Seeking Alpha
Profile| Send Message| ()  

The Long View

We should want the market to drop. Perhaps more specifically, we should want lower market valuations. When I say "we," I am referring to those individual investors who intend to be invested over the long term and will not be trimming their holdings in the near future. I know this may seem counter intuitive to some. I often get those strange looks and comments from friends and family when I mention that I would prefer to see the stock market go down. Please don't misunderstand me. I certainly do not hope for bad things to happen such as wars or high unemployment rates. I am able to enjoy the market heading higher especially if earnings, cash flows and dividends are increasing as well. It is just that I realize that I will get better long-term returns if investors are simply more leery of stocks.

Buyer Beware

I believe the majority of individual investors in the stock market should be long-term investors or at least willing to be. How else does an individual investor stand a chance of navigating the vicissitudes of the stock market? An investor who may need the investment back within 10 years probably should not be substantially invested in stocks. Sure, I think stocks, particularly dividend stocks with sustainable earnings growth, are one of the best vehicles for growing wealth over the long term. This has certainly been true in my life. However, individual investors must understand the risks and have realistic expectations. In this article, I am not exploring those risks but rather why we may benefit from lower market valuations. Before we delve too deeply into these benefits, I first want to discuss how we fundamentally think of stock prices.

Changing Perspective

Imagine that you had a large part of your savings invested in one company. You get up one day and you realize that the company has a trading value of zero. You can't sell your equity for a penny. What if you also had a lot of unpaid time invested in the company? In addition, you realize your reputation is on the line. What would you do? Would you panic?

Interestingly, this is the normal situation for entrepreneurs. When I was building my last company, I never once panicked because there was no trading value or even a single bid for my equity. Instead, I was focused on owning a business not a stock symbol. I was concerned about our operations, clients, cash flows, etc. but not about the value of my equity. Admittedly, I became very interested in the valuation of my equity when I received an offer to sell it.

Buying Businesses Not Stocks

Shouldn't we think of our stock purchases the same way? Shouldn't we be buying businesses that provide real products and services and that generate real cash flows? Here is what legendary investor Warren Buffett had to say:

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years."

Having owned private businesses, I look at the fact that I could sell my stocks on a moment's notice at market value as a blessing and not a curse. I think investors many times get this backwards. Still that does not explain why I would generally prefer lower stock valuations. The reason for this has to do with earnings and competition.

Earnings

Public companies may utilize their earnings and the large amount of cash they are holding in the following ways:

  1. Dividends
  2. Stock Buybacks
  3. Acquisitions
  4. Investments in Operations

As a stockholder I potentially benefit from lower stock valuations from each of these uses of earnings.

Returning Cash to Shareholders

When a company returns cash to shareholders either through dividends or share buybacks, shareholders potentially benefit from lower stock valuations. If the shareholders reinvest any of the dividends received, we benefit from lower valuations by getting more in earnings, cash flow, dividends, etc. for each dollar reinvested. Even if we do not reinvest our dividends, we still benefit from lower valuations because of stock buybacks. Warren Buffett uses the example of IBM to explain why lower stock prices are beneficial in regards to stock buybacks:

"Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

"If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the 'disappointing' scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the 'high-price' repurchase scenario had taken place." (Source: 2011 Berkshire Hathaway Annual Report. page 6)

Buybacks are significant when you consider that their value has exceeded that of dividends during 7 of the last 8 years for the S&P 500. Not unlike dividends some companies execute more buybacks than others. The following are the top 20 companies for the largest buybacks for the 1st quarter of 2012 according to S&P Indices:

S&P 500 20 Largest Q1 2012 Buybacks, $ Millions
CompanySectorQ4 2011Q4,'04-Q1,'12
Exxon Mobil (XOM)Energy$5,704$179,606
Intl Bus. MachinesInformation Technology$3,015$87,045
American International Group (AIG)Financials$3,000$10,855
Procter & Gamble (PG)Consumer Staples$2,259$59,274
AT&T (T)Telecomm Services$2,066$23,502
ConocoPhillips (COP)Energy$1,899$35,003
Lowe's Companies (LOW)Consumer Discretionary$1,789$12,642
Oracle Corporation (ORCL)Information Technology$1,659$18,408
Pfizer (PFE)Healthcare$1,659$29,724
Wal-Mart Stores (WMT)Consumer Staples$1,589$39,090
Intel Corporation (INTC)Information Technology$1,519$46,570
Philip Morris International (PM)Consumer Staples$1,427$22,710
Amgen (AMGN)Healthcare$1,375$31,548
Motorola (MSI)Information Technology$1,365$10,184
DIRECTV (DTV)Consumer Discretionary$1,260$19,759
McKesson Corporation (MCK)Healthcare$1,202$6,507
The Home Depot (HD)Consumer Discretionary$1,131$28,500
The Coca-Cola Company (KO)Consumer Staples$1,079$17,726
Microsoft Corporation (MSFT)Information Technology$1,023$103,193
Chevron Corporation(CVX)Energy$996$25,628
Top 20 $37,016$807,474
S&P 500 $84,294$2,702,068
Top 20 % of S&P 500 43.91%29.88%

Acquisitions and Investments in Operations

If you are a shareholder in the acquiring company, lower stock valuations are a direct benefit when the acquisition is done with cash. When it comes to investments in operations, the benefit from lower stock valuations is a bit more opaque, but nonetheless true. Higher stock valuations create a larger incentive for more competition. Consider the internet-related companies in the late 90s. When the premiums for these businesses soared to the point of valuing them based on eyeballs or simply on possibilities, we were flooded with more. You can see this in the IPO market with many new companies going public as market valuations are getting stretched and the opposite when the stock market is depressed.

Summary

Lower stock valuations increase the likelihood that the earnings of companies, whether they are returned to shareholders or used for growth, will generate higher future rates of return. In addition, lower stock valuations should discourage hyper competition among companies. If you are a long-term investor and not looking to trim your holdings in the near future, you might actually benefit over time from a contracted market multiple.

Source: We Should Want The Market To Drop