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In the middle of all the chaos, I kept my optimism on the global recovery by staying on the bullish side of the market. I do not think the doom and gloom atmosphere created by the pessimists is justified by strong fundamentals. Surely, the post-crises global macro environment does not look as clear as the pre-crises period. Especially since the Eurozone issues will keep irritating the investors for a long period. However, amidst this chaotic atmosphere, the global U.S. companies managed to keep on reporting increasing profits. Particularly, the technology companies such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), IBM, Google (NASDAQ:GOOG), and Oracle (NYSE:ORCL) experienced whopping EPS growth rates. They are also attractively priced in the stock market. Looking at the following table further clarifies my points:

Company

Avg P/E

Dividend Yield

EPS growth past 5 years

EPS growth next 5 years

Exxon Mobil (XOM)

9.62

2.35%

1.71%

8.49%

Apple (AAPL)

11.77

0.00%

64.95%

18.71%

Microsoft (MSFT)

9.00

3.08%

17.63%

10.48%

IBM (IBM)

13.45

1.63%

18.59%

10.71%

Google (GOOG)

17.84

0.00%

39.28%

19.31%

Chevron (CVX)

7.70

3.21%

7.69%

6.32%

Wal-Mart (WMT)

12.51

2.51%

8.96%

9.64%

General Electric (GE)

12.42

3.53%

-6.74%

13.38%

Procter & G. (PG)

15.41

3.22%

9.95%

8.68%

Johnson & J. (JNJ)

13.99

3.55%

7.35%

6.24%

AT&T (T)

13.14

5.96%

17.77%

3.54%

Pfizer (PFE)

12.83

3.80%

-0.04%

3.10%

Coca-Cola (KO)

14.32

2.79%

19.98%

6.37%

Oracle (ORCL)

13.81

0.82%

21.12%

12.96%

Wells Fargo (WFC)

8.81

1.85%

-0.35%

11.85%

Philip Morris (PM)

15.25

4.07%

8.06%

11.41%

JPMorgan (JPM)

6.64

3.14%

11.34%

8.69%

Intel (INTC)

9.59

3.62%

7.49%

10.65%

Merck & Co. (MRK)

17.14

4.63%

-33.42%

4.90%

Verizon (VZ)

15.39

5.16%

-16.07%

10.68%

Average

12.53

2.95%

10.26%

9.81%

For simplicity, let's assume that there exists a fund that sells for $1000 which allows us to equally distribute an amount of $50 into each of the stocks above. By getting a single share of that fund we will achieve a pretty diversified portfolio of 20 equities. I excluded Berkshire, since it is a diversified holding company that invests in other companies. In this exercise, we are creating our fee-free portfolio of U.S. equities.

Our fund has an average trailing P/E ratio of 13.93 and forward P/E ratio of 11.13. Thus, the mean P/E ratio of our portfolio will be 12.53. The current value of the fund will be $1000, but the fund itself will invest in companies which have a total book value of $471 (We will use this number, later). Dividend yield will be equal to 2.95%, with a payout ratio of 37.84%. The annualized EPS growth projection for the next 5 years will be 9.81%. While the black swans might claim that this is unattainable growth estimate, these companies were able to boost their earnings at an annualized rate 10.26% in the last 5 years amidst the chaotic periods.

Although we have experienced one of the worst economic disasters since the Great Depression period, these companies experienced a double-digit earnings growth rate. Only General Electric, Merck, and Verizon experienced considerable declines in earnings. Note that both GE and Verizon had several spinoffs in this period, which partially explains the negative EPS growth rates. Surely, things did not work out well for General Electric in the last decade, but I think the company has a much better future. (Full analysis, here).

Let's return back to the portfolio, where we invested an equal amount of money in each of the stocks above. We just acquired a diversified portfolio of companies that has shown a pretty good earnings growth performance ---even after accounting for the profit-crusher effects of the financial crises. And best of all, the earnings are expected to grow near the same amount for the next 5 years. One might wonder about the fair-value of our portfolio, since the mean book value is only half of what we paid for. We can estimate our portfolio's fair value using discounted earnings plus equity model as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate.

Calculation Results

The mean EPS growth estimate of our portfolio is 9.81%. I will use a discount rate of 11%, since that is the traditional return of the equity markets. You can set these parameters as you wish according to your own diligence.

Based on the model above, the 5-year discounted earnings model will give a fair value of $1300, and this number does not include the book value. A significant portion of these companies have free cash and other types of assets at hand, which are recorded in their book value. Adding the book value of these stocks will give us an upper range of $1714. We just calculated the fair-value range of our portfolio as between $1300 - $1714 per share. Since this portfolio is valued at $1000 at the current market prices, it is obvious to me that our portfolio has significant upside potential. In fact, it is undervalued by at least 30% with a potential of up to 70%.

One can also calculate the O-Metrix score of the above portfolio as follows:

  • O-Metrix = 5 x (EPS Growth Estimate + Yield) / PE ratio
  • O-Metrix = 5 x (9.81 + 2.95)/12.53 = 5.1

For the portfolio above, the O-Metrix score will be calculated as 5.1 out of 10. This is surely not a great deal as the mid-recession valuations, but it still signals a good margin of safety.

Summary

The stocks did not perform as well as the other asset classes in this year so far. Even precious metals that have no value, other than what you are willing to pay for, had positive returns. There are pessimistic views on the global economy, but the markets are undervalued. It might be claimed that cash is the king, but cash does not earn anything other than a negative inflation-induced de-valuation. The end-of-the-year period and the first month of the year are traditionally known as the best performing periods. Last year, in the same period, S&P was up from 121 to 131. So, get into the market while you can to make the most from the year turnaround rally.

Disclosure: I am long AAPL, INTC.

Source: Get In The Markets While You Can To Make The Most Of The Turnaround Rally