Wednesday, March 21, 2012

Quick Comment on the Market

So the market has come up quite a bit since last fall when I made a bunch of posts showing that the market was reasonably valued and there was too much pessimism.  I think the market still looks and feels fine.

There are people who say it's getting bubbly and bullish consensus is too high, but I don't sense that too much at all.  People still seem to be in denial about stocks.

I agree that we aren't out of the woods, but I think the market rally so far has just discounted the lower likelihood of a bad blowup in Europe.  Sure, Greece is certainly not fixed.  But as I have been saying here, a complete blowup/meltdown is off the table for now.  Last fall, the market feared a complete Euro-implosion.    The likelihood that we will just muddle our way through this has increased substantially and that's what the market is reflecting; the market is not reflecting all problems solved/nirvana.

As proof of that, the financials even with the substantial rally is still pretty cheap.  Maybe I'll post a quick update later, but Goldman Sachs (GS), for example, is still trading at around tangible book value which is incredibly cheap barring another financial crisis. Despite the headlines, GS is still the best managed investment bank out there and is pretty nimble when it comes to changing market environments. 

Unsustainably High Profit Margins?
Anyway, one argument I keep hearing is that even if P/E ratios are reasonable-looking at this point, profit margins are at all time highs and are unsustainable.  So if margins go back to what they usually are, the argument goes, then P/E ratios aren't as cheap as it looks.

I posted about this before, but here's a quick update.  First, here's what people are talking about:

So just by eye-balling it, it looks like profit margins average around 6% over time, and now it's way up over 10%.  Sure, this looks unsustainable!  This may mean profits are overstated by 60%.  If profit margins revert back to more normal levels, profits can plunge 40%.   That means, with a constant P/E ratio, stock prices can go down 40% too.

But here's the thing.  I spend most of my time reading annual reports and SEC filings, and I haven't come across anything close to this sort of abnormally high profit margin.

I posted a table before and I updated it with 2011 full year figures.  I just picked a bunch of large cap names off the top of my head so I didn't cherry-pick names to make my point.

Here is something closer to what I see:

Operating Margins of Some Big Blue Chips

If you look through the table at the operating margins of these 'typical' companies, I don't see any abnormally high profit margins at all.  I did expect Exxon Mobile (XOM) to have some excessive margins with crude oil up here at over $100 and gasoline prices on the rise.  But even at XOM, margins have been lower in the past three years than in 2001 and much of the early 2000s.

So where is the excessive profit margins?

My favorite investment ideas lately as I've been posting here since the fall are financials.  I didn't include any financials in the above table as we don't have to look to know that profit margins at financials have been pretty low since the financial crisis.  Banks, investment banks and insurance companies are not making anywhere close to the profits they did before 2008.  So there is no abnormally high margins there either so go figure.

Graham and Dodd P/E Too High!?
The other argument I hear a lot these days is that although the regular P/E ratio is reasonable at around 15x last year's earnings, the Graham and Dodd P/E ratio is way too high at 24x or some such high number.

So what is the Graham and Dodd P/E ratio?  This is simply a P/E ratio calculated by using the average earnings over the past ten years instead of just the most recent year.  This adjusts for the 'cyclicality' in earnings.  Earnings of companies tend to be cyclical; high in good times, low in bad times.  So by taking a ten year average of the earnings, this supposedly smooths out these cyclical ups and downs and makes valuing the market a little easier and more 'accurate'.

Above is the chart that shows that although the trailing P/E shows a reasonably priced market, the red line shows that we are still way overvalued.  One reason I've been skeptical of this figure is because I think that the large losses from the financial crisis is included in the ten year average earnings so tends to make the earnings look really low.  Is this abnormally low?  I tend to think so even though others will argue that those losses were 'real' and not necessarily one-off events as financial crises tend to happen with regularity (I would counterargue that the 2008 crisis was not a typical once-in-a-decade event, but much bigger, less frequent event).

Otherwise, I would think the message it sends would be reasonable.

But again, we have to look at what this means for investing.  I scratched my head when I saw this chart so decided to create a table of my own using the blue chip stocks in the operating margins table above and see what the historical P/E, 2012 estimated P/E and Graham and Dodd 10 year average earnings P/E ratios look like.

