Several years ago, I used to admire General Electric (NYSE:GE) for its industrial business. However, I disliked its media business segment and was not keen on GE Capital either. So I steered clear of General Electric. In 2009, when General Electric bought Vivendi's (OTCPK:VIVEF) stake in NBC Universal, and agreed to sell a controlling stake to Comcast (NASDAQ:CMCSA), I was pleased. The sale concluded in February 2011, and I bought into General Electric during August and September 2011, adding to my position in February 2012. When General Electric sold its remaining 49% stake in 2013, I added further positions. As far as GE Capital is concerned, like most major industrials (examples Caterpillar (NYSE:CAT) or Deere (NYSE:DE)), a financing arm is more or less a necessity. The part of GE Capital offends that me is its consumer facing business, and it is clear that the company is rapidly shrinking this business. Along with the recently reported spin-off of Synchrony, it is clear that the consumer business is considered non-core by General Electric. Thus, I am now wondering whether it is worth adding further positions.
In this post, I seek to understand how different market participants view General Electric and then determine whether General Electric provides a worthy opportunity to create alpha through beta.
In my view, General Electric is poised to deliver alpha. However, since I already have a substantial position in the company, I will take the risk of missing out on this alpha opportunity. There are reasonable odds that a better entry point will present itself if the market weakens.
How do different market participants view General Electric?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better. The model output for General Electric can be viewed here. There will be some differences between the model output you will see on the website versus the information presented below - this is because I run the algorithm for a coverage universe of all stocks with a market capitalization of over $100 million, while the site runs it for a coverage universe of all stocks with a market capitalization of over $10 million.
This quantitative analysis of investor behavior suggests that the market is neutral on General Electric. The model indicates that the stock might be very attractive to a value investor who gives no weightage to other important key investment criteria: the key indicators for growth, ownership quality, return and profitability and momentum are fairly ugly.
Source: MaxKapital Archives
However, despite high value scores, value investors, however they might allocate capital, are neutral to General Electric. The stock is shunned by momentum, growth, balanced and by stock selection style agnostic investors allocating capital at industry level, and to growth investors allocating capital with no specific industry or sector capital allocation bias. For everyone else it is unexciting.
Source: MaxKapital Archives
The Case for General Electric:
Why look at General Electric now?
Firstly, General Electric is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, the stock delivers a generous yield of 3.38% (see Reuters Quote for GE) which is a premium to the market yield. This too adds defensive characteristics to the stock.
Cyclicality and General Electric
In my view, the U.S. economy is getting ready to shift from mid-cycle to late-cycle conditions. And during late-cycle, stocks in the industrials sector tend to underperform, having outperformed during the early and mid-cycle phase of the business cycle. You can have a look at this information from Fidelity here to understand their take on sectors and the business cycle. One note of caution: I find reading the business cycle is getting increasingly difficult with globalization - for instance, today I think the U.S. is exhibiting classic signals of a move towards late-cycle conditions. However, the global business cycle is quite out of sync with the U.S. business cycle. And since many U.S. companies are very influenced by the global business cycle it is more difficult to figure how U.S. sectors will behave. For example, industrials are expected to underperform in late cycle conditions. But if Europe, other developed markets or emerging markets shift into early or mid-cycle conditions (which is a time when technology typically outperforms), U.S. companies in the industrial sector in general (and General Electric in particular) could well outperform.
Regardless of the current state of the global economy, in my view, the long-term growth drivers lie in emerging markets; and General Electric is a major beneficiary of this theme. It is amongst the best ways of playing the long-term emerging markets growth opportunity, without the risk associated with direct investment in an emerging market company. This provides a wonderful balance of opportunity combined with corporate quality superior to that available in emerging markets.
The S&P 500 at 1,891 is trading at 19.55 times 2013 as reported earnings estimated at $96.72. General Electric reported consolidated earnings of $1.47 per diluted share for 2013. On February 26th, General Electric lowered diluted earnings for 2013 by $0.09 per share after reaching an agreement with Shinsei Bank (OTCPK:SKLKF) on the Japan "Grey Zone" claims. Ignoring this one off item, with General Electric priced at $26, it is trading at 17.69 times 2013 earnings. Earnings expectations for 2014 are $1.70 for General Electric and $106 for the S&P 500. Thus, General Electric trades at 15.30 times current year expectations, and the S&P 500 trades at 17.80 times. As a result, General Electric is seen as cheap relative to the market.
Now General Electric does not have a low beta. The beta, based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, is 1.37. Adjusting this for beta's tendency to converge to 1 gives an adjusted beta of 1.30. So perhaps General Electric does deserve to be cheaper than the market on a risk adjusted basis. On the other hand, I estimate that, General Electric will enjoy a 175 basis point growth premium over the S&P 500. This offsets the higher return demanded by investors as a consequence of the higher beta.
What is our long-term return expectation for a stock with a beta of 1.30, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate, and it works out to almost 12%, versus a market return expectation of 10.25%. The math of the multiple is influenced by growth as well as beta; and if General Electric does enjoy a growth premium of 175 basis points versus the S&P 500, it offsets the beta risk spread demanded by investors of 175 basis points. Thus, General Electric should attract the same multiple as the market. And if it did, General Electric would be priced at $28.74 using S&P 500 multiples of 2013 estimated earnings, or $30.26 using S&P 500 multiples of 2014 estimated earnings.
This tells us that General Electric is cheap versus the market, but in my view, the market is expensive. So I would like to estimate whether General Electric is rightly valued for the long-term on a stand-alone basis instead of on a relative valuation basis.
