk appears to be more concerned with deflation these days. Some have suggested the US central bank is about to pursue another round of quantitative easing. As John Mauldin suggests in his conclusion, if deflation becomes a serious threat, the FedRes will likely have to bypass the banks.
  • The Volker Rule (New Yorker): The battle over financial reform. Rumour always had it that former FedRes chairperson, Paul Volker, was more for show than anything serious the Obama administration was considering. I have avoided any comment on the massive financial legislation because it's way too complicated and I have no idea what any of it means. All I know is that it can radically alter banking or end up doing absolutely nothing. Yes, that isn't saying much and that's probably why I'm keeping shut ;)
  • First serious oil-spill lawsuit against BP (Fortune): A flounder gigger—apparently some recreational fishing-type "sport"—is suing BP after inhaling/digesting/touching the oil-contaminated water and suffering rashes, nosebleeds, and the all-too-popular "emotional distress." It remains to be seen what the ultimate damages end up being.
  • (Highly Recommended for growth investors) Google hits young-adult stage (Fortune): Google's core business is slowing; investors are getting nervous; and it is aging. A good article touching on where Google stands and where it may head. If you invest in, or are interested in, technology, this is a good overview of what typically happens in the sector.
  • Businessweek interview with Nassim Nicholas Taleb (Bloomberg Businessweek): I'm not a fan of Nassim Nicholas Taleb but some of you are so here is an interview I ran across. Nothing earth-shattering in the interview other than Taleb's suggestion that the next big negative event may be government deficits.
  • A look at Consumer Reports (Bloomberg Businessweek): A detailed story of Consumer Reports, the 74-year old venerable publication famous for unbiased product reviews.
  • The revival of Lego (Bloomberg Businessweek): People don't realize it but Lego almost lost its crown in the building-block toy category a few years ago. But it managed to fight back.
  • (Recommended) The rise of commodity ETFs & the wealth lost by investors (Bloomberg Businessweek): A very good, lengthy, overview of commodity ETFs, including various issues that make them unsuitable for most investors. Too many newbies caught up in these instruments, given how it's almost impossible to gain exposure to commodities through other means.
  • (Recommended for those interested in entrepreneurship) The Greek Canadian who bought the Pontiac Silverdome (Bloomberg Businessweek): As is the case with almost anything in and around Detroit, the giant Pontiac Silverdome stadium has been in decline for decades. A Canadian real estate entrepreneur placed a low-ball bid of around $600k and actually ended up owning it—this, for a stadium that cost $56 million to build ($220 million in 2010 dollars.) This is the story of what Andreas Apostolopoulos, the buyer, plans to do.
  • Slideshow: America's 50 laziest states (Bloomberg Businessweek): hmm... who is the unlucky—or is that lucky?—soul that lives in Louisiana? ;)
  • (Recommended) (not related to investing) Rebel with a cause: Julian Assange and his pursuit of total transparency (New Yorker): I have always been of the opinion that the Internet is the most signficant scientific/engineering/technological development in the last few hundread years. It is very similar to the printing press, which is another significant development. Unlike something like flight or automobile, the printing press permanently altered society by destroying the Church, as well as the unholy alliance between the tyrants (monarchs) and religion. Not only would people not be as free, thoughts that challenged the Church, such as scientific thinking, wouldn't be quite what it is today. The power of the Internet hasn't been unleashed but we are getting a taste of it. Julian Assange, an Australian with no permanent fixed address, is a controversial character these days. He runs, an Internet site dedicated to releasing information from whistleblowers, insiders, and others. WikiLeaks recently released a massive dossier of classified data from the Afghan war and some in USA (and elsewhere) consider WikiLeaks to be harming the war effort. Some even charge Assange with working for the enemy. There are also question marks about libel, falsified data, and various other issues that plague information. Regardless of what one thinks, they cannot deny what just happened. All of a sudden the public isn't beholden to the elites at the high level or the mainstream media for information. Anyone and everyone can go straight to the source. It remains to be seen what transpires but I don't think I'm exaggering in saying that we may be witnessing the beginning of the decline of modern government power. The printing press destroyed the Church because anyone could read the bible all of a sudden and didn't have to wait for transcriptions or official word from the Church and its agents. Could the day come when mainstream media loses its relevance and government officials and corporate officiers can't keep information from the public?

