- Risk aversion levels are rising as is apparent from a recent swing in investor interest from growth to value, and from small-cap and mid-cap stocks to large-cap stocks.
- The S&P 500 is priced to deliver negative alpha, whereas Wal-Mart is not.
- Wal-Mart displays solid defensive characteristics, attractive during a period of expected market weakness.
- With a low co-efficient of determination, Wal-Mart is especially attractive because its price movement is dependent more on company specific factors, than on general moves in market prices.
The market is expensive. If we work with a risk free rate expectation of 4.50%, and a long-term equity risk premium of 5.75%, we are setting our long-term return expectations at 10.25%. This we expect from a market where long-term nominal growth can be expected at 6.25%, with shareholder value returned via a mix of dividends and buybacks of 53% of earnings. You can read more about where I get my estimates for long-term market returns, long-term nominal growth, and the equity risk premium here.
With as reported earnings for the S&P 500 estimated at $106 for 2014, if we use a very long-term growth expectation of 6.99%, the S&P 500 is worth 1,845.00. S&P 500 Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.99% * $106 * 53% / (10.25%-6.99%) = $1,845. At this price, it is likely that an investor with a return expectation of 10.25% will be satisfied. My estimate of long-term nominal earnings growth for the S&P 500 is 6.25%, based on a mix of long-term nominal U.S. growth and long-term nominal global growth. Alpha is the difference between actual returns and the risk adjusted return expectation. And if I am correct, the market is over-valued and pricing seventy-four basis points, of negative alpha. If we use S&P 500 operating earnings estimates of $116 for 2014, we get forty-four basis points of negative alpha.
As of now, negative alpha of forty-four to seventy-four basis points suggests that markets are expensive, but not terrifyingly so. It is time for lower risk appetite or rising risk aversion levels, and for rotation out of expensive pockets of the market, to cheaper areas. Churn, not exit is what is evident. The S&P 500 is attractively valued at 1,492, if you rely on as reported earnings, and at 1,633 if you rely on operating earnings. This does not necessarily suggest that a bear market is imminent: the implied over-valuation of 11% to 19% is very much in-line with the customary level of over-valuation during periods outside of recessions.
In my view, selling a market simply because it is expensive is not a good idea. Markets can go from being expensive to very expensive, and from being cheap to very cheap. And no one knows which it will be. But negative alpha is an important market timing tool for asset allocators - it hints that it might be time to return to allocation by selling some of the expensive asset class, and buying another asset class.
During times when alpha expectation turn negative, it also pays to listen closely to the voice of the market, for that is where we can see changing levels of risk aversion. In U.S. we have seen small and mid-cap stocks out-perform large capitalization stocks for a long while. We have also seen growth stocks outperform value stocks for an extended duration. This signals low levels of risk aversion amongst market participants. But in recent times this has changed. There are clear signs of a shift in bias back to value from growth and from small and mid-cap stocks to large cap stocks. This suggests that risk aversion levels are rising. And so the more active asset allocator might also use an expectation of negative alpha to adopt a more defensive equity portfolio.
In this post I will use the AOM SmartScreener to produce a list of stocks with strong defensive characteristics, and look closely at Wal-Mart (NYSE:WMT). I am more than happy to do future posts on any of the stocks on this screener: just leave a request in the comments section, send me a message, and I will.
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. The AOM SmartScreener is a tool currently in development: it will allow users to the output of the AOM system in conjunction with several key indicators, to generate customized investment ideas.
The AOM Smart Screener
This screen displays stocks with a market capitalization of over $50 billion, beta of below 1.2, weekly and monthly volatility in the lowest quintile, and an AOM Score of between 55% and 70%. Since the screen objective is safety, I have selected low beta, low volatility large capitalization stocks, which the AOM System sees as ranging from acceptable to strong, but not too strong.
Source: MaxKapital Archives
How do different market participants view Wal-Mart?
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of 38 key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stocks sector, and the stocks industry of operation.
Wal-Mart scores high on value. It scores high on quality in comparison to its industry of operation, with lower but acceptable scores in comparison to the whole market or its sector of operation. The score for momentum is positive in comparison to its industry of operation, and acceptable in comparison to the whole market and its sector of operation. However, Wal-Mart scores very poorly on growth, regardless of how we look at it - the key indicators for growth at whole market, sector or industry level are all abysmal.
Source: Alpha Omega Mathematica
AOM Model Recommendation
While value investors typically focus on value, they will give some weightage to Quality, Growth, and Momentum. Wal-Mart value scores are impeccable, but it carries most appeal to a value investor seeking to allocate capital at industry level. A value investor seeking to allocate capital at a sector level, or without any sector or industry bias, would be comfortable to hold. The same holds true for persons using a balanced or momentum stock selection style, and for persons with no specific stock selection bias (the style agnostic investor): for all these stock selection strategies, those seeking to allocate capital at a sector level, or without any sector or industry bias, would be comfortable to hold, while those allocating capital at industry level would be inclined to buy. A person using a growth based stock selection style might hold the stock, regardless of whether the allocate capital at sector, industry, or whole market level: while it might be difficult to believe, growth investors will consider value, quality and momentum when making investment decisions.
Source: Alpha Omega Mathematica
The Case for Wal-Mart:
Why look at Wal-Mart now?
Firstly, Wal-Mart is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, on February 20th, Wal-Mart raised the dividend to $1.92 per share taking the dividend yield to 2.5%, which is a premium to the broad market dividend yield. This too provides defensive characteristics to the stock.
Beta, co-efficient of determination and alpha intercept considerations
Value-line reports a beta of 0.60 for Wal-Mart. The value-line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 0.43, and I adjust it to 0.88 on account of the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock.
