VALUATION UPDATE 2020 Q2
Our grandparents would make a point with a question: “what are you going to do with that car once you catch it?”, alluding to the craziness of dogs chasing cars and biting tires.
Well, Wall Street provides many examples of this behavior where investors emotionally chase concept stocks. At the end of the cycle Wall Street crowds into ‘the stocks that you have to own’ and those ideas tend to get more and more over bought. This has happened during many, not all, expansions since the Nifty Fifty dominated the 1960’s bull market (the idea was that you only needed to buy 50 stocks and you would be fine, yes, it ended badly).
Looking at the graph that I shared with you earlier this week you can see that currently 5 mega cap stocks dominate the stock market and market returns as they did at the end of the technology bubble in 2000.
Let’s look at the ‘5 Amigos’ as I have dubbed them, more closely. What exactly, from a valuation perspective, would you be putting your money into if you chased the FOMO rally (Fear Of Missing Out)? In my opinion, 5 good companies that have over-valued stock prices.
The first four lines represent basic price to earnings and price to sales data. Light and dark red represent the highest valuations (top 20% in terms of expense and then the next quintile, the top 21% to 40%). Given that the ten year average for a PE Ratio (price to earnings ratio) on the S&P 500 is 14 and currently the S&P 500 has a TTM PE Ratio of 20, the PE ratios are high: from 22 to 100.6.
The PE 10 figure is the Price to Earnings Ratio average over the past 10 years: from 32 to 386.
At the bottom of the above table there is a note relating to two legends of the investment business Peter Lynch and Ken Fisher. They created rules, which not only made them famous but infamous in investment circles, which guided them to success; much like Warren Buffet. These investors were known for sticking to their guns.
Peter Lynch said that a Price to Earnings Growth rate (the PEG Ratio) below 1.0 was attractive (a buy), above 2.0 was unattractive (a sell), and between the numbers was a ‘probably not’. None of the 5 Amigos would be on Peter Lynch’s buy list, a person who is one of the most well known and successful top growth managers.
The Price to Sales Ratio is handy because it allows an investor to better compare companies across industries and between countries. Ken Fisher found that if he could find companies with a PS Ratio below 1.5 he might have a winner, the 5 Amigos are trading a many multiples of his line in the sand.
If Peter Lynch and Ken Fisher would not put their money into these 5 companies should you, or should you not, put your retirement money into said companies? (in spite of the high quality cat videos on Facebook.
The 5 lines at the bottom are the Zack’s Investment Research rankings (A to F) and scores (1 being best). Good growth scores, lousy value scores. Good earnings quality scores (other an Facebook) but poor insider scores (the insiders are net sellers). Overall ranking typically 3 or below, but mostly in the middle; in my opinion it’s hard to justify the high valuations.
Let’s pull out one company, Apple, and dig into their earnings. Earnings are the lifeblood of the stock market. The table below summarizes Apple’s net income and earnings per share over the past 5 years.
Total net income growth +3.4%, or +0.69% per year. Net income in 2015 $53B and $55B in 2019; it went down, up, and down again; basically ending up where it was in 2015.
Total EPS growth +28.95% or 5.79% per year.
I know, I know: you’re saying to yourself “why would I want to pay a high PE multiple, high PEG ratio, and high Price to Sales rate for low to below average growth?”
Here is the Apple data from Zacks Investment Research. (the per share data from above looks better than the net income data due to share buy backs, you can see that the shares outstanding on the table below goes down over time)
In my opinion it is high likely that investors will look back at this scenario and scratch their heads like they did in the early 2000s after the tech bubble burst.
I wish you the best.
LPL 1-05005039
DEFINITIONS
Price-to-Earnings Ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple.
Price-to-Sales Ratio: The price-to-sales (P/S) ratio is a valuation ratio that compares a company’s stock price to its revenues. It is an indicator of the value placed on each dollar of a company’s sales or revenues. The ratio can be calculated by dividing the company’s market capitalization by its total sales or on a per-share basis by dividing the stock price by sales per share.
S&P 500 Index: The modern design of the S&P 500 stock index was first launched in 1957. Performance back to 1950 incorporates the performance of predecessor index, the S&P 90. The index is a capitalization weighted index of the 500 large companies listed on various stock exchanges (such as the NYSE or NASDAQ). The S&P 500 was developed and continues to be maintained by S&P Dow Jones Indices, a joint venture majority-owned by S&P Global. The S&P 500 differs from the Dow Jones Industrial Average and the NASDAQ Composite index, because of its diverse constituency and weighting methodology. It is one of the most commonly followed equity indices, and many consider it one of the best representations of the U.S. stock market.
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