YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

Valuing the S&P 500 Index

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While our focus is picking individual stocks, we occasionally like to take a step back to see if the broad market is over or undervalued to help paint a backdrop to our current environment. Last quarter, we wrote a blog explaining why the market appeared to have hit new all-time highs, even though the S&P 500 was trading far below its previous all-time high. The market has since dropped 17 percent from the May high, and we are frequently hearing the media state that stocks are now cheap. Normally, they cite that trailing 1-year earnings on the S&P 500 index are estimated to be $87.98 at the end of the third quarter, thus trading at a P/E multiple of 12.9, compared to a historical average of 15 to 16.

We believe this statistic is very deceiving – it must be understood that these earnings are being produced during a time of peak operating margins. We all know there are business cycles – times of booms and bust. Historically, margins for the largest 500 companies have fluctuated between 5.5% and 7.5%. By definition, capitalism has reliably kept this a very mean-reverting statistic. Most recent data implies a new record with margins around 9%! This has come as a result of vicious cost cutting measures taken during the downturn, primarily through job cuts; but now that companies are lean, they will find it difficult to grow earnings through more cost cutting. One might reasonably ask, “If employee compensation has dropped, how are consumers still spending to maintain wide corporate profit margins?” A friend of mine, John Hussman, explains “Government transfer payments are now substituting for wage income to the greatest extent ever observed in history. In effect, the elevated level of profit margins is largely a reflection of government deficits that maintain transfer payments…” (transfer payments refers to welfare, unemployment, social security, etc.). You can see this graphically at his website near the end of his commentary. We believe it’s dangerous to extrapolate growth in profits from a peak under the assumption this trend can prevail forever, particularly when our government is funding these payments through massive deficits. When you “normalize” profits, the resulting P/E is 17.2, making the market switch from looking cheap to overpriced!

In citing that the market is cheap, sometimes analysts are even more aggressive stating 2012 operating earnings are estimated to be $111.46, putting a 10.2 multiple on the market. In addition to the problem explained above, there are two additional flaws with this “Pollyanna” approach. First, they are comparing a forward P/E to trailing P/E’s, which will obviously appear lower due to growth expectations. More importantly, they are looking at operating earnings which exclude non-recurring charges – the trouble is, ironically, these are recurring and should not be excluded. Analysts do not remove depreciation from earnings estimates even though it is a non-cash charge, because it is estimating a true cash charge of capital expenditures. Equally, they should not remove extraordinary charges because they are simply deferred depreciation taken up front instead of over the life of the asset. These are real expenses because these assets have become unproductive. Likewise, if the expense is related to acquisition costs, it would not be wise to assume managers will never overpay for acquisitions in the future, particularly in aggregate. Analysts desire to disregard these charges create lofty earnings expectations that are unrealistic, artificially bringing down P/E ratios.

So, how can we value the S&P 500? The value is whatever someone is willing to pay. From 1871 to present, historically market participants have on average been willing to pay 14.5 times trailing earnings (if you delete extreme bubble outliers of P/E’s over 26, a level markets never traded above until recently, so we remove them to prevent distortion of the average). Trailing sales on the index were recently $1007.77/share, multiplied by a normalized profit margin of 6.5%, obtains normalized earnings of $65.51/share. A P/E of 14.5 implies a fair market value of $950, or 16% below the current price of $1,131.42.

A more sophisticated method commonly used to strip out the effect of business cycles was developed by Yale economist Robert Shiller, where he takes an average of the trailing 10 years of earnings, adjusted for inflation (referred to as CAPE, or cyclically adjusted P/E). Historically, the CAPE has averaged 15.8 (median) to 16.4 (average). With 10-year, inflation-adjusted, average earnings currently at $59.48, interestingly, this implies a fair value between $940 and $976 for the S&P 500 index.

We should point out that we don’t use this analysis to help us determine whether or not we should be buying stocks. For starters, the market can remain over or undervalued for many years. We prefer to look at things from the perspective, “What forward return can I expect if I buy at this price level?” Without running through the details, we estimate forward annualized real returns on the S&P 500 index to be 4% over the coming decade(s) if you bought at today’s prevailing price – you can only earn what cash is generated and delivered to shareholders. The only way you can achieve higher returns is if there is a major technological shock such as the railroads, which transformed our economy to another level (or you rely on trading at bubble valuations in the future). For most people, they would be better off paying down their mortgage (a guaranteed return) as opposed to passively investing in index funds (which carry risk, particularly when at high valuations). However, our job is not to invest in the broad market, but to identify individual stocks where the risk-reward ratio is more compelling. As we have reiterated many times, all that matters is what you own. The market could be overvalued, yet you can still do extremely well being fully invested if you pick out good deals. For example, in the year 2000, during the biggest bubble of our lifetime, there was a dichotomy between overvalued tech/internet/large-cap stocks and undervalued small-cap stocks.

Ultimately, what we glean from all of this analysis is that when we are researching individual stocks, we need to be careful to normalize earnings to prevent the mistake of extrapolating earnings from unsustainable peak profit margins.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | October 01, 2011 | Permalink

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