Valuing Stocks During a Recession

Now that third quarter earnings reports have largely been released, I thought I would write a bit about valuing stocks during a recession. Having seen all of the numbers and listened to all of the conference calls, I am beginning the process of going through my client accounts and making adjustments, if necessary, based on what information has come out during earnings season.

Drastic business model shifts are rare, so this analysis largely involves looking at management's execution of a company's particular strategy (are they doing what an investor would expect?) coupled with valuation analysis (what price is the market assigning to the business and what assumptions are embedded in those assumptions?).

Valuation analysis is a bit trickier during a recession because earnings are at depressed levels. The key is to understand that a stock price is supposed to equate to the present value of expected future cash flows in perpetuity. As a result, corporate profits for any given single year are not always indicative of value, meaning that valuations using earnings during a recession will likely underestimate a company's fair market value and vice versa during boom times.

A lot of people these days remain negative on stocks, despite the recent crash in prices, because they are assigning a low multiple to depressed earnings and are concluding that stocks aren't very cheap, when in fact, they have not been this cheap since the early 1980s. For instance, many expect earnings for the S&P 500 to dip to $60 in 2009. Market bears will assign a "bear market" P/E of 10 to those earnings and insist the S&P 500 should be at 600 (versus 865 today). More aggressive projections might use a P/E of 15 (the historical average) and conclude that the market is about fairly valued right now (15 x 60 = 900).

The problem with this analysis, of course, is that it assumes the economy is normally in a recession and a $60 earnings target for the S&P 500 is a reasonable and sustainable estimate for the future. In fact, it represents a trough level of earnings, which is not very helpful in determining the present value of all future cash flows a firm will generate, unless of course the economy never expands again.

Consider an entrepreneur who sells winter coats, gloves, and hats in an area that has normal seasonal weather patterns. If this person wanted to sell their business and a potential buyer offered a price based on the company's profits during the month of June (rather than the entire year as a whole), the offer price would be absurdly low.

Because of that, you will often hear the term "normalized" earnings power. In other words, when valuing a stock investors should focus on what the company might earn in normal times, rather than at the extremes.

Take Goldman Sachs (GS) for example. Wall Street expects GS to earn $0.28 per share in the current quarter, whereas in the same quarter last year it earned $7.01 per share. Just as one should not use a $7 per quarter run rate to determine fair value for GS (the stars were aligned perfectly for them last year), one should also not use a $0.28 per share run rate either, because today represents close to the worst of times for the company's business.

Investors need to value stocks using a reasonable estimate of normalized earnings power and apply a reasonable multiple to those earnings. With cyclical stocks, oftentimes you will see share prices trading at elevated P/E multiples during the down leg of the cycle because earnings are temporarily depressed. Investors are willing to pay a higher price for each dollar of earnings (as shown by high P/Es) because they don't expect earnings to remain at trough levels longer term.

One of the reasons stocks are so cheap today in historical terms is because many firms are trading at single digit P/E multiples based on recessionary profit levels. Buying trough earnings streams for trough valuations has always been a winning investment strategy throughout history, which is why so many long time bears are finally stepping up and starting to buy stocks again.

Take a very recent purchase of mine, Abercrombie & Fitch (ANF), as an example. The stock is trading at $16, down from $84. ANF typically trades for between 10 and 15 times earnings. The company earned $5.20 per share last year but profits are expected to drop to $3.30 this year and to below $3 in 2009. The 2007 level of profitability is not what I would consider a "normalized" number, but earnings could drop 50% from the peak by 2009 (to $2.60) and that would not be normalized either.

The great thing about today's market for long term value investors is that we can buy a company like ANF for only 6 times earnings, even after taking its 2007 profits and slicing that number by 50% to account for the recession! When the economy recovers, isn't ANF going to earn more than $2.60 per share and trade at more than 6 times earnings? If one believes that, then ANF is a steal (as is any other stock that is trading at a similar price) as long as one is willing to be a long term investor and wait out the full economic cycle.

Full Disclosure: Peridot was long shares of ANF at the time of writing, but positions may change any time

Comments

[caygee:]

Its hard to invest even in value stocks as the earnings estimates are now totally unreliable and consumers are not going to spend money .
Best one can hope is to hope the value stock you picked is not going to lose more than another say 30% in next 6 months and try to hedge this fall.

2008 Nov 18 04:41 AM

[Schweizer:]

The charts will show when value has been reached on ANF and other stocks. ANF is showing no sign of bottoming on any time scale. The 2000 lows of $7.59 on ANF might bring in some buyers, but not here at $15.

2008 Nov 18 07:54 AM

[Smarty_Pants:]

Just 3 months ago LEH was trading around 15 too.

2008 Nov 18 10:39 AM

[Camille:]

Good article with a nice, broad, long term perspective.

