America's Latest Obsession And Its Investment Consequences: Part 3 - Stock Market Valuation Issues

Includes: ESIC, KO, MSFT, PG, T, VZ, WMT
by: Philip Mause

Editor's Note: This article is the third in a series: Part 1, Part 2.

One of the interesting things about many of the national obsessions I have lived through is that, after an enormous flood of publicity, after grave speeches solemnly delivered by politicians and "opinion leaders, after elaborate academic studies and proposals, not a lof lot really got done. This has certainly been true of the "moral equivalent of war" declared by President Carter on the Energy Problem, has largely been true about concerns over "competitiveness," and almost certainly will be true of the recent national concern about obesity.

After a great deal of huffing and puffing, Congress didn't really cut spending much this summer, and most cuts will turn out to be non-binding commitments which can be abandoned by future Congresses and Administrations. On the other hand, the Federal Reserve took the occasion to make its own non-binding commitment to keep short Treasury rates at essentially zero for another two years. Of course, the Fed can always renege on this promise, but the Fed has always been concerned about "credibility," so I think that it will not behave like Lucy with the football that Charle Brown constantly wanted to kick unless the economy is really steaming along. And even after two years, it is likely that the Fed will be cautious in raising rates, given the traumatic financial experience it has been through.

What, if anything, does this mean for stocks? How and/or why are interest rates relevant to stock valuations, and what are the transmission mechanisms that will tend to push the market one way or the other, due to low interest rates?
I frequently read a variety of commentators who opine that the "market is cheap" or the "market is expensive," based on a valuation metric. Some of these metrics take no account of interest rates - for example, the 10 year trailing PE or the Tobin Q. Others - like the Fed model - put interest rates at center stage. At a time like this, it is vitally important to think this issue through because you get a very, very different answer depending upon whether a metric takes interest rates into account.
I also believe it is important to differentiate interest rates the Treasury pays from interest rates corporate America pays. In late 2008 and early 2009, Treasury rates were low but corporate rates were insanely high. Many of the mechanisms I am going to discuss here were simply not operating. So we must have our eyes set on corporate rates - perhaps using triple B rated bonds as a crude surrogate for the borrowing costs of corporate America.
That said, let me emphasize that I believe that a period of extremely low interest rates, if combined with reasonable spreads on corporate debt obligations provides a very strong tailwind for the stock market. Here are some of the reasons.

1. The Dividend Yield/Interest Rate Comparison. Investors seeking yield on their investments will find stocks relatively attractive if the dividend yield on the stocks is higher than interest rates on bonds, CDs, money market funds or other fixed income investments. At last week's close, the Dow 30 had a dividend yield of 2.82%, the S&P 500 was at 2.35%, and the Dow Utilities Index was at 4.27% - all above the interest rate on 10 year Treasuries. Bear in mind that these are all dividends that qualify for the favorable tax treatment granted by the Bush (now Obama) tax cuts which have a year and a half to run and which the Republicans will fight to extend the way the Russians fought at Stalingrad. It is not hard to find companies with a well- established record of increasing their dividends for not only years, but scores of years - Procter & Gamble (NYSE:PG) or Coca Cola (NYSE:KO) or, better yet, companies with so much cash on their balance sheet like Microsoft (NASDAQ:MSFT) that even a downturn in the operating business would be very unlikely to cause a dividend cut. It is very hard to imagine that ten years from now you will be better off having bought a 10 year Treasury than having bought a selection of these type stocks.

2. Financial Engineering - Share Repurchases. Companies that can borrow at very low rates or that have substantial balance sheet cash can almost certainly increase per share earnings substantially by using cash to buy back stock and reduce share count. Our tax system makes this especially attractive because interest is tax deductible. As long as the earnings yield per share is more than the after tax interest expense (or lost interest income in the case of a company using balance sheet cash for the repurchases), the repurchases will be accretive to earnings. Since the earnings yield is the inverse of the price earnings ratio, a company like Microsoft (MSFT), which is earning roughly 1 percent after tax on its balance sheet cash can increase its earnings by using the cash to buy back stock as long as the price earnings ratio of MSFT stock is less than 100. MSFT can even save money on a quarterly cash flow basis, because its dividend yield is higher than its after tax interest income on balance sheet cash.

3. Financial Engineering - Cash for Stock Takeovers. The same kind of analysis applies to cash for stock takeovers. As long as the PE of the acquired company is less than the after tax borrowing cost incurred to do the acquisition or the after tax interest income on the balance sheet cash used for the takeover, the takeover will be immediately accretive to earnings without any synergies. I have been analyzing a company - EasyLink (NASDAQ:ESIC) - which has essentially followed this strategy by acquiring an operation which was somewhat larger than its own pre-acquisition size.

These are the most important, but there are others. For example, companies with considerable balance sheet debt may be able to refinance at lower interest rates and immediately save money. Private equity firms(to the extent they have access to cheap borrowing) can also afford to pay more for takeover targets and still make money.
Some of the names that this strategy suggests are: 1. High dividend yield stocks - Verizon (NYSE:VZ), AT&T (NYSE:T); 2. Stocks of companies that have been and will continue reducing share count through repurchases financed at low opportunity costs - MSFT and Wal-Mart (NYSE:WMT); 3. Takeover targets to the extent you can find them before they are actually taken over (don't try to pull a Gordon Gekko here); 4. Companies that have used and/or will use the low interest rate environment to make strategic acquisitions like ESIC.
Of course, in the stock market, in the short-term, anything can happen. But after the dust settles, investors will be hungry for yield, and corporate managers will be delighted to use some of these strategies to "engineer" their corporations into higher earnings per share.

Disclosure: I am long PG, KO, MSFT, T, VZ, ESIC, WMT.