…while enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster. - Benjamin Graham (1894-1976)
Benjamin Graham is regarded as the father of value investing. In 1949, he wrote the first edition of the investment classic The Intelligent Investor. Graham begins his treatise with a differentiation between speculators and investors, deriding speculators as opportunists seeking unreliable gains by "following the market." He goes on to say that in order to generate consistent returns, investors should focus on the intrinsic value of a company rather than get caught up in the day to day fluctuations of the market. In the short-term, he viewed the vagaries of the market as a voting machine moving up or down based on the immediate perceptions of speculators. Over time, Graham believed that the companies that hold real value will see appreciation in their stock price as the business grows. He goes on to tell readers that "the investor's chief problem - and even his worst enemy - is likely to be himself." In short, it is not the brainpower that an investor has that will make him or her an intelligent investor. Rather, it is discipline and patience that will lead to success on Wall Street. Of course, divorcing oneself from emotion and instinctive responses, particularly when it concerns money, is hard to do in practice. And even if you can keep emotion out of the investing equation, discerning between perception and reality can be an even greater challenge.
The voice through the phone asks, "Why don't we sell everything and go to cash for the rest of the year?" It's always the seemingly simple questions that are the most difficult to answer. The question is a good one, and came to us the other day from a client with a considerable background on Wall Street in their own right. The gains in the stock market in 2013 are beyond our expectations. As 2013 began, we were looking for a re-acceleration of growth in the United States due to the tremendous stimulus from the Federal Reserve and record low interest rates. The employment picture was improving and housing was picking up momentum. Fears of tax hikes were largely unfounded as rates remained at prior levels for most Americans. Based on these macro-economic factors, we generally had confidence in the short-term direction of the market, and these factors at the start of 2013 made the forecast easier than usual. We thought at the start of the year we might see 10% gains in 2013 on the S&P 500 after the 13% gains in 2012. To our delight, the S&P gained nearly 11% in just the first quarter. In April, we joked we should sell all equities and take the rest of the year off. Fortunately, instead of selling stocks, we sold bonds with the prospect of rising rates, and used the cash to buy even more stocks. Now, six months later, the S&P is up nearly 18% provoking us to reconsider the question of selling equities yet again.
Whenever expectations are exceeded, it is easy to say we are due for a pullback. We try to avoid "gut" reactions and look to analysis instead. We have all heard more than a few commentators, usually investment professionals, say the market "feels" expensive or that the market is due for a "correction." The very term "correction" implies that the market somehow made a mistake. The trajectory has veered off course and needs to be fixed as though the market were a spacecraft bound for orbit. Of course, markets don't make mistakes. It's the irrational exuberance or unwarranted fear that requires correcting as rational investors seek a reasonable intrinsic value. Maybe the herd failed to see the economic implications of particular events or investors failed to remember that the "obvious prospects for physical growth in a business do not translate into obvious profits for investors," as Ben Graham pointed out in 1949. To answer the question of whether to sell, we need to understand what the common perception of the current economic environment is and then do our best to gauge whether that perception is reasonable relative to current economic reality.
Our glib answer to our client's question was to ask a question of our own. "If you tell me what corporate earnings will be in 2014 I'll tell you whether we sell." Many people think investment in the stock market is an investment in an intangible asset, particularly compared to an asset class such as real estate. Benjamin Graham, Warren Buffett and we at GKV would argue the contrary. The shares of stock are direct ownership in the underlying company. Even if your share is only one millionth of the value of the whole, you still own a share. The future earnings and future cash flows from your share has tangible value. Furthermore, if you knew for certain all the future cash flows of a company and could forecast future interest rates with certainty, you could discern exactly what your share is worth using an inexpensive calculator. Of course, the problem is you don't know all the future cash flows (and neither do we), which is where perception comes into play.
Companies with great expectations will have higher valuations due to those expectations. For example, the future growth expectations of Tesla Motors (TSLA) is greater than the expectations for J.C. Penney (JCP) and the valuation reflects this. The growth expectations for Facebook (FB) are considerably greater than for Yahoo (YHOO). The expected future cash generated by these companies is significant and if accomplished will justify their very expensive valuations relative to their current earnings. If their perceived opportunities fall short of reality, if Facebook fails to generate enough paid-for advertising or Tesla fails to make affordable cars in volume or if either are eclipsed by future competitors, then the stocks are too expensive and will fall considerably. Not too long ago, many investors believed Apple (AAPL) would follow the iPhone with another insanely great product which would generate even more earnings. Today the perception is that competition is gaining ground and no new product appears imminent. The perception has changed and the stock has declined (too much in our view). The current value has to be measured against future expectations and a discerning investor should question whether these future expectations are likely in reality.
This exercise works the same way for the broad market as for individual companies. By examining earnings for an index (such as the S&P 500), we can treat the market as though it was a single company. Future earnings estimates for each of the companies that comprise the index can be added together. Analysts make forecasts on each individual company based on management's outlook. These estimates then make up an earnings forecast for the considerably broader index.