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5 Response to Articles for a mid-summer night

Ashish Gupta
August 1, 2010 at 7:02 PM

On your question -  why market is pricing these blue chips so low?
1) Does market assigns P/E based on growth expectation of the company? Is PEG better matrix to look at then PE.
2) I would allocate my money to investments which give me best returns for a given risk. Market, including myself, did not view many of these investments as best use of money. It is probable more psychology than fundamentals. But some of these stocks like JNJ and PFE had been very poor investments lately (last 10 years or so) compared to pretty most everything else.

Parker Bohn
August 4, 2010 at 8:32 AM

On large-cap vs small-caps...
If you find that historical PE data, please post a source :)

Small-caps should rationally sell at a cheaper valuation and a higher expected return than large-caps, which over time, does seem to be the case.  There seem to be wide swings in relative value / performance along the way, however.

For instance, I see that the Russell 2000 has posted a 10-year nominal return of +34%, while the S&P 500 has posted a 10-year return of -21%.  Quite a difference, but one which I can't really explain.  I agree with Ashish Gupta, that psychology is probably quite important here. 

A possible theory:
Large caps were over-priced in 2000.  Over the next few years, small-caps outperformed due to valuation.  At the same time, the internet was spreading rapidly, and on the one hand, you had technicals and momentum trading being popularized and used on small-caps.  On the other hand, Grahamian asset-backed value investing ideas were also spreading in the internet and blogosphere, and being used on small-caps.

After a while, this started to take on a life of its own, and a feed-back loop was established where the asset class attracted attention because it outperformed, and outperformed because it attracted attention.  When small-caps inevitably underperform for a few years, I suspect that lots of individual investors will throw in the towel, and we will probably see less 'small-cap-bargains!' style blogs as well.

That said, I am positive that the best bargains are going to be in some tiny misvalued company.  I try to own shares in a few, but they seem to be increasingly hard to find.

Parker Bohn
August 4, 2010 at 8:36 AM

I want to add that this looks to me like more of a case of small-caps being overvalued, than of large-caps being undervalued (with notable exceptions on both sides of course).

In fact, I think that most asset classes are priced for meager results (by historical standards), but I suppose its all about relative return at that point.

Sivaram Velauthapillai
August 7, 2010 at 11:15 PM

Yeah... it does look like smallcaps are overalued more so than largecaps being cheap. I'll post something if I find some data to back up any theories I have...

One thing to note, though, is that Jeremy Grantham is forecasting very high returns for "high quality" US large caps. His estimate was something like 7% real (say 8% to 10% nominal) returns oer the next 7 years.

Sivaram Velauthapillai
August 7, 2010 at 11:20 PM

Here are some thoughts regarding your comments:

1) The market isn't always efficient but I like to think it looks at everything. So, it does look at the PEG ratio. However, the P/E is supposed to factor that in. For instance, the market should rate a low growth company at a lower P/E than a higher growth one. This is what you actually see in practice. A lot of high growth companies (often found in technology or retail industries) have high P/Es while slower growth ones (such as in consumer staples or utilities) tend to have lower P/Es.

2) Psychology does play a role and many mega-caps and large-caps have been poor investments in the last decade. But in the grand scheme of things, the market should be pricing based on future returns. We can't be certain but it does appear as if we are at the point where the future returns on large-caps are higher than on small-caps. The weird thing is how the large-caps are heavily followed on the Street so they shouldn't be so cheap (unless there are reasons I am overlooking.)

Interesting time for sure...

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