Macro Uncertainty and Fundamental Value
March 4th, 2011The following is an excerpt from the November 24, 2008 issue of Spinoff & Reorg Profiles. I’m posting it now to set up for a coming post on what I call “investment battleships.”
Last Thursday [11/20/08], the S&P 500 marked a dubious milestone, surpassing the 1973-4 and 2000-02 slumps to become the biggest U.S. broad index crash since the Depression (although, to rival the 1929-32 crash, it would need to fall by half again).
This naturally leads to the question of whether the broad index is now cheap. The answer seems to be, “slightly.”
The 125-year U.S. index price/earnings record compiled by Yale economist Robert Schiller implies long-term mean reversion to an index PE10 ratio of about 16, where PE10 is defined as current price divided by the average of inflation-adjusted earnings over the past 10 years. With relatively high reliability, 20-year investment returns tend to be better when PE10 was well below that level at purchase time; returns tend to be worse when the purchase was made well above that level.
Mean reversion oversimplifies, by ignoring the relationship between earnings yield, interest rates and inflation; however, it is a useful long-run rule of thumb, reflecting reasonable expectations of current net earnings yield on volatile but growing assets.
Today [remember, this excerpt was written in Nov. 2008], the S&P 500’s PE10 is about 14 — below the long-run average, but well above the bottom of previous crashes. PE10 went below 10 in 1974, and below 6 in 1932. So while the market today is rather cheap by historical measures, it has occasionally been 30% to 60% cheaper, relative to this particular average earnings measure. [We now know that the S&P did fall another 15% from November 2008 to the 2009 trough.]
This argues for a good, if unspectacular, long-run prognosis for the index as a whole. By contrast, the earnings streams of many individual stocks are now for sale far below traditional prices, with excellent long-term promise for those who can afford to wait.
The predictable exposure is recession; the more complex exposures are in three interrelated areas, all with unpredictable volatile outcomes.
Dollar stability – The dollar is supported by central banks in nations now entering sharp recessions. They have domestic incentives to continue support, but if a retreat did begin, there would likely be a multinational race for the exits, resulting in dramatic dollar decline.
Inflation – Not only is price stability unlikely, but experts even disagree about the direction. Commodity-driven inflation has abruptly given way to deflation. Next year, we will see intensely, deliberately inflationary fiscal stimulus, with certain trillion-dollar federal deficits. The result could go either way.
Long rates – Fiscal stimulus will be financed by offshore lenders, with their own problems, and without infinite capacity or patience. As borrowing greatly increases, the stage may be set for Treasury auction revolt and further loss of control over long-term rates.
The best path through this minefield appears to be cheap companies with substantial foreign earnings, competitive advantage (ability to raise prices, often exhibited by high return on employed capital), and low debt. These features partly inoculate against dollar instability, inflation, deflation and high interest rates. A fourth necessary feature is investor patience, since even the best firms will likely see a wild ride in coming months.
Among spinoffs from recent years, Coach (COH) is perhaps the best fit for these conditions, and quite appealing just now.
Coach has more than tripled since that day, which is gratifying, but that’s actually not the most important message here. The critical thing is that our downside was protected. If credit had remained impossible to get, Coach could have financed itself from cash, even as indebted rivals like Bulgari might well have failed. If the dollar had collapsed, Coach’s US production for export to Japan and China would have worked out fine, even as the “Chimerica” offshore production model would have collapsed. If inflation had taken off, Coach’s strong brand and low capex would have helped sustain margins. At that price — it was under 10 times earnings — Coach was what we like to call an investment battleship, all but impervious to whatever storms the global economy might bring.
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interesting that prior to march 2009, the last time the s&p pe10 dropped below 14 was jan 1988. perhaps we’ve entered an era where the magic pe10 of 16 is archaic, but i’m not well-versed enough in macro to justify that belief.
nevertheless, the coh call was brilliant, i will be subscribing to your spinoff/reorg profiles soon. thanks for the write up!