The coefficient of determination for Wal-Mart is 21.82%. This suggests that only 21.82% of the price movement in Wal-Mart is explained by movements in the market: the residual price movement is based on company specific factors. This low coefficient of determination suggests that the market related risks are low. And because company specific risks can be diversified, Wal-Mart is a great pick for most portfolios at the present time.
Wal-Mart also have an alpha intercept of 0.05%, which means that if the S&P 500 returns 0%, the stock can be expected to return 0.05%. But because of the low coefficient of determination, the raw beta and alpha are less meaningful.
Cyclicality and Wal-Mart
In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, stocks in the consumer staples sector tend to outperform. If I am right, this is good news for Wal-Mart investors. Wal-Mart belongs in the consumer staples sector. Consumers visit Wal-Mart for their monthly needs, which tend to be stable as monthly essentials don't change very much during recessions and slow downs. As a result, earnings volatility is low over the course of an economic cycle. This too lends a defensive character to the stock.
You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance today I think U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync, with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle, it is more difficult to figure out how U.S. sectors will behave. For example, technology is expected to underperform in late cycle conditions. But if Europe, other developed markets, or emerging markets, shift into mid-cycle conditions, which is a time when technology typically outperforms, U.S. companies in the technology sector could well outperform. Let's not forget that of Wal-Mart's $473.07 billion in net sales, $136.51 billion (28.9%) came from Wal-Mart International.
Analyst price expectations
Recently Wal-Mart traded at $77.31. From Yahoo Finance we know that twenty-one analysts expect an average price target of $81.29 (median $81.00), with a high target of $90 and a low target of $66. This is a wide dispersion in expectations, which suggests risks are high. It is early in the year. So far, the bulls looking for $90 are behind in the race, as are the bears looking for $66 as a twelve-month target - no one has the upper hand. In a bearish market, I would look to consensus for the winner.
We might believe that Wal-Mart is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Wal-Mart is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in-line with our long-term expectations on a stand-alone basis and regardless of broad market valuations.
Mathematically, the worth of Wal-Mart is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 0.88, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Wal-Mart, we should be targeting a long-term return of 9.56%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. Since Wal-Mart is less sensitive to the economy, and the history over the past ten years displays low levels of volatility in earnings, I am happy to go with $4.85 as an estimate of sustainable earnings. This chart below displays normalized trailing twelve month earnings over the past ten years, together with analyst expectations for the current and coming three years.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Wal-Mart will pay out approximately 50% of earnings via dividends and buybacks (approximately 35% via dividends and another 15% via buybacks) over the long-term. An adjusted payout ratio of 50%, assuming nominal earnings growth of 6.25%, implies a return on incremental equity of 12.50%: the 50% of earnings retained, invested at a 12.50% return on equity, delivers the required 6.25% (50% * 12.50%) growth. This return on incremental equity is not unreasonable to expect.
If we use a very long-term growth expectation of 6.23%, Wal-Mart is worth $77.31. Wal-Mart Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.23% * $4.85 * 50% / (9.56%-6.23%) = $77.31. At this price, it is likely that an investor with a return expectation of 9.56% will be satisfied.
The growth estimate implied by the current market price of 6.23% is in-line with my expectations. However, if analyst expectations are to be believed there is a small alpha opportunity of forty-four basis points. Value-line, which is one of the best sources for quality research and data, expects earnings for Wal-Mart to be at $7 during the 2016-18 period. You can download their research report here. Alpha is the difference between actual returns and the risk adjusted return expectation. In the case of Wal-Mart, an estimate of earnings of $7.25 for the year ended Jan 2018 suggests that earnings growth is expected at an annualized rate of 10.57% over the coming four years. If we get this level of growth for four years, after which growth reverts to a 6.25% long-term rate for the next forty-six years, we get a composite very long-term fifty-year growth rate of 6.67%. By computing this composite fifty-year growth rate we are not suggesting that growth will decline to 6.25% in the fifth year: we are simply implying that we are willing to pay a premium for the next four years' growth, after which as long standing shareholders, we would expect to participate fully in growth rates which run at a premium to market growth rates. Since we have a risk adjusted return expectation of 9.56% for Wal-Mart, a long-term investor targeting a risk adjusted return of 9.56% will end up earning alpha of forty-four basis points (6.67% composite long-term growth less 6.23% growth currently priced by markets) and earn a return of 10.00%.
An investor with a shorter time horizon might do quite well too. A price target of $90 implies confidence in long-term earnings growth rising to 6.69% from 6.23% at present. And this level of expectation is well within the realm of possible outcomes. Wal-Mart Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.69% * $4.85 * 50% / (9.56%-6.69%) = $90.
To cut a long story short, Wal-Mart is priced at a level which offers between zero and forty-four basis points of alpha, compared with the S&P 500, which prices between forty-four to seventy-four basis points of negative alpha. That indicates that Wal-Mart creates alpha relative to the S&P 500 of between forty-four to one hundred and eighteen basis points. I know it does not sound terribly exciting, but with the magic of compounding it is significant. And it represents 4.3% to 11% of a total long-term market return expectation of 10.25%.
The post is done - this is an explanatory note
The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.
If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta and stock return expectations.
There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratios, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas, which I hope will help.
1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is long-term return expectation minus long-term growth rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations, and higher for stocks where the confidence in growth is low. In the very long-term, the growth risk premium has tended toward 4.5% for the market.
2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings
3. When you look at long-term growth rates, remember it is not the next years' growth or the next five years' growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rates for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in-line with market growth expectations for the following 45 years. What this signals is that I'm willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].
4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long-term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.
Disclosure: I am long WMT, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.