Thursday, January 26, 2012

Are Large Cap Stocks Cheap?

For some context, I'll start this out by looking at valuations in the late 1999. At that time, the top five U.S. companies in terms of market capitalization was Microsoft (MSFT), General Electric (GE), Cisco (CSCO), Exxon Mobil (XOM), and Wal-Mart (WMT).

Combined, these five companies had a market capitalization of roughly $ 2 trillion dollars at the time.

Yeah, that's right.

Now, check out the annual earnings of these five stocks back in 1999:

Microsoft: $ 7.8 billion
General Electric: $ 10.7 billion
Cisco: $ 2.1 billion
Exxon Mobil: $ 7.9 billion
Wal-Mart: $ 4.4 billion

So, back then, these five businesses had ~$ 33 billion of combined earnings power.

With $ 2 trillion of combined market capitalization, that means investors were willing to pay an average of ~60 dollars for every dollar of earnings.

For whatever set of reasons or rationalizations, not nearly enough investors (professional or not) seemed to find this to be a bit of odd situation. I remember it well and still find the rationalizations that were being used to justify the market prices to be completely astonishing to this day.

How can companies of that size possibly be worth on average 60x earning?

An earnings yield of less than 2%, really?

Why wasn't that perfectly obvious?

Well, it wasn't and that's worth remembering.

In contrast, this year these five companies will earn more than $ 100 billion. As far as I'm concerned, if businesses this large can triple earnings in a little over ten years like they did, that's a good decade of work.

Today, these five businesses have a combined market value that is ~ $ 1.2 trillion. So investors are paying a far more reasonable 12x earnings or so. That doesn't mean these stocks will do well in the next few months (or even years), but 12x provides at least some margin of safety in a way that 60x certainly does not.

The next time someone says a particular stock has been performing poorly for a long time, it's worth remembering where some of them started in terms of valuation a little over a decade ago.

Apple (AAPL) is now, of course, one of the top five. Actually, as of yesterday, it is roughly tied for being the most valuable company with Exxon Mobil (~ $ 420 billion). In the late 1990s, Apple was certainly nowhere near this top five. The company was being nursed back to health after its near collapse and had, at the time, a relatively low market value.
(Yesterday's post covers Apple's earnings and what still seems hardly an extreme valuation.)

Back in 1999, there were many favorite rationalizations on display (expert and otherwise) of why paying such extreme multiples of earnings for stocks made sense. Sure stocks seemed expensive but somehow they should be. Those rationalizations clearly made no sense but, at least for some, they seemed to at the time.

At least enough market participants believed it that prices sustained increasingly lofty levels for quite a while.

To me, there's a simple, practical reason that all this is worth remembering.

If someone tries to now rationalize why these stocks are cheap and they should be*, it's worth considering that this is probably the same error in judgment only in reverse.

They are cheap now for the same reason that were expensive then.

Mr. Market is one moody dude.

Adam

* It's not all or none, of course. Many understood stocks were overvalued in the late 1990s just as many today see valuations as compelling. Having said that, Dow 36,000 is a book written by James K. Glassman and Kevin A. Hassett that was published in 1999. With stocks already very expensive by any measure at the time, they came up with a rationale why Dow Jones Industrial Average should rise to 36,000 within a few years. From this article in the Atlantic back in 1999: In explaining their new theory of stock valuation, the authors argue that in fact stock prices are much too low and are destined to rise dramatically in the coming years. So that's just one example of someone rationalizing why it was warranted for stocks to have been expensive. These days, there are many rationales for why stocks should be cheap. Some of the current favorites are global deleveraging, various systemic risks, banks, Europe, China, inflation, and deflation among many others. The list goes on. Those are real concerns but there is always something on the radar. Yes, stock prices would likely fall, maybe even for an extended time, if the worst scenarios played out. The fact is no one should own stocks without a very long time horizon. There will never be a shortage of bullish and bearish rationales. To me, it's better to just ignore them all. Investing is mostly thinking for yourself, occasionally gaining an insight, and not getting distracted. Effectively judging value (calculated conservatively) and always paying a nice discount to account for errors and the unforeseeable guarantees nothing, but at least increases the probability of good long-term results. The rest, especially the macro stuff, is mostly noise and distraction. The past century supplied plenty of good reasons to be fearful about the future (there's no reason to not expect more of the same)Despite those oft-warranted fears, many good businesses persisted through the worst and kept creating value. During those rare occasions when economic skies appeared clear and all seemed calm, you can be sure that stocks weren't cheap. So, while there will always be future risks to consider for investors, some known and some unknowable, the good news is the world doesn't end all that often.
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