PE? No, PEG!

by: William Darusmont

As an investment professional with 45 years of experience, I can't stomach the astounding P/Es on a few stocks.

The market will go up until it doesn't.

The PEG is vastly more important than the PE.

Old timers may recognize the title as a play on an old General Electric (NYSE:GE) ad that began. GE! I am constantly told on SA and by many investors I know that these astonishing P/E ratios are nothing to worry about. Instead, they are a sign of investor confidence. That they are but Robert Shiller would and has called it "irrational exuberance."

A friend, who manages money, sent me a list of industries he had an active interest in, some of which he holds, others are on his watchlist. That got me to thinking, so I researched them and some others I am curious about and present them for you to decide whether these stocks and the broad market are overpriced:

Stock Symbol P/E Fwd P/E P/E to Gr (PEG) DIV.
AAPL** 18.8x 15.0x 1.75x 1.46%
AMAT 17.0x 13.4x 0.96x! 0.74%
AMZN** 304.0x! 278.6x! 19.2x! n/a
CSCO** 20.3x 16.0x 2.21x 2.96%
HD 26.2x 25.3x 2.1x 1.88%
LOW 22.1x 20.1x 1.6x 1.78%
FB 34.3x 31.5x 1.2x n/a
GOOG 36.4x n/m 1.77x n/a
PYPL** 59.7x! 41.0x! 3.06x n/a
MAR** 37.1x 32.2x 2.47x 0.97%
RHI 21.9x 22.2x 8.85x 1.72%
TWTR* æ 61.8x! æ n/a
BAM (Note: not BAC!) 93.7x! 95.4x! 11.6x 1.30%
BIP 166.9x 46.7x 4.9x 3.96%
BPY 95.5x n/a n/a 5.37%?
LRCX** 17.6x 13.2x 0.8x! 1.04%
LMT 26.1x 24.5x 10.0x 2.49%
CHKP 22.5x 20.0x 2.7x n/a
WKDY n/a 108.0x! n/a n/a
ITW 25.5x 24.9x 2.4x 1.88%
PH 25.9x 21.1x 1.8x 1.31%
*Neg. Earnings
** 10%+ in >5 ETFs
***5%+ in >5 ETFs

Compare the columns showing the P/E ratio and the P/E to Growth, or PEG, rate. To this observer, they imply that many of the stocks shown, and the broad market, can only perform well as long as the market continues to climb. As Irving Fisher, the most respected economist of his day, found out the hard way when he stated: "I believe stocks have reached a permanently high plateau." That was just days before Black Monday, 1929.

How many holding overvalued stocks will continue to do so? More likely they will sell in a market rout if history is any indicator. It may be a 1987 type selloff or it could be more like 2000, and with margin borrowing at all-time highs, like a roller coaster, the first drop will be the worst.

Make your own conclusions, but I found those asterisked of particular interest, especially those which are held by ETFs where they are 5% or more of the funds holding them. I would have liked to have had the actual number of funds holding them, but based on their size and importance, it is safe to say that there are many more which would give them even more downside risk in a market rout. I also see the combination of huge P/Es and little or no dividends troubling. Draw your own conclusions.

How many of those stocks would Warren Buffett, a disciple of Graham and Dodd, look at, let alone buy? G&D professed the importance of dividends, and while the decline in the corporate tax rate from 35% to 22% is a boon for the smaller companies, the S&P 250 average rate currently is 19%. Thus it could be a boon for small caps...large ones not so much. Furthermore, many of those with offshore headquarters or tax headquarters, think Medtronic (NYSE:MDT), are paying far less there as I pointed out in a prior article. I also discussed the broad labor market available to companies offshore due to access to the entire EU labor pool at a time when the administration wants to limit access to U.S. companies. The upshot of this is the corporate tax cut will not succeed as intended. Don't take my word for this: here is a compilation of the rates paid by major corporations.

As I wrote this yesterday, Costco (NASDAQ:COST) had just announced blowout earnings, taking the stock to a new high on an opening gap to $195.36...and immediately plunged and is now off 1.4%...that's what I'm talking about.

Going one step further, ETFs, if they are managed properly, do the opposite of what many mutual funds do, which is the number one reason for owning them: tax considerations. Instead of getting a big capital gain at year end as with a mutual fund, ETFs harvest losses and then offset them with gains. The second reason to own them is significantly lower fees and no time restrictions without penalties (if they don't do both, avoid them). The other caveat is pay attention to bid/ask spreads and if they are wide use limit orders to avoid getting burned. With regard to Costco, it is unlikely there will be much ETF selling due to the tax consequences...especially under the new tax law where all sales are FIFO: first in, first out.

While Apple is not a favorite of mine, despite being at all-time highs, it isn't overvalued. In contrast, Amazon is priced to perfection. PayPal is even more absurd and priced like Bitcoin (yesterday, Merrill Lynch announced it will not allow any transactions in it on its platform).

Twitter is so rich that Trump must be buying it. Surveys of advertisers continue to show they have no confidence whether social media is adding value. To me, they would get more benefit from political contributions. Lastly, Lockheed Martin (NYSE:LMT) better benefit from the increased military spending that Trump has promised.

This brings us to the new, improved tax bill, which is a huge bet on corporations doing the right thing: repatriating funds from abroad, paying the tax, and hiring U.S. workers. In the U.S., where our CEOs receive around 300 times the average employee, we are blinded to compensating them for moderate or even mediocre performance, whereas foreign companies (although not nearly to the degree of U.S. corporations) have followed suit since the Millennium, but still lag significantly. Meanwhile the majority of CEOs are not overpaid and in fact underpaid.

This brings us back to dividends and how to avoid the double taxation that Congress has bestowed upon them, regardless of the corporate tax rate. Thus, as Nobel laureate Dr. Franco Modigliani preached for decades up to his death, the correct rate is zero. With a zero tax rate (offset by elimination of all government subsidies, one can wish anyway, and taxing all dividends at the full individual tax rate), the incentive to do stock buybacks is diminished or eliminated, except when the stock is priced by the market way below its true value thus allowing management to show confidence and buy back the stock.

My finance background began with Dr. Harry Markowitz, also a Nobel laureate for his work in Modern Portfolio Theory, and who heavily influenced Stanford's William Sharpe. For that reason, I cannot accept the high price/earnings multiples as sustainable. Yes, the market is always right, but only in the short run, and when we forget this, we set ourselves up for failure. Thank you for reading!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.