It's always good to look under the hood to see what the big, macro charts actually means.

Here is my table:

So what people usually look at are the historical P/E ratio (most recent fiscal year or trailing twelve months or some such) and the expected P/E ratio for the current and next year. 

In this table, I do see that many of these companies do have a pretty high Graham and Dodd P/E ratio.  Coca-Cola (KO) has a Graham and Dodd P/E of 27x and IBM's is 28x.  Disney's is 27x and MCD's is 34x.

So those are pretty high figures.  But wait a second.  Of course they are going to be high since these companies have grown their earnings in the past decade.  The higher growth in EPS in the recent past, the higher the 10-year average EPS P/E is going to be.

Is that a bad thing?  Should we look at MCD, KO, IBM and DIS and think they are too expensive because of their high Graham and Dodd P/E's?

I'm not too sure about that.

Let's look at the Graham and Dodd P/E versus their prospective EPS P/E (for the current fiscal year):

                          Graham and Dodd P/E          2012 estimate P/E      10 year EPS growth
KO                     27.31x                                  17.36x                          +12.7%/year
IBM                   28.05x                                  13.72x                          +21.9%/year
MCD                  34.35x                                 16.94x                          +23.4%/year
DIS                     27.04x                                 14.61x                          +17.1%/year

So even though the Graham and Dodd P/E ratios look ridiculous, the prospective P/E ratios look very reasonable.

I don't really know the dynamics of how this works for the whole market.  It may have something to do with the big losses in financials during the crisis and their current 'high' valuations due to depressed earnings that make the 10 year average EPS P/E ratio look high.

The other argument would be to doubt the prospective earnings for 2012.  Again, they will point to the unsustainably high profit margin chart shown above.  But if you look at these 'typical' blue chips, they don't have unsustainably high margins (see margin table).

So although I would be cautious if the overall market was getting expensive, again, I don't really see it when you really get on the ground and look around; the top down macro story (unsustainably high profit margins combined with way too high Graham and Dodd P/E ratios) that looks compelling doesn't really match the reality of individual companies.

Quick Comment on Apple
So what's up with Apple?   Apple looks insane for sure; it does look like it has come too far too fast and is talked about so much that it has to be a candidate as a bubble stock.   BUT, the most important factor is missing from the "Apple is a bubble" story; valuations.  Apple stock is still astoundingly cheap on a valuation basis. 

Is the earnings unsustainable?  I can't say where it will be in five or ten years, but at the moment, they seem to have incredible momentum.  They do seem to have a high market share of the tablet market, but if you look at tablets, laptops and computers together, then they are barely scratching the surface.  The iPhone too, doesn't seem to have unsustainable market share either.  

So the runway still looks pretty long.    I would be a worried long, but definitely not short this thing.  I think at some point before the Apple boom starts to tire, the stock price will get up to a more 'reasonable' valuation.  That's my guess.

There is certainly a lot to worry about.  Sovereign debt levels look very high around the world so we haven't solved all of our problems.  But as wise investors always say, it's not usually a good idea to wait around for all the problems to be solved because then the markets would reflect that and would probably be pretty expensive.

The most important takeaway from the above discussion is that oftentimes we will get scary looking charts that scare people away from stocks.  It is a good idea to keep an eye on these things.   But I think it's not prudent to just sell stocks just because of some scary looking charts.

Back in 2000, the charts were quite scary too and it sure wasn't a bad idea to get out of stocks.  On the other hand, you might have done even better if you looked under the hood and just stayed out of the expensive things (tech stocks, internet stocks, Coke at 40x p/e etc...) and invested in things that weren't expensive (most notably Berkshire Hathaway at the time and many of the old 'industrials' that didn't have a .com at the end of it's name).

There are quite a few people who made great track records in long only portfolios even starting in 1999/2000.

It is very important to know and understand what the charts and other information you get mean before acting on them. 

