The S&P 500 Not Overvalued, Still Undervalued Given ROA Strength Of USA Corporates

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 |  Includes: SPY
by: Joel Litman

Summary

Aggregate US Corporate Profitability, as measured by Adjusted Return On Assets (ROA) Is Highest in 60+ Years.

US Corporate ROA's hit new highs in 2012 and 2013, now exceeding those levels in 2014.

Underlying corporate management activities and discipline, including low corporate investment growth, supports continued - not a short-lived - ROA peak.

The notion of "reversion to the mean" from peak levels is important if viewed in context. There is danger in calling for a reversion before it begins.

A higher corporate ROA supports higher market valuations, making the market specifically NOT overvalued and more likely still undervalued.

Every month, we update our best estimate of aggregate U.S. corporate profitability. We calculate the Adjusted Return On Assets (ROA) of 4,000+ of the largest companies in the United States. Today, our estimated ROA for 2014 stands at an amazing 11%. This is a record-setting high, and above 2013's 10% ROA. It's a testament to the discipline of US Corporate Management in the face of tough economic times. It's also the reason why market valuations for major indexes like the S&P500 (NYSEARCA:SPY), are actually justified at current levels, if not slightly under-valued.

Note that this is a follow-up to our article last year in Seeking Alpha, about the folly of going short when corporate profits are hitting new peaks.

This strong and steady upward march of corporate profitability has not stopped, with 2012 around 9%, 2013 above 10% and now 2014 estimated at 11% or better. This ROA improvement helped to drive 2013's stock market performance, and it continues to support it now. These levels are well-above the long-term, 50+ year corporate average of around 6.5%.

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This is one of the continuing reasons that the team at Valens sees the existing U.S. stock market as fairly-valued and even slightly under-valued. Certainly not overvalued.

Continued strength in corporate Adjusted Earnings (E) contributed heavily to the observed increase. Meanwhile, over the last six years, management teams have by and large focused on asset efficiency. Our Adjusted Assets (A) calculation remains tempered in growth. Divide a cleaned-up calculation of earnings into assets, E over A and you see how both are driving the strong ROA.

One of the major concerns at the time we published last year, and no doubt an even stronger one today, was for "reversion to the mean." If ROAs are at peaks, the concern was and is, maybe the market is at peaks ready to revert. Maybe, though probably not.

The following quote is from the great economist and Nobel Prize winner George Stigler in 1963:

"There is no more important proposition in economic theory than that, under competition, the rate of return on investment tends toward equality in all industries. Entrepreneurs will seek to leave relatively unprofitable industries and enter relatively profitable industries…"

Bart Madden, a long-time friend and important mentor, and the author of the book, CFROI Valuation, first introduced me to Stigler and his concepts. At the time, I was beginning my career as a financial analyst learning the hundreds of adjustments necessary to removing distortions that stem from the many incomparabilities and inconsistencies in reported financials.

Bart also taught me about "context." One learns that the precision and discipline for calculating corporate returns is wasted if one does not understand the context of those returns. What levels constitute a high return, what makes for a low return, and what characteristics accompany returns fading up and down over time? This context is as important as the sophistication of the return calculation itself.

The bears in the market would see the peaking ROAs as a sign that there is a long way down. If that happens, and ROAs retreat, then corporate valuations will fall with it, and so the stock market. With this notion, the market pessimist has a foundation for gloom even in such a healthy environment of profitability. So much for having such great returns. The bear market outlook would interpret this to suggest the market's imminent collapse with the impending reversion to the mean.

However, there is a key point in Stigler's remark, which can be lost. The reversion to the mean requires competitors to "...enter relatively profitable industries..." When that happens, those ROAs are competed away as price competition reduces the numerator of ROA, Adjusted Earnings.

New entrants to an industry mean new capital and otherwise larger balance sheets, increasing the denominator of ROA, Adjusted Assets. Unless there is untapped potential in that market, the source of the falling ROA comes from companies growing faster than their profits.

"When that happens" is the operative phrase. We need to ask where the competition will come from to reduce these ROAs. It seems like for a while at least, there is no desire for new entrants into most industries, regardless of the desirable ROA levels.

Companies continue to restructure their balance sheets, with a long-term hangover effect of the 2007-2008 credit crisis. As a whole, management teams in the U.S. continue to harvest their existing assets, making their businesses more efficient. They are not pouring new assets into business expansion.

Healthier balance sheets and improving ROAs are behind improving credit ratings as well as rising equity valuations. For instance, Valens Credit's recent calls on Navistar (NYSE:NAV) and US Steel (NYSE:X).

Our measure of quarter-to-quarter and year-to-year Adjusted Assets shows the low-growth trend among companies. The idea of "new entrants" to these relatively profitable markets doesn't appear strong.

In our proprietary aggregate earnings call analysis, we benchmark key management statements, and how they state them, for several hundred earnings calls per quarter. In the last three to four quarters, management has displayed a distinct disinterest in investing much of the incredible profits they are generating.

Companies in Europe and much of Asia are still re-building from the credit crisis and the impact of too-early-implemented austerity rules. European firms are not exhibiting such high levels of profitability as we see in the States. Therefore even if they had the desire to grow, they don't have the cash flows to do so. It would seem that as a whole, much of the world is still trying to pull back on capital expenditures in a more defensive posture.

When companies begin spending on business investments again at a faster pace, that alone still wouldn't suggest a reversion of the peak ROAs. In the past, companies have shown a remarkable ability to grow into markets where they see incremental ROAs as very positive. That may serve to even compound the value of the ROAs, generating higher valuation multiples. For now, however, we see lower investment growth levels, making for easier analysis - and forecasts - of sustained ROAs and market valuations.

Trends do not continue forever, and the concept of reversion to the mean is one of the most important concepts for investors. That said, attempting to pick exactly when that reversion will begin is not easy. Given the drivers of profitability and market levels, trying to identify that peak ahead of time takes more than simply identifying that a peak exists. We may be seeing new highs, however these highs can get higher, as in 2012 and 2013. Now 2014 is showing that higher peak again.

Markets can be volatile and can retract after making new highs. However, if the fundamentals highlighted here continue, a correction may more likely be a buying opportunity than a selling signal.

Our fundamental signals weigh heavily in saying that the reversion to the mean is not coming anytime soon. Higher ROAs justify today's market valuation levels, and also moderately higher.

I personally thank you for reading through the work of all the personnel at Valens Equities and Valens Credit that is used in this article, and I truly welcome your comments.

Disclosure: The author is long SPY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.