2008 Nov 18 10:53 AM

[The_Value_I...:]

Nice POV, I think ANF is a fairly bold call though, huge fashion risk, cyclical sector, expensive retailer. I too think stocks are cheap, but I tend to stay away from the retailers that have fashion risk, one name I have always liked in retail is TJX with the off price retailing and same seasons buy/sell they are always selling "fashionable" clothing, buying it on the cheap and keeping a bare bones storefront which keeps costs low. Not to mention, TJX carries ANF & Gap et al, which in these generally tough economic times can lead to shoppers "shopping down" at TJX, Marshalls etc. They are seeing a value proposition for their hard earned dollars. I will also disclose that I have been long TJX since April 2007. I think the comment above about the charts while a valid one, might not apply here, technical analysis and value investing couldn't be more polar opposites. As a value investor I can honestly say I hardly ever look at price charts.

2008 Nov 18 11:30 AM

[Jordan M:]

This article is one that should be read by many. I think that during 2007 we were not in much of a boom (GDP growth of only 2%). While consumer spending might have been slightly higher than normal due to increased borrowing - home equity lines of credit, I think that using average earnings (or even better, FCF defined as operating cash flow - maintenance capex) from recent years would be the best way to value a company like ANF. If you are looking at a commodity-based company, then you need to be more careful since earnings from the past couple of years are based on unprecedented run-ups in underlying commodity prices.

2008 Nov 18 12:52 PM

[TheWay:]

Absolutely. The key is long term. The only question for all investors to ask themselves is: Is my portfolio positioned for the S&P 500 at 2400 within 10 years?

2008 Nov 18 01:57 PM

[Lilguy:]

I use fundamental analysis to help me in making investment decisions, and it is consistently a great "plus" in that effort. So, I appreciate your POV on the infinite timeframe cash flow horizon.

Still, I find it almost impossible to see around the corner, that is, the next market upturn (or downturn in happier times). As a result, I tend to use fundamentals, especially PE ratios, as a way to look at the intermediate term. This enables me to consider the earnings issues you mention and their implication for price. Other things being equal (a rare occurrence), I find that a combination of a low PE ratio, a high dividend yield (ie--higher than USG or bank CD returns) from companies with a long history of steady or increasing dividends, and sound prospects for participating in an economic recovery (I won't be in ANF) whenever it comes makes for the basis of a pretty good quantitative valuation analysis.

2008 Nov 18 02:08 PM

[eternitus:]

Good article and I agree entirely. Problem is there is no long-term money playing in the market right now. Looks like only short term traders are left. Long-term guys are either fully invested (because stocks have been very cheap) or waiting for stability. Meanwhile... leveraged investors and hedge funds are trying to raise cash from the market to stay in business. Plus, we have tax-loss selling to contend with. Stocks will be under pressure until January.

I'll keep buying right through the bottom... wherever that is. Very nice dividend opportunities out there.

2008 Nov 18 02:50 PM

[akenaton:]

normalized earnings means nothing as this would imply that we are in a normal world which is not the case. To me what is more important is the amount of cash remaining into the company and its burn rate.

There are few stocks (like Conoco that somone mentionned above or Schwab) that are trading below their cash value and on top of it they still make money. Those are the real value stocks as they are the ones that are likely to re-rate the fastest not due to earnings growth but to market sentiment.

2008 Nov 18 04:24 PM

[Jordan M:]

Normalized earnings refer to "normal" times, not boom or recession. Right now we are in a recession, obviously not normal times. When you say "real value stocks," you are referring to deep value investing (Ben Graham style), where you are looking for stocks that are trading at less than book value, or have hidden assets not reflected on the balance sheet properly. While Schwab does have more cash then its market cap, it is trading at over 4 times book value, not cheap based on Graham's standards. Conoco is trading at 3/4 book value, which I would consider deep value. At the current price, you would be buying Conoco at less than its book value and getting its relatively fast earnings growth power for free. My investing style is closer to Buffett's than Graham's. In these extraordinary times I am able to buy "Philip Fisher stocks" at "Ben Graham prices" -- small, extremely fast-growing stocks with durable competitive advantages at low price to book value, low price to free cash flow, and low private market value.


On Nov 18 04:24 PM akenaton wrote:

> normalized earnings means nothing as this would imply that we are
> in a normal world which is not the case. To me what is more important
> is the amount of cash remaining into the company and its burn rate.

>
>
> There are few stocks (like Conoco that somone mentionned above or
> Schwab) that are trading below their cash value and on top of it
> they still make money. Those are the real value stocks as they are
> the ones that are likely to re-rate the fastest not due to earnings
> growth but to market sentiment.
>

2008 Nov 18 04:59 PM