It would be a huge mistake to see the above charts and sell stocks and buy bonds or whatever, as I still see great values in the stock market (I will post a short, quick update on Goldman Sachs later).  If high valuations are a concern, sell stocks that are trading at high valuations.  If high and unsustainable profit margins are a concern, find the companies in your portfolios that might have unsustainably high profit margins and sell those.  Don't sell stocks that don't have this problem!


  1. i like your articles in general, but here you are cutting some corners if you ask me.....

    i find this approach more realistic.....


    1. That's good. My point really was that if you are looking at stuff that doesn't have excessiv and unsustainably high margins, it's not that important. Back in 2000 the market p/e was very high and you could have surveyed every stock to see what percentage of stocks were expensive, but if you owned cheap or reasonably valued stocks, it really didn't matter if the market had a 40x p/e or how many companies had 40+x p/e. I'm sure there are companies with high, unsustainable margins. I just happen not to come across many of those myself.

  2. KK,

    I think you are right about the individual companies you mention. In fact, most of those pointing out the issue with profit margins have specifically mentioned that the kind of high quality companies you are mentioning have been in the reasonable range (Grantham, Hussman, Montier, etc.) Some are even cheap, if not spectacularly so.

    However, for that same reason I think you are wrong for the market as a whole. You may be right about the opportunity to buy cheaply is always there, but most investors (by definition) won't identify those values. They will suffer when the market collapses. Your arguments are similar to those I heard in 2007, which was an extraordinarily over valued market, and far more broadly so than in 2000 as you so rightly point out. So I would be careful of doubting issues in aggregate just because you are able to find values.

    I will also point out that great investors like Buffett, Klarman, Greenblatt and others are more top down than you suggest in looking at valuation. Why? Because if you are fully invested, even if in decent values, the optionality of cash when the market as a whole becomes undervalued is lost. Most great value investors hold more cash (or other alternative strategies and assets for while you wait) in overvalued markets and less in undervalued markets so they can take advantage of the declines. Thus identifying todays general levels of overvaluation is important for stock picking investors, not just macro traders.

    Margins for the cyclical's will come down, we just don't know when. Sure the huge declines in earnings in 2008-2009 are in the 10 year Graham and Dodd, and todays depressed financial earnings, but so are the far above average earnings and margins prior to then, especially in the financials. Those earnings were just as abnormal on the upside (especially for financials) as the downside. Those earnings were artificailly inflated for a number of reasons (and in fact were a large part of my thesis for shorting financials. My "margin of safety" on such a recommendation would be that no crisis was needed for financials profits to mean revert.) In addition, we have abnormally high earnings due to margins elevated by the aftermath of the crisis as well. The beauty of 10 year averages is that it smoothes out such issues. However, we can check whether the G&H PE is overly distorted pretty easily. Has real earnings growth over that 10 year period been artificially low? Is the total denominator in the G&H PE substantially lower than past history projected forward would have implied? Not that I can see. It looks to me as if profits have grown at an annualized rate as fast or faster than the past (due to margin expansion) despite slower than normal economic growth over the same period.

    By the way, I love your blog. Great stuff!

    1. Thanks for the post. You make good points. I do know Klarman has hated the market for most of the time since 1983 or whever and always held tons of cash. BRK does so for regulatory purposes (insurance) and because cash keeps coming in faster than they could spend it. I don't know about Greeblatt, though. It's always nice to have liquid reserves, but I think the key point is that people seem to base that on opportunities available, not some bigger macro thing (except, again, Klarman). I disagree about 2007, though. I was looking very hard in 2007 and it seemed like, unlike 2000, EVERYTHING was overvalued. Even BRK. I couldn't find anything interesting to buy at all. So that was very different than 1999/2000. Anyway, thanks for the nice comment!

    2. p.s.,

      and by the way, if you look at Greenblatt's returns in his Stock Market Genius book, they are spectacular. And the key point there is that he didn't really achieve those returns by buying more stocks in 1982 (at cheap prices) and less in 1987 (when it was expensive). He did just as well in 1987,88 and 89 as he did in other periods. Buffett too, bought Solly preferreds right in front of black monday despite the stock market being bubbly expensive. The key is that they don't *not* do something due to those 'macro' concerns whether it's an economic outlook or a market p/e. Buffett's returns weren't made by lightening up in 1987, piling back in 1988, lightening up in 1993, buying back in 1994, selling out i 2000, buying back in in 2003, selling out i 2007 and getting back in in 2009 etc... That's not how he made his money and that's the most crucial point. Being aware of bubbles, though, is important, of course.

