Saturday, November 22, 2008

Did We All Wake Up and Find Ourselves Stupid in July?

From the Desk of Joe Rollins

There’s no way to sugarcoat the stock market’s poor performance during October and November. As I write this post, all three of the major market indices are down roughly 50% year-to-date. The Dow Industrial Average, the S&P Index of 500 Stocks and the NASDAQ Composite all have virtually the same returns year-to-date – all are down around 50%. Indisputably, that fact is hard to swallow. This has been the worst year for stock market investing since 1937.

I’m not exactly sure anyone can properly explain what is going on in the stock market right now, but I certainly don’t think it has anything to do with economics. One of my clients pointed out in frustration with me that we are living in a different world now, but I take exception to that statement. I truly don’t feel that the fundamentals of economics and the valuation of stocks are any different today than they have been throughout history, which I hope to illustrate below.

Around July 1st of this year, something drastic happened. The markets were undoubtedly bad for the first six months of 2008, but since then, the losses have gone to incomprehensible level. As of this writing, 99% of all publicly traded mutual funds have suffered losses for 2008. The very best fund managers in the world have accumulated losses of 50% or more in 2008. Bond funds and conservatively-balanced funds also have losses approaching 30%. The destruction of wealth over such a relatively short period of time has been nothing short of mind-boggling.

In spite of the market’s terrible performance, I just don’t believe that we all woke up in July to find ourselves completely unable to understand the basic fundamentals of stock market valuation. Perhaps some people are generalizing the facts instead of reading detailed information for a complete and proper analysis of the current situation. This makes me wonder if the traditional approach to market analysis has become unfashionable. Current analysis tools tend to deal strictly with market momentum – up is up and down is down, and never shall the two meet.

As I often hear exclaimed on the daily financial news, the “buy and hold” philosophy is dead. I don’t concur with that exclamation, and I have some evidence to indicate how the market has so mispriced securities that there is incredibly high hope for our investments.

It’s apparently become chic to criticize the world’s most well-known investor, as evidenced by a lot of posts I read by other financial bloggers. Lately, Warren Buffett has become the favorite whipping boy, in spite of him taking Berkshire Hathaway, a little-known shirt manufacturer, from nothing to a current market capitalization of $120 billion. In fact, Berkshire Hathaway, as early as one year ago, was valued at one-quarter of a trillion dollars. There aren’t many investors who can proclaim to be as successful as Warren Buffett, but according to some bloggers, he woke up stupid at some point in 2008.

In October of 2008, Warren Buffett invested $3 billion in one of the world’s largest conglomerates, General Electric. In addition, he was given warrants to purchase GE’s common stock into the future at a price of $22 per share. Based on today’s valuation, that agreement appears to have been a mistake. However, I wouldn’t discount Warren Buffett’s prowess too quickly.

At the same time Warren Buffett invested in General Electric, he also invested in Goldman Sachs. Both of the stocks are suspect at the current time, but based on fundamental analysis, they continue to be brilliant purchases. General Electric isn’t your typical corner store investment, and over the last three years, it has made the following in net profits: 2007 - $22 billion; 2006 - $20 billion, and; 2005 - $16 billion. General Electric has had gross sales in the same years as follows: 2007 - $172 billion; 2006 - $163 billion, and; 2005 - $150 billion. This is one of the most successful companies, not only in the world today, but also in the history of American finance. However, it’s priced almost like a penny stock today.

At Thursday’s close, General Electric stock was valued on the market at $12.84 per share. General Electric has now confirmed that their Board of Directors has approved their dividends at $1.24 per share annually, through the end of 2009. Therefore, if you invested in their common stock at $12.84 and you received the $1.24 dividends per year, you would have a return on your investments in dividends alone of 9.66%. That’s a fairly stunning return on one of the top capital titans in American history.

Based on Thursday’s market price, the entire enterprise value of General Electric was $127 billion. During 2007, General Electric generated cash flow from operations of $46 billion. Therefore, on a cash flow valuation basis, General Electric could be purchased in its entirety from its cash flow in only 2.8 years. Valuations currently defy any level of imagination.

