Big Difference between Price and Value

When times are good for the economy and investors are optimistic, equities tend to rise above fair value because there are more buyers than sellers. When things take a turn for the worse, stocks often trade below fair value. But Murray Leith, director of investment research at Odlum Brown, wants his clients to remember that there is a big disconnect between “price” and “value” in emotionally-charged, fear driven markets.

Market experts say peak-to-trough declines of 50% for both the S&P/TSX composite index and the S&P 500 have pushed many companies to well below their intrinsic value. Many large companies on both sides of the border that are in less-cyclical industries and were intrinsically attractive before the latest market downturn are now trading at exceptional prices, Mr. Leith said. And in many cases, he believes there is a very wide gap between price and value.

As a result, he said the risks associated with the overall stock market are low, noting the unprecedented scope and massive amount of monetary and fiscal stimulus in the economic pipeline.

Mr. Leith said:

Investors are impatient and forget that there is considerable delay (typically 12-18 months) before changes in monetary and fiscal policy and other economic variables work their way through the financial and economic system.

Given that most of the stimulus is quite recent and more help is likely coming, he expects economic conditions will improve in the latter part of 2009. If investors buy quality companies, with strong franchises and solid balance sheets, he said the odds of losing money are very low with a three to five-year investment horizon based on current prices.

One thing investors are likely watching closely is earnings forecasts from analysts. Pierre Lapointe, market strategist at National Bank Financial said they have become more realistic, as lower equity prices make forward-looking valuations highly attractive – at first glance.

“But North American equities are really cheap only if earnings expectations are realistic,” he said in a research note, adding that the consensus calls for earnings to grow 11.8% in the U.S. and 5.2% in Canada next year. As a result, Mr. Lapointe is taking these expectations with a grain of salt, noting that “earnings go down, not up, in a recession.”

He cited four conditions for going overweight in equities. The first is a bottoming of U.S. home prices. The stabilization of unsold inventories and lower homebuilder confidence suggests supply is steadying.

Calming of the financial sector and the abatement of credit stress is next. This is, of course, a big one due to the banking sector’s role as a link between monetary policy and the economy.

Earnings forecasts are also a factor, as is the price of oil, which Mr. Lapointe said is the only factor to show marked improvement. So while all four have shown some signs of turning for the better, until the financial stress eases, National Bank suggests a neutral position in equities.

It lowered its 12-month target for the S&P 500 to 1050 from 1150 a month ago and reduced its forecast for the S&P/TSX composite index to 9,800 from 10,800.

Mr. Lapointe said:

There is no doubt at this point that value is beginning to surface in the sectors that have been hardest hit in the past year. However, our recommended allocation remains tilted towards financials, IT and non-commodity cyclical stocks, which usually rebound the most in the latter part of a recession.

“Clearly, investors remain mesmerized by the short-term movements of the market averages, and not on things that really matter,” said Leon Tuey, technical analyst with Octagon Capital. Those are the monetary, economic, valuation and sentiment factors, which continue to suggest a “low-risk, extremely high-reward juncture has been reached,” he told clients.

He expects monetary growth will help the U.S. economy recover by the second half of 2009, if not sooner, and the current quarter will represent the trough of the economic downturn.

By any metric, Mr. Tuey sees the market as very cheap. The price-to-book for the S&P 500 is historically between 1.0 and 4.2. These days is it closer to 1.1x. The IBES Valuation Model shows that the index is 68% undervalued and its dividend yield exceeds the yield on 10-year T-Bills – the first time this has occurred in 50 years, he added.

Insider buying has surged and fear has reached an extreme, the analyst said, predicting that it will subside in the coming months, producing a market rally. “Investors should maintain their staged buying program.”

Comments

[raising4dau...:]

In ordinary times, it would be hard to dispute anything presented in this article. What ways on my mind is the massive amount of debt taken on by the gub'mint (mainly in the Bush 1.0 and Bush 2.0 administrations) as well as consumer debt.

All the "intrinsic value" in these companies could be wiped out as the feds inflate away the debt, the world runs away from our currency, and/or interest rates get ratcheted up to 20%.

The fear right now is pretty darn rational.

2008 Nov 30 03:49 PM

[investor88:]

Agree with raising4daughters, better be cautious and run risk of missing some action than take the plunge "cash is trash" which it isn't.

2008 Nov 30 05:14 PM

[happysoul77777:]

Don't tell that to the SEC and the FASB accountants. They all think that (exit) price is fair value. Therefore. all companies need to price their portfolios using exit prices. As a result, the market keeps getting cheaper and lending has been impaired, and hence the economy has been greatly damaged.

it is time to ignore the old metrics and stick to technicals.

2008 Nov 30 05:33 PM

[John Lounsbury:]

Valuation metrics quoted by the auther are all correct, but on an earnings basis the market is still over-valued. According to Standard & Poors, about one month ago, 4Q/2008 earnings would be down 13%. At the same time, the consensus of Wall Street analysts was for an earnings gain of 14%. So far, S&P estimates are looking pretty good. Furthermore, an earnings decline of approximately 20% is being forecast by S&P for the entire year 2009. Wall Street analysts are forecasting earnings growth.

If you believe S&P predictions, stocks are extremely overvalued with mature bull market-like PE ratios. We are in a contracting economy, not a bull market condition, particularly not a mature bull market..

2008 Nov 30 08:05 PM

[Prudent Man...:]

So much for the stock market's discounting validity. Another myth like the efficient market hypothesis.

I hope that only the talking heads on CNBC, WSJ, Bloomberg, Fox, and other members of the mindless business media still believe these hoaxes in order to draw naive investors into the Wall Street financial slaughter houses.

Does anyone believe that the value of a company like Exxon-Mobile, with all their various products, assets and subsidiaries, varies every day depending upon the news or what some clueless analyst says? Such nonsense has little to do with investing and only results in the chaos such as we are seeing today.

When the smoke clears and the public learns what money managers have done to pension funds and peoples life savings a generation, hopefully, will be gone from the Wall Street predators. But, with the emotion of greed that has been present forever, the lambs will be back to be slaughtered.

2008 Nov 30 08:27 PM

[User 309781:]

I believe the author of this article is right on. The securities of the U.S. economy are on a major sale at the current time.

2008 Nov 30 09:39 PM

[Jack K:]

Nobody knows. Most people look in the rear view mirror and tell you what is in front of them

2008 Nov 30 10:49 PM

[Jack K:]

And don't blame just Pres Bush. Ever see a democrat really cut spending?

2008 Nov 30 10:50 PM

[bobbobwhite:]

Leave the potential early profits to the ultimate risk takers and you will sleep better. By buying only when market technicals improve consistently, and not just when the jollyboys/girls on the nightly economic news say to buy, you will have a much greater probability that something realistically beneficial to you will happen.

2008 Dec 01 01:56 PM