To demonstrate the correlation between actual earnings and stock market fluctuations, it is useful to look at recent history which we have included in the table below. In 2007, the earnings for the entire S&P 500 was $82.54. The corporate environment was weakening in 2007 as cracks leading up to the recession in 2008 began to show. Earnings in 2007 declined 5.9% over 2006 and the S&P 500 recorded very meager gains of 4%. As the extent of the crisis began to become known, investors adjusted their perception to fit the emerging reality and the market tumbled as earnings evaporated. Earnings in 2008 totaled $49.51, a 40% decline from 2007, and stocks in the S&P 500 declined 39% for the year. As earnings began to grow again, stocks moved higher in concert. In 2010, the S&P 500 gained 13% with the expectation that earnings would grow in 2011, which they did, by nearly the same amount, 15%. When earnings growth slowed to 0% in 2012, the market presciently recorded a 0% gain for 2011.
Accepting our argument that there is indeed a direct correlation between earnings and stock prices, the question still remains, where do we go from here? For that answer, we need to look at the expectations. The current earnings estimate on the S&P 500 for 2013 is $107.86. This estimate, if attained, will represent 11% growth over the $96.82 reported by all the companies in the S&P 500 for 2012. In our view, these results would justify the 13% appreciation in the stock market in 2012. Because investors are valuing stocks based on what they expect a company to earn in the future, it is appropriate to compare the performance in the market with earnings for the year ahead. The one exception is when investors are blindsided by a significant, unanticipated surprise such as they were in 2008. Looking farther forward, the forecast for 2014 stands at $121.85 representing 13% year-over-year growth. Not coincidently, the S&P 500 is up 18% through the end of September.
We've glossed over a few important subtleties around earnings and stock valuation, such as what exactly should an investor pay for earnings? A more rigorous exercise is to discount the anticipated future cash flows to arrive at a present value. The most common shortcut is the price-to-earnings ratio. We will spare you the details (and arguments) around using P/E ratios, but suffice it to say that P/E values for the S&P 500 have remained very stable since 2010, hovering in a tight range between 13 and 14 times earnings. So if earnings in 2014 will be $121.85, then a 14x multiple of earnings results in a value of $1,705 for the S&P 500. On September 30th, the S&P 500 closed at $1,682. The earnings multiple is very useful for looking at possible scenarios. Assume that the price-to-earnings multiple should remain constant at 14x (this is a big assumption, but humor us). If earnings were to decline to $100.00 on the S&P 500, then we can effectively argue that fair value would be $1,400 or a 17% decline from the current level. If we were to claim that 2015 earnings will be $150.00, then at 14x earnings, the market should reach $2,100 by the end of 2014 resulting in a 25% gain from September 30th.
Source: S&P Dow Jones Indices LLC, P/E is calculated based on S&P 500 on 12/31 versus actual EPS for forward 12 months.
To continue our exercise, if we have an earnings estimate for 2014 and we have a reasonable price-to-earnings multiple, then we can establish a fair value for the index as a whole. Unless of course our earnings forecast is wrong. For some time now, economists and even the Federal Reserve have been forecasting an acceleration in growth for the U.S. economy. This recovery has been slow to materialize, however. As a result, forecasts have been repeatedly revised lower as growth has failed to meet expectations. The chart below shows the progressive revisions in earnings expectations over the last eighteen months. At the close of the March quarter in 2012, the earnings forecast for 2013 was $117.91. Since then the estimate has been steadily revised lower as company guidance has tamped down expectations. As of September 30th, the forecast for the full-year 2013 stands at $107.86, a reduction of 8.5% since the early 2013 forecasts eighteen months ago.
Source: S&P Dow Jones Indices LLC.
Despite the fact that growth has been slower than anticipated, earnings growth has still been sufficient to move the market forward. The lower expectations in 2013 of $107.86 still represents 11% year-over-year growth. Additionally, the expectation remains that an acceleration is coming at some point in the near future and investors have been willing to wait for it, particularly with the Federal Reserve flooding the system with monetary stimulus.
Lastly, we think it is important to point out that earnings can grow (or decline) in one of two ways. Sales can increase which in turn will increase earnings or a firm can increase its profitability by becoming more efficient or there can be a combination of the two. Earnings growth for any reason is positive, but growth through greater profitability is finite. Over the last several years, companies have been reluctant to hire and have maximized their operating margins. As a result, operating margins for the S&P 500 are near their highs, hovering around 9.5% the last few quarters. With corporate profitability already near highs, earnings growth will have to increasingly come from increases in sales rather than through increases in productivity.
If the estimates are realistic, then we can argue that the market is fairly valued and as earnings continue to grow into 2014 and beyond, the market will move higher commensurately. Thus, we would not sell now. We would not go to cash. The stalemate in Washington will not alter perceptions for the fourth quarter of 2013 or 2014. Over the coming weeks, companies will report their September quarter results and analysts will be updating their forecasts for the December quarter and for 2014. The perception is, as best we can tell, that the economy is poised to pick up steam through the second half of the year and into 2014 and certainly the market is telling us that these estimates are feasible.
For the moment, we remain predominantly invested in stocks. If earnings reality weakens even marginally, then investor perception of fair market value is likely to weaken also. We remain cautiously optimistic that earnings growth will continue and even accelerate, but we emphasize our cautious demeanor. For now, we will stay substantially invested in common stocks. We believe the perception of smooth earnings per share growth for the next 15 months may have gotten ahead of reality, but reality still indicates a modest upward price trend in the stock market into 2014.