As of the General Electric’s third quarter, they have a book value – meaning the sum of their total assets less their liabilities – of $11.28 per share. Since that time, they have raised in the open market and through Warren Buffett an additional $15 billion in capital. Therefore, even if the company made no profits in the fourth quarter of 2008, they would have a book value of close to $14 per share.

In summary, you can basically purchase one of the greatest manufacturing conglomerates of all-time for less than book value and earn a return of close to 10% assuming the stock never actually goes up. I would argue that Warren Buffett’s purchase price is more closely correct than the market at this point.

This is even more compelling when you take current interest rates into account. Yesterday the one-month Treasury bond was yielding 0.1% annually. I am not saying 1%, I am saying one-tenth of 1%. Interestingly, a three-month Treasury on Thursday was yielding 0.2% annually, which means that you could purchase a Treasury bond for no return only to guarantee that you would get your money back.

The yield payable on the two-year U.S. Treasury bond, which reflects trends in interest rates, is below 1% for the first time ever. The yield on 30-year Treasuries, led by expectations of inflation, is below 4%, at an all-time low.

Even more stunning is the long-term interest rate on Treasury bonds. Today, a 10-year Treasury bond was yielding 3.03% annualized. This is the lowest rate recorded on Treasury bonds in over 50 years. Basically, if given the choice, you could buy Treasury bonds yielding 3.03% or General Electric stock generating close to 10%. Of course, in the case of Treasury bonds, they would not increase in value and General Electric just might.

To further inspire you to invest, the U.S. Treasury’s low yield would be taxed to you at a stunning 35%, while the 10% return from General Electric would be taxed at a preferential rate of 15%. For these reasons, I argue that we have not entered a new investing world. Rather, our current investing world is misguided.

At about the same time as Warren Buffett’s General Electric investment, he also invested $5 billion in Goldman Sachs Group, Inc. Once again, this is not a run-of-the-mill company – it’s a worldwide respected investment house. Goldman Sachs is considered by all to employ the best and the brightest business managers in America. Its net income over the last three years are as follows: 2007 - $11 billion; 2006 - $9 billion, and; 2005 - $5.6 billion. Its sales in those same years are as follows: 2007 - $88 billion; 2006 - $69 billion, and; 2005 - $43 billion. Not exactly a mom and pop shop, right?

Along with Warren Buffett’s $5 billion investment in Goldman Sachs, he received warrants to purchase Goldman Sachs’ common stock at $115 per share. As of Thursday’s close of business, the stock was trading at $52 per share, or a stunning 65% less than the price that Warren Buffett agreed to purchase it at only two months ago. I know it seems like the fourth quarter of 2008 has gone on for decades, but on October 1st, the greatest investor of our lifetime agreed to buy the stock at $115 per share and less than two months later, it is selling on the open market at $52 per share. Did Warren Buffett wake up in July and become stupid? I don’t think so!

As of Friday, Goldman Sachs has a book value of $130 per share. Assuming that the company just broke even in the fourth quarter of 2008, the stock is now trading at only 40% of the value of Goldman Sachs’ assets less its liabilities. I am still not a believer that fundamental stock market valuation is this far removed from reality.

Let me give you an example of why Warren Buffett hasn’t lost his touch: He has the patience and understanding to know that in the end, stock market fundamentals are more important than short-term fear or momentum. In 1973, Warren Buffett bought shares in the newspaper, The Washington Post. Shortly after his purchase, the stock plummeted 20% and stayed there for not just a few months, but for three years. It was a full three years later, in 1976, before Buffett’s investment had finally made it back to break-even. In fact, Warren Buffett later reported that it took until 1981 before it got to a value that he thought it was worth when he first purchased it.

