Esteemed Yale economist Robert Shiller recently did a brief, yet insightful, interview for Money Magazine. He expressed that the current Shiller P/E multiple of ~22 implies an annualized 4% return but that this figure may not be trustworthy since "there's no solid reason it should do so well". He then balanced this commentary by explaining that (1) his colleague from the Wharton School, Jeremy Siegel, has data going back two centuries indicating a real (ie. inflation-adjusted) return of 7% and that (2) riskier assets are thought to outperform safer ones.
While I have great respect for Shiller's emphasis on value in financial markets and strongly recommend reading his work, I have my differences. In my view, P/E multiples ought to always be considered in the context of growth and that growth assumptions should be appreciative of normalization. Is there something fundamentally different about our economy five decades ago versus today? And, moreover, investors who backed the stock market for the decade surrounding the greatest crash in history would have seen their holdings more than double. Ultimately, companies have demand to supply and, if the economy normalizes around 3%, the growth drivers (ie. public companies) should also normalize around their 9% true annualized return. That has been the approximate annualized return dating back to the Gilded Age, WW1, WW2, the revolutionary 1960s, the Reagan era, and the 1990s.
To be sure, 2000-2010 was a weak decade, but we are still near the 2008 nightmare. From January 2008 to December 2011, the annualized return of the stock market was -1.7%. From January 1929 to December 1935, the annualized return of the stock market was -2.8%; but, it has been strong since. In short, there is a lack of historical evidence to say that "this time, it's different".
The total market cap of the stock market is 91.7% of GDP, which indicates that it is slightly overvalued but still likely to generate a 4.6% return. And even though the Shiller P/E multiple stands at 21.2 (versus the 16.4 average), the current S&P 500 multiple is slightly below average. Put differently, equities will almost certainly outperform bonds. And I anticipate that growth from a full recovery will compensate for the overly high P/E multiple and drive returns to their historical 9% geometric average.
In light of the uncertainty, it is nevertheless recommended that investors back certain undervalued plays. Gold producer Freeport (FCX) looks cheap based on its current valuation against probable future performance. I find that the stock might hit as high as $100 based on a logarithmic regression indicating $7.49 earnings per share by 2016. The current 7.9x multiple is well below the sector average and the 11.1x figure just 26 weeks ago. A multiple of 13x at my 2016 figure implies that the future value of the stock is $97.43 which, at a 10% discount rate, has a present value of $60.50. Needless to say, that offers a high margin of safety for an already strong brand name company. With the target price of $52.85 being more than 50% above the current market assessment, risk/reward is highly compelling despite the beta of 2. Freeport also pays a 4% dividend yield on top of this return and, accordingly, merits the "strong buy" consensus on the Street.
Oil well service firms, as a whole, also appear to be undervalued based on future growth prospects against past valuation metrics. Halliburton (HAL) may be notorious after the overblown Macondo oil spill, but the fundamentals are excellent. Despite consistently beating expectations by an average of 4.8% over the last four quarters, the stock has lost around two-fifths of its value. What's going on here? Fear? Political scorn? A combination of the two? Whatever it may be, Big Hal offers a sizable margin of safety with the P/E multiple at three-fifths of its 5-year average and 35% of its sector's.
A logarithmic extrapolation off of past momentum indicates $4.60 EPS by 2016. At a P/E multiple of 15.2x (the 5-year average), the future stock value is $69.90. A 10% discount indicates a price target of $43.40, which provides more than a 50% margin of safety. The Street similarly sees Halliburton as a "strong buy" and excellent value play.
Microsoft (MSFT) may have also lost its luster, but it has substantial value. Windows 8 looks like an attractive answer to shift the artsy market away from buying MacBooks and sticking to the historical leader. It also has an innovative user interface that translates well in tablets. Technology is an inherently competitive industry with few barriers to entry, but Microsoft still has a virtual monopoly in the PC operating system market. Office Suite is unlikely to be replaced. And although the company has flopped several times in mobile and search, they can still begin anew with little fixed costs. In light of the brand name and consistent growth performance, it is at once bewildering and temporary that the firm is valued at only 10.9x earnings. The Street seems to agree with the "buy" rating.
Then there's Intel (INTC), which is bizarrely trading at 11x earnings despite being well positioned to capitalize on positive secular trends in technology. This free cash flow machine has a $50 intrinsic value by my calculations. The target price is $39.54 based on a 10% discount rate, logarithmic extrapolation using past performance, and 16x multiple. The rise of netbooks, ultrabooks, and tablets is indicative of something larger: technological progress.
Semiconductors directly supply the end markets of technology and thus are a convenient way to diversify across the sector. There is no saying for sure what direction Microsoft will go, but it likely will experience growing demand for R&D and thus semiconductors. Betting on technology is thus an ideal way to capitalize off of a recovery.
In short, while the market may appear modestly overvalued by some metrics, even the most reserved commentary finds that equities will outperform. Whatever overvaluation there currently is, growth at the heels of a full recovery more than compensate based on my analysis. Lastly, investors can still invest around the edges of sectors in search of high risk-adjusted returns.
Author's note: all rating citations are taken from FINVIZ.com
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.