[Originally published here on 8/1/2014]
Today’s 30-point sell-off in the S&P 500 is consistent with my warning a few weeks ago that the Fed was “behind the curve.” It made no sense, I argued, for Chair Yellen to still be pursuing an emergency monetary policy, with zero short rates and continued bond buying, five years into an economic expansion that is finally gaining some traction. Fear of rising inflation could hit the bond market hard, particularly because Dodd-Frank has dried up capital on the trading desks of those nefarious investment banks.
That warning has been validated by a 4% GDP print for Q2 and a 0.7% jump in the ECI (Employment Cost Index)—figures that obviously are not consistent with a labor market that has plenty of “slack.” Throw in “unrest” in Ukraine and Gaza, stiffer sanctions on Russia that will hurt European “growth,” and incoherent domestic policy with respect to tax policy, the Texas “border,” etc. and you get a 2% sell-off which may get worse.
The stocks most at risk in a bursting bond bubble are “bond surrogates” such as utilities with juicy dividend yields. They have looked expensive to me for quite a while but performed well as investors “reach for yield.” Which got me to wondering—how over-priced are these “bond surrogates,” some of which I own? So, I turned to my oh-so-sophisticated valuation model, the PETTR Principle, which is the equation:
PETTR Ratio = (PE of the stock on consensus 2014 EPS) / (dividend yield + long-term EPS growth rate)
So, for a stock with a PE of 16x, a dividend yield of 2%, and a growth rate of 11% the PETTR ratio . . .
=16 / (2+ 10)
(In this equation, the PE ratio and the dividend yield are established fact; the growth rate you have to estimate based on your knowledge of the company and economy. No database will provide it. And remember this is about the future, not the past; extrapolating the past four years probably won’t work too well.)
Solving for the Growth Rate Consistent with a PETTR Ratio of 1.5
The stocks I own—a broad selection of quality growth stocks—have an average PETTR of 1.5. So, I looked at a group of “bond surrogate” stocks – 8 electric utilities, the 2 big telecoms, 3 consumer staples, and 4 big pharma names—and asked “What growth rate do these names need to have, for their PETTR Ratio to be 1.5?” For example, (NYSE:AEP) has a PE of 15.3x and a dividend yield of 3.8%, so it would need to have a growth rate of 6.4% for the PETTR ratio to be 1.5—that is, 15.3/(6.4+3.8)=1.5. The next step is to look at that 6.4% growth rate and ask “Is this figure look realistic, given analysts’ EPS estimates for the company, and what we know about the state of the industry?”
Before we get to the results, consider a few characteristics of the 17 “bond surrogates” studied:
- Their average dividend yield is 3.9%, about twice the S&P 500
- Their average PE is 16.7x, about the same as the S&P 500
- Their dividend payout ratio averages 64%, about twice the S&P 500—which, by definition, means their retention ratio (1 minus payout ratio) is half the S&P 500.
These facts suggest their growth rate should be less than the S&P 500, because the very high payout ratio and low retention ratio mean they have comparatively little capital to reinvest in their business to generate future earnings growth.
Anyhow, here are the results:
- For all 17 companies, the average growth rate needed to have a PETTR ratio of 1.5 is 7.3%; the median is 6.2%. These figures are not ridiculously high, but they do look too high for 17 big, mature companies with very high dividend payout ratios. Judging from history and the current weak state of the global economy, the future EPS growth rate of the entire S&P 500 (which includes many fast-growing companies) is probably 6%. These companies will probably grow only 4-5%, not 6-7%. Bottom line: as a group, they do look overvalued.
- From a “bottom-up” perspective, when I examine the individual companies and compare the growth rate consistent with a PETTR ratio of 1.5 with my best guess at the “actual” future growth rate (based mainly on analysts’ estimates over the next three years), on average the actual growth rate is 1.2% lower. Again, they look overvalued.
- Most overvalued are the electric utilities, where the actual growth rates look to be 2.2% (220 bps) less than the growth rates consistent with a PETTR ratio of 1.5. The industry faces slow growth because demand for electricity is slowing, plus the government-subsidized “roof-top solar revolution” will hurt growth as consumers produce their own power. Companies may be obliged to maintain transmission infrastructure while they are starved of revenue from generating power. I would avoid all electric utilities that are not restructuring stories or “special situations.”
- The two telecoms, Verizon (NYSE:VZ) and AT&T (NYSE:T), look reasonably valued; VZ looks cheaper than T.
- The three consumer staples Altria (NYSE:MO), Philip Morris (NYSE:PM), Kraft (KRFT) also look reasonably valued, though not as cheap as tobacco stocks used to be.
- The four big pharma names Merck (NYSE:MRK), Pfizer (NYSE:PFE), Bristol-Myers (NYSE:BMY), Johnson & Johnson (NYSE:JNJ) look rather expensive. On average their growth rates look 120 bps lower than the figure consistent with a PETTR ratio of 1.5. I admit the growth rates are idiosyncratic and hard for an amateur like me to assess; they depend on the ability of these companies to develop new drugs. JNJ has been doing this lately, but in general big pharma has a poor track record of drug development over the past decade. Furthermore, Wall Street was treating Pfizer as a “streamlining” story that had shifted from an acquisitive behemoth to a more nimble, focused company—until it tried to acquire Astra Zeneca. This gives me pause. In general, the risk / reward in these names does not look compelling, although, again, it all depends on the specific pipelines.
Investment Conclusion: Avoid electric utilities, treat big pharma with caution.