Analyst price expectations
Recently General Electric traded at $26. From Yahoo Finance we know that eleven analysts expect an average price target of $28.73 (median $28.00), with a high target of $32 and a low target of $26. This is a not a particularly wide dispersion in expectations. It is early in the year, so far, the bulls looking for $32 are behind in the race, while the bears looking for $26 as a twelve-month target have the upper hand.
We might believe that General Electric is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that General Electric is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in-line with our long-term expectations on a stand-alone basis and regardless of broad market valuations.
Beta Assessment: Making alpha through beta
When we look at the make-up or components of alpha, it is clear that the market return and risk free rates are uncontrolled by investors. It is equally clear that investors cannot influence the beta. Therefore, the question is, what does influence beta? There is more detail on both alpha and beta in this post. In my view, the key factors that influence beta are business mix, financial leverage and the market's perception of leadership quality. If a change in any of these factors can be reasonably expected, the beta will change. When it does change, the perception of risk associated with the security versus the market also changes. And as the perception of risk changes, returns demanded by investors change. This provides a massive opportunity to generate abnormal returns, or alpha.
In the case of General Electric, we have seen the business mix changing with the disposition of the media business. We have also seen business mix changing with down-sizing of the GE Capital segment and we have seen financial leverage reduce too. Because of this, it is important to look at not only what the beta is, but where it can be expected to go. The beta based on a three-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, is 1.18. And adjusting this for beta's tendency to converge to 1 gives an adjusted beta of 1.14. Now with the Synchrony IPO, both the financial leverage employed and business mix will change further, and that could reduce beta even further. We could well see the General Electric beta fall to one or less in the years to come. But for now, to err on the side of caution, I will estimate the forward beta at 1.14.
Mathematically, the worth of General Electric is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.14, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 1.14 differs from the beta you will find elsewhere, because it is based on a three-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. The rate of return investors can be expected to demand is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for General Electric, we should be targeting a long-term return of 11.06%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. For General Electric, I am using the Reuters analyst consensus earnings per share for 2014 of $1.70, as an estimate of sustainable earnings. This might seem a bit aggressive, but earnings (excluding non-recurring and discontinued items) declined from $2.20 in 2007 to $1.03 in 2009 and have been growing nicely since. In addition, I do expect a return of the emerging market growth cycle, as well as the energy cycle perhaps a year later, and these should be very positive for General Electric.
Besides, from this chart, you can see the trend of normalized trailing twelve-month earnings, together with analyst projections for the current and next three years. Not that it means much, because analysts, including myself are often proven wrong! The point is that while I may be barking up the wrong tree, I am in good company.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect General Electric will pay out approximately 55% of earnings via dividends and buybacks (40% to 50% via dividends and another 15% to 5% via buybacks) over the long term. An adjusted payout ratio of 55%, assuming nominal earnings growth of 8%, implies a return on incremental equity of 18%: the 45% of earnings retained, invested at an 18% return on equity, delivers the required 8% (45% * 18%) growth. This return on incremental equity might be viewed as a bit on the high side, but is an acceptable estimate given the level of leverage employed in General Electric's capital structure.
If we use a very long-term growth expectation of 7.2%, General Electric is worth $26.00. General Electric Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107.20% * $1.70 * 55% / (11.06%-7.2%) = $26.00. At this price, it is likely that an investor with a return expectation of 11.06% will be satisfied.
The growth estimate implied by the current market price of 7.2% is low. In my view, General Electric can be expected to grow at a faster rate: an 8% growth rate in line with potential real Global GDP growth of 4.2% and global inflation of 3.8% should be achievable. If I am right, the spread between the 7.2% growth priced by markets, and an 8% growth expectation, is 0.80%: this represents potential long-term alpha. Alpha is the difference between actual returns and the risk adjusted return expectation. Since we have a risk adjusted return expectation of 11.06% for General Electric, a long-term investor targeting a risk adjusted return of 11.06% will end up earning a return of 11.86%.
In comparison, the S&P 500 is priced to deliver negative alpha of 0.70%. If we use a very long-term growth expectation of 6.95%, the S&P 500 is worth 1,890.00. S&P 500 Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.95% * $106 * 55% / (10.25%-6.95%) = $1,890. At this price, it is likely that an investor with a return expectation of 10.25% will be satisfied. My estimate of long-term nominal earnings growth for the S&P 500 is 6.25%, based on a mix of long-term nominal U.S. growth and long-term nominal global growth. And if I am correct, the market is over-valued and pricing seventy basis points, of negative alpha. Thus, relative to the S&P 500 as currently priced, General Electric is positioned to deliver 155 basis points of alpha.
An investor with a shorter time horizon might do quite well too. A price target of $32 implies confidence in long-term earnings growth rising to 7.9% from 7.2% at present. And a 7.9% long-term growth rate expectation is broadly in line with my long-term expectations. General Electric Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107.90% * $1.70 * 55% / (11.06%-7.9%) = $32. But I suspect for this to occur we need no market weakness, and catalysts such as delivery of earnings at or over the current estimates.
The post is done - this is an explanatory note
The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.
If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations, and the equity risk premium. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted payout assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stock's beta, and stock return expectations.
There is a high degree of inter-connectivity between beta, growth, adjusted payout ratios, risk free rates and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas, which I hope will help.
1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is Long-term Return Expectation minus Long-term Growth Rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations and higher for stocks where the confidence in growth is low. In the very long term, the growth risk premium has tended towards 4.5% for the market.
2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. Then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings
3. When you look at long-term growth rates, remember it is not the next year's growth, or the next five years' growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rate for some years, reversion to market growth rates and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five-year forward rate, and then assume growth shall revert to being in-line with market growth expectations for the following 45 years. What this signals is that I am willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].
4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the payout ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk and this implies a higher beta, and a higher market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.
Disclosure: I am long GE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.