In our previous post, we reviewed the valuation of the Market based on CAPE and forward operating earning estimates for the S&P 500. These two indicators provide the reader with a general estimate of valuation of the whole Market. Consequently, after our brief analysis and review, they seem to indicate that the Market is currently expensive.
Analysis of Individual Companies Supports Notion that Market Appears Expensive
Nevertheless, our bottom-up analysis of individual companies initially indicated to us that the Market may be expensive and was the initial source of our concern as well as motivation for writing this letter to you. Currently, few companies appear to be cheap when looking at future earnings and cash flow on a risk-adjusted basis. Where we used to have nearly 150 companies on our list of potentially cheap companies that required evaluation, we now have approximately 30. The reader should note that this list is updated daily. Of those 30 companies, we will be content if three to four of them pass our evaluation process as strong potential investments.
Furthermore, from the company screens and research that has been conducted in the past couple weeks we’ve noticed a trend of caution from our anecdotal evidence. The trend is that companies that appear cheap on an earnings basis are usually expensive from a free cash flow basis. For those that may be wondering, this problem has been revealed in both asset-light and asset-heavy companies. In theory, cash flow and earnings should, over time, eventually move towards and not away from each other. With this in mind, we worry about the quality of earnings that are being reported by companies. If the quality of earnings is in decline, then one can expect future earnings and cash flow to be lower than those levels necessary to justify current Market prices. One metric that may prove helpful is the “Excess Cash Margin,” which is explained in more detail here. Investors who are currently evaluating their investments should be on guard for such differences and look into the reasons for these differences.
Yes, we understand our evidence is not empirical. Again, we remind the reader this is a very informal opinion that will continue to be fleshed out in future weeks.
As stated in the prior post, expectations of future earnings and cash flows for these companies seem to be very high. In other words, the Market and its companies appear to be priced for perfection with no room for error or risk. In such a situation, if estimates are not met to the liking of analysts and the market, then the price of the Market or the company will decline significantly.
For instance, on November 10th, Cisco announced that its growth rate estimate for its revenue for the next fiscal quarter was about half of the growth rate analysts had estimated. As a result, the stock dropped approximately 16.3% in one day. This is a rather large one day drop. The problem is that in an expensive market with high expectations and bullish sentiment, any shock to high expectations can cause a stock to drop rather quickly, and in some cases cause a panic, as people realize their investment was on hope and not sound fundamentals.
Since this drop, Cisco’s management and others have argued that the stock remains a buy and is cheap. Cisco’s management has gone an extra step in announcing an additional $10 billion repurchase of its common stock. Based on our models, the only way that Cisco can be justified as cheap based on fundamental operating data is if for the next five years it averages 10% sales growth per year and yields an earnings before interest and taxes (“EBIT”) margin of approximately 30%, both of which require the company to significantly outperform its last 10 years of operating performance. Moreover, the company would have to obtain such growth as a much larger company than it was 10 years ago. This revenue growth, if achieved, would have Cisco surpass the current revenue of Microsoft in 5 years. With its growth estimates in mind, perhaps Cisco should save its cash for growth projects and not repurchase its shares. Even if it does achieve such growth, Cisco still doesn’t present an investor with a large margin of safety. Of course, this is a back-of-the-envelop evaluation that serves as a sanity check and does not include a qualitative perspective, which is required for a complete analysis. Nevertheless, even though many value investors appear to like the stock, it would not go on CBI’s list of possible investments for more detailed evaluation at its current price, primarily due to our belief that it remains expensive with little margin for safety.
More non-performance of operating fundamentals or future shocks have a strong likelihood of putting downward pressure on Cisco’s price and other stocks whose price is dependent on lofty expectations of future performance. From our experience the more hope that a stock’s price is based upon, the more acute the decline in price, which means it may be hard for investors to close out of such a position before losing their gains.
Furthermore, we are beginning to question the wisdom of the many companies that are announcing share repurchases as a good use for their cash. Does an investment in their own shares represent the best return possibilities for companies and their cash? A company that states it wants to execute a repurchase of its outstanding stock can have several motivations, but prices do not appear cheap enough, especially in Cisco’s situation, to make such a use of cash appear wise at the moment. This is worrisome especially for the asset-heavy firms that rely on capital expenditures to justify their future earnings and free cash flow forecasts. At present, no one should blindly purchase shares due to a company announcing a repurchase of its shares. Such an action should be evaluated in context of the whole company.
Many companies before 2008’s collapse announced buybacks thinking their shares were cheap. Yet, they probably wish they had waited a few months longer. This is a topic that we will definitely be following up on in more depth later this month.
To be continued with more analysis on sentiment and some basic steps one can take to protect himself.
Disclosure: No Positions