We sat down with a colleague yesterday discussing the current market state. We stated that current conditions are producing a non-correlated equity market. We define correlation as an aggregation of intentions producing directional markets—or market participant’s act as if they are in a herd environment where everyone follows overall sentiment. For instance, the tech market of the late 90’s and early 2000’s had a high correlation of investors buying technology stocks—some of which had no game. Late 2008 and early 2009 showcased a highly correlated market of selling everything. From March of 2009 the market has displayed correlation of buying beta inspired by Qualitative Easing 1 and 2.
But we stated diversity seemed to hold dominance today. Our colleague disagreed with us. He said while the extremity of March 2003 or March 2009 was obviously gone, there still exists herd mentalities in certain areas. Our conversation was cut short and he wasn’t able to extrapolate his opinion but it prompted us to look for correlation we might be missing.
We found an area we feel is showing signs of correlation which could lead to a bubble down the road.
In today’s market, a rare commodity is safe income. With interest rates low and the fed’s intention to keep inflation at bay it’s hard to find income of any size in today’s market. The exception to this is certain companies where the dividend is high. We looked at two companies with outsized dividends, StoneMor Partners and Alliance Resource. StoneMor’s dividend yield currently is 7.85% and Alliance’s dividend yield is currently 4.57%. Both yields are considerably higher than any high quality corporate/municipal/treasury bond in the market today. The correlation we found lies in the valuation—which makes perfect sense based on yield craving investors littering today’s market landscape.
Both have similar valuations. We looked at each from two different valuation methodologies.
First we looked at each from a historic accounting based ratio perspective. We calculated the 10 year average for 4 different ratio’s and then took that average and applied it to current numbers to see where each company could trade at if it traded at 10 year averages. For instance, Alliance’s 10 year price to earnings ratio average is roughly 9 times. We calculate 2010 earnings per share at $8.74 so if the average price to earnings ratio is 9 times, a fair value based on the price to earnings multiple would be roughly $78.5 per share. Alliance currently trades at roughly $75 per share so we feel alliance is trading at fair value based on a 10 year price to earnings average. Most of the other ratio’s brought to the same conclusion of fair value for both Alliance and StoneMor.
We then looked at each company from an economic valuation methodology. We calculated multiple multi factored discounted cash flow simulations on each company and came to a widely different conclusion. Based on free cash flow, each company is overvalued by roughly 20-30%.
So what does this mean.
We interpret this as investors correlating to past accounting driven valuations instead of future based economic reality.
In our history of investing, this divergence is a recurring scenario that can exist for long periods of time. We happen to think eventually stock prices will adjust to economic reality creating opportunity based on current valuation divergence.
The simplicity of the evidence is an opening to short economically overvalued dividend paying companies—Stonemor and Alliance being at the top of our list to short.