Fiscal Cliff, Presidential Election, European Debt Crisis, S&P 500 up over 100% in the past four years: these are all legitimate concerns investors face in today's market. Why on earth would anyone want to buy stocks at today's price level given the uncertainty that lies ahead? I have heard this same question asked for the past four years (with different fears of course), and yet the market continues to push higher. By constantly listening to the media and absorbing all the negative news which bombards us, we are missing one of the greatest corporate expansions in the past few decades. Capital is cheap, dividends are growing, cash flow is booming, and earnings are pushing to all time highs. All this is occurring while stocks are still trading at very reasonable valuations.
I am going to present my case for equities by evaluating the S&P 500 index. Investors can seek to track the index by purchasing the SPDR S&P 500 Trust ETF (SPY). With an expense ratio of nine basis points, diversification can be found at a fairly inexpensive price.
One argument I hear from clients is "the consumer is still not spending." Depending on your geographic location, this comment may feel accurate, but as the chart below depicts, consumers are spending and corporate revenue growth continues to reach new highs. Revenue is one of the most difficult line items on an income statement to manipulate and one of the most widely followed metrics by Wall Street analyst. Corporate revenue growth (as measured by the S&P 500 index) has easily expanded above pre-recession levels, a time when money seemed to grow on trees (or under your home).
Corporate earnings have followed a similar path as revenue. The old saying "stock prices follow earnings" has proven true over the past few years. As corporations refinance debt to lower interest rates, increase productivity and repurchase shares, earnings have grown at a CAGR of just under 24% since 2009 (see graph below). Profit margins (Net Income/Sales) have also increased steadily, growing from 10.75% in 2008 to 13.6% in the current calendar year.
"A bird in the hand is worth two in the bush." With all the cash flow being generated by corporations, dividends have been a very popular way to keep investors satisfied. The current dividend yield on the S&P 500 index is 2.37%. This is greater than the yield on a 10 year US Treasury Bond (less than 2%)! Corporations are not just paying stable dividends, they have been increasing them for the past few years. It is worth noting in the chart below that during 2008 financial stocks made up a quarter of the S&P 500 index and paid very high dividends. Since most financial institutions cut their dividend to zero, and have only since begun to raise them (at very low levels), the dividend yield on the S&P 500 is not back to pre-recession levels.
Conservative investors would likely respond, "dividends are not secure, while interest from the US government is." You are certainly correct: the US government has an obligation to pay you 2% for the next ten years, and corporations can cut their dividends any time they wish. The graph below shows the S&P 500's dividend payout ratio (total dividends paid divided by earnings). As you can see in 2008 corporate America was paying out more than they were earning! Common sense tells you this cannot go on forever, and as the chart above showed, dividend yields fell. I am not saying dividends are 100% secure. However, looking at the current payout ratio of just over 40%, we could see earnings fall significantly and still not jeopardize the dividend payment. Corporations are generating higher earnings, increasing their dividends, and retaining more capital on the balance sheet than anytime in the past few years.
While we are discussing the United States Government, how does their balance sheet look? In the past five years total US debt has more than doubled to over $11 trillion (see chart below). If you loan money to the US government, which has an incredibly weak balance sheet, you will certainly be repaid, but the 2% annual interest payment will likely be eroded away by inflation.
Taking a look at corporate balance sheets, we see the opposite story. By keeping interest rates at virtually zero for the past few years the Federal Reserve has essentially transferred corporate debt onto its balance sheet and allowed corporations to refinance debt at substantially lower interest rates. This has allowed corporate America to strengthen their financial position and lower their interest expense. The Fed's asset purchase programs have worked, and corporate America is now sitting on more cash than ever. The graph below shows cash per share for the S&P 500 (cash plus short term investments divided by shares outstanding). What we are observing is a growing pile of cash on corporate balance sheets, this data should help ease investors' anxiety when compared to the US government's balance sheet.
Uses of Cash
So what will corporate America do with all this cash? Isn't a growing level of cash indicative of fear among corporate boards (failure to deploy capital)? I think four possible scenarios will be played out with all this cash over the next few years, all beneficial for shareholders.
-Share repurchase programs - as more shares are repurchased and retired, there are more earnings, cash flow, and dividends for each shareholder. This has been a theme for the years and will likely continue.
-Increasing or initiating dividend payments - we have already seen proof of this over the past few years, as large technology companies like Apple (AAPL) begun initiating dividends this year. Microsoft (MSFT) recently increased their dividend payment by 15%.
-Mergers and acquisitions - a great way to grow and reach new consumers is to merge or acquire your competitor. Companies like International Business Machines (IBM) are approaching double digit acquisitions this calendar year.
-Capital Expenditures - as companies strive to become more efficient their technology and infrastructure, spending will increase. We have already witnessed this as corporations are rapidly improving productivity. The graph below depicts sales per employee (revenue dividend by employees). Although you can argue that job cuts have improved this metric, we are beginning to see new jobs created every month (roughly 100,000 a month).
We have witnessed an impressive market rally and stocks are still attractively valued based upon a number of historical price multiples (see chart below). Price-to-Earnings (orange line), Price-to-Cash Flow (yellow line), and Price-to-Book (green line) are all trading below pre-recession levels and below their five year averages. Remember that these low valuations occur at a time when corporate America is more profitable, more efficient and more financially healthy than they have ever been.
So with the final quarter of the year just getting underway, take time to consider your investment goals and objectives. Earning 0.05% in a money market or 0.30% with your bank's CD is not exciting to anyone. While the 2% 10 year government bond seems attractive, when rates tick up and inflation begins to rise, your perceived "safe" investment will actually earn negative real returns.
Stocks, on the other hand, offer a compelling case for long term growth potential. As long as you can avoid the "noise" and don't mind the occasional quarter or two of volatility, you may want to consider stocks over the long term. With a possible 2.3% dividend yield and the potential for growth, a few years down the road investors will likely be asking themselves why they didn't invest in more equities.
Disclosure: I am long AAPL.