Warren Buffett is the ultimate example of “buy and hold.” He has said on numerous occasions that he does not purchase for a few months, but rather, for a lifetime. How successful has he become? Today, he is the richest man in the U.S., recently surpassing his good friend Bill Gates’ wealth.

It’s also interesting to understand how his Washington Post investment turned out. At the end of 2007, Warren Buffett’s investment was worth a cool $1.4 billion. Given that he had purchased it for only $11 million in 1973, the stock had increased 127 times the purchase price in the 34 intervening years. All of us could stand to be as stupid as Warren Buffett. For a man of modest means, he has become an incredible success due to his long-term investing philosophy, which has made him the richest man in America. I don’t think the definition of “stupid” applies to Warren Buffett.

I certainly do not want to diminish the losses that we have all incurred; they have been major and excruciating. There’s no way for me argue that I was right and the market was wrong when losses incurred are approximately 50% on all the major indices for 2008. Even though I do believe the market was wrong, I still understand that the losses incurred have been devastating. My intention is only to explain stock market valuation, and that the fear factor encompassing the market today has nothing to do with fundamentals. I have written extensively on the subject of the Federal Reserve’s method for valuing the stock market. This valuation method creates a relationship between anticipated earnings and the yield on the 10-year Treasury.

I recently received my Standard & Poor’s valuation of 2009 earnings, dated November 19, 2008. Their anticipated earnings for 2009 on the S&P 500 is $91.85. The expected P/E ratio is a little over nine. The historic multiple for the S&P 500 is approximately 16. By any standards, these rates are incredibly cheap. If you divide the estimated earnings for 2009 by the aforementioned return on the 10-year Treasury ($91.85/0.303), you get an implied valuation of the S&P 500 of 3,031. As of Thursday’s close of business, the S&P 500 has a valuation of 752. Therefore, to reach fair value, the market would have to go up 300%. I recognize that 2009 earnings are probably too high and the 10-year Treasury rate is probably too low, and assuming that both of those are wrong by a factor of 50%, then fair value on the S&P 500 would be approximately 1,500, or a 100% return from where we are today.

Admittedly, I have never seen market valuations as cheap as they are presently. In fact, I haven’t even read any historic valuations that approach this level of undervaluation. Stocks were definitely cheap during the Great Depression, but at that time, there were no earnings. While some corporations have high profile lack of earnings in 2008, anticipated earnings for 2009 are expected to be at record levels.

Even more stunning than these numbers is how ridiculous valuations have become. Currently, the indicated dividend payout on the S&P 500 is $27.47. Based on Thursday’s close, the dividend yield on the 500 stocks making up the index would be 3.65%. In summary, that means you could purchase the entire index of 500 stocks and have an implied dividend yield greater than a 10-year Treasury and double what money market accounts are paying in interest. This is the first time in over 50 years that the dividend rate exceeded the 10-year bond. I assure you that there have never been valuations that give you this type of future profit opportunity.

As of Thursday, over 100 individual stocks making up the S&P Index of 500 Stocks were selling below $10 per share. These are the 500 largest and most successful corporations in the greatest economy in the world, yet the stocks are selling in the single digits.

My intention in this post is not to explain the Wall Street carnage – there is no explanation for fear. Stock market investing as a profession for 2008 has been thrown out the window. As I have said before, current valuations have nothing to do with fundamental analysis, only fear. I am not trying to make light of the losses that have occurred; I only want to make sure that you are aware of the opportunity going forward. Now is not the time to get out of the market, it is the time to get in. At some point, valuations will overwhelm fear and the potential for gains will be absolutely spectacular in magnitude.

I am often asked how I can be so optimistic in times like these. Believe me, I’m not blind to the problems in the market, but I also understand its potential. If someone offered me the opportunity to go to Las Vegas and gave me the same odds as we have today in the stock market, I would take them. With a risk of going 10% down or 100% up based on current valuations, would you take it? I would in a heartbeat. That’s where we stand today, with enormous potential in front of us once fear has finally lessened.

I did not wake up to find I had become stupid in July – just poorer.