Monday, September 19, 2011

Large Cap Stocks: High Earnings Yield, Low Borrowing Costs

From this recent Barron's article on cheap European stocks. According to the article, the Euro Stoxx 50 trades at roughly 8x earnings and has a dividend yields above 5%. The S&P 500 is more like 12x earnings with a 2.2% yield.

Here are some of the stocks* mentioned in the article.
-Telefonica (TEF)
  P/E: 8.4, Dividend: 8.1%
-Total S.A. (TOT)
  P/E: 6.2, Div: 6.9%
-Vodafone (VOD)
  P/E: 9.6. Div: 5.4%
-Royal Dutch Shell (RDS.A)
  P/E: 8.0, Div: 4.3%
-Sanofi (SNY)
  P/E: 7.0, Div: 3.9%
-Novartis (NVS)
  P/E: 10.1, Div: 3.6%
-Unilever (UN)
  P/E: 13.4, Div: 3.3%
-Siemens (SI)
  P/E: 8.9, Div: 2.8%

With the exception of Unilever, all the above have earnings yield (inverse P/E) exceeding 10% and, in the case of Total S.A., more than 15%.

Many large companies (whether in Europe or elsewhere) are tapping the bond market, raising low cost money, to make acquisitions or return cash to shareholders in the form of dividends and share repurchases.

In the month of September alone, there has been $ 40 billion of investment-grade debt offered so far.

The combination of low-cost borrowing and, at least in some cases, oddly undervalued shares of large capitalization businesses makes what is happening pretty inevitable.

It creates an excellent environment for the long-term investor.
(Though some of the above businesses happen to be beyond my comfort zone and, as a result, their shares are of little interest to me as long-term investments.)

Now, this past decade brought to the forefront how extremely overvalued assets produced in bubbles cause serious economic problems. Widespread mispricing and misallocation of capital leads to recession or worse.

What may be less obvious is that extremely undervalued equities can, at least in the short run, also hinder near term economic potential.

How?

Consider that in some cases the above is done in lieu of building plants or buying equipment; things that tend to lead to economic expansion and job creation. So at least the short run, these expansion opportunities becomes a relatively less attractive alternative when extremely low cost borrowing is available to a strong business with a cheap stock.
(Building factories, launching new businesses is not exactly easy. Plenty can go wrong. Buying back stock to generate something like a low risk 15% return for shareholders is a lot easier than building factories, launching new businesses, etc.).

In addition, many companies in that situation will frequently be acting wisely by using a good chunk of its free cash flows for buybacks. This process should continue until the market adjusts price to something that more closely approximates intrinsic value.
(Well, at least if management is tending to their capital allocation responsibilities.)

Buying a company's own cheap stock is the right thing to do for corporate managers but, at least in the short or intermediate run, it produces at the margin somewhat less economic activity. Some might be tempted to "fix" this to somehow encourage growth.

That'd be a mistake. Capital allocators need to focus on deploying dollars based on their judgment of return potential relative to the risk being taken (especially when the opportunity happens to be something that management should understand best...the business they are running).

For the economy at large, clearly expansion by these businesses would be the more desirable outcome. So consider the following:

In a perfect situation capital markets** serve the world best when, more often than not, the prices of individual securities spend most of their time fluctuating around some reasonable estimate of intrinsic value.

Realistically, capital markets will always be sometimes manic other times depressed and prices inevitably will reflect emotions as much as logic and insight (things like efficient markets might suggest otherwise but that thinking is flawed at its core).

That is the nature of markets.

Knowing this, it seems clear they shouldn't be structured in a way that amplifies this nature.

In its current short-term hyperactive construct I'd say the markets do tend to amplify.

Extremely low valuations can, at least at the margin in the near term, delay or suppress an economic recovery (though I am far from suggesting this alone is at the root of our current weak economy). Still, there's no reason to change what amounts to rational corporate behavior.

Instead, it'd probably be better to get at the root of why our capital markets are going to extremes so frequently.

Maybe it is, at least in part, as Mason Hawkins and his colleagues suggest:

"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders..."

Capital Markets: An Overshadowed Servant to Traders?

So I doubt it comes down to any one thing but odds are good that what Hawkins is saying is a part of the problem. Developing a market structure (along with other incentives) that better supports a longer-term investing ethos in place of the existing hyperactive casino-oriented system would surely be a win.

So until an opportunity to expand becomes the best risk-adjusted use of capital for a good business, buybacks make sense if the stock is cheap, debt can be had at low cost, and the balance sheet is healthy. A recent example:

Intel's Debt Issuance
Intel (INTC) recently announced it was issuing debt to finance a buyback.

Intel's $ 5 billion Bond Sale

Last week Intel issued 5, 10, and 30 year debt at an average rate of 3.35% (the after tax cost is even less when you consider the deductibility of interest). They can use those low cost funds (and their ample free cash flow) to buy back a stock with an after tax earnings yield north of 10%.

In this statement, the company said the proceeds will mainly be used to fund stock buybacks.

As it stands now, there's the potential for more situations like this.

A good thing for the long-term shareholder as long as the core business franchise has a reliable moat combined with a healthy balance sheet and the stock is, in fact, cheap.

Adam

Long positions in TOT, SNY, INTC

* Cheap valuation is just a starting point, of course. More research and due diligence is naturally always required.
** The market as a whole is not particularly inexpensive in my view. I'm talking about the mispricing of individual securities. Keep in mind, mispriced securities is a great thing for an individual long-term investor. While true at the individual level, a market system designed in a way that produces frequently mispriced assets doesn't serve its broader role for society very well. That role being, among other important things, the transfer of capital from investors to productive businesses that can provide a return on that capital long-term. How much in the current financial markets culture do we hear of making sure the system is doing a good job of capital formation and allocation? I think it is pretty clear the answer is not enough. Just because human nature nearly guarantees that there will always be mispriced assets, that doesn't mean we shouldn't attempt to design things in a way that reduces the tendency to misprice -- beyond what's, well, inevitable -- as much as possible. Intrinsic values just don't change nearly as much as market prices would suggest. There are sensible ways to begin reducing how often and by how much things become mispriced. It surely won't happen anytime soon, but real improvements could be made on this front. Difficult is rather different than not possible.
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