    3. I agree with your point about what is most important in each case as investors, but still believe we can say the market is overvalued. I didn't mean to imply today is the same as 2007. I agree that it isn't that bad now, but that the arguments you make above were as valid (or not as valid) then. Profit margins broadly were actually lower and the (at the time largest profit decline since the great depression) profit collapse of 2002 was also cited as distortive of the 10 year earnings portion of the calculation.

      As for your point on great value investors ignoring such measures I don't really think you are wrong I gues, but maybe it would be beter to say incomplete. I don't think Klarman can be said to have hated the market since 1983, he just always like some cash. He has hated it(and rightly so) since the mid 1990's. Greenblatt is a special case, but he tended to do more special situations as the market got more overvalued. The years from Stock Market Genius were not all that expensive. His behavior post 1995 has been a good bit different, but he is the one who is least afected by general overvaluation because of his concentration on special situations.

      On Buffett (and most of the value superinvestors) I will just disagree, though your point is still good, just incomplete. They routinely head to those areas where the market was undervalued and held cash when it was generally overvalued. Usually some part of the market is undervalued, allowing concentrated investors to go someplace. You are correct that the lack of opportunity rather than a G&D PE was the main determinant of their raising cash, but it coincided anyway. Buffett however has often raised cash specifically with the remark that the markets were generally overvalued. Famously he said as much when he closed the Buffett partnership and sent investors money back. Several other times he has pointed out the general unattractiveness of the market and the rationale for holding more cash than he would like. In fact, I believe in 2007 he specifically made the point he was carrying more cash than usual until the market got cheaper.

      "Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge."
      -March 2003 Warren Buffett

      "I am out of step with present conditions. When the game is no longer played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, and so on. On one point, however, I am clear. I will not abandon a previous approach whose logic I understand ( although I find it difficult to apply ) even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don't fully understand, have not practiced successfully, and which possibly could lead to substantial permanent loss of capital."
      1969 letter to investors.

      Anyway, I think that while you are correct that value is value, regardless of the markets general level of overvaluation, it is not irrelevant to be aware of it. It can give you a signal that with patience the barrel's you are shooting in will have a lot more fish (and bigger values) in the future. Not everyone has a circle of competence large enough to find value in any market, and for those investors especially such things are important to monitor.

      Anyway, we are actually very close in how we see this issue, I am just sensitive to more casual investors being convinced an expensive market is cheap just because you or I can find areas that are reasonable. For them it can be really dangerous to listen.

    4. Good points. I don't disagree with what you say, but I guess we see different things around us. I more often see people get out of stock and rush into gold, for example, because they think stocks are expensive. Having liquidity is a good thing for sure and being aware of what's going around is important, I suppose. But my point is more that it really doesn't work to buy and sell stocks according to what the total market valuation is. BRK made tons of money on KO, for example, and he did it by buying a good business at the right price and then holding on to it (even though he should've sold it in 1999). Most of his wealth was created by buying right and holding on, not moving in and out according to market valuation which is what people try to do from what I see. Holding excess cash in pricey times is fine when there aren't a lot of opportunities, but that's a little different than actually selling good businesses at good prices just because the market is expensive.

      What I try to tell people is if the marke is pricey, just take a good look at your holdings. If you like them, they are reasonably valued and don't have unsustainably high, bubbled up margins, then don't worry about the market. Don't sell that stock just because the S&P 500 is at 20x or whatever p/e.

      Even if someone owned the S&P 500 and the market p/e was 25x, I don't know that I would tell them to sell.

      As Buffett says, the market returned 10% in the past century but most people didn't earn that on their stocks. Why? Because nobody held on throughout. They bought and sold and ended up worse than the market. You could've prudently sold out in August of 1987, but how many of those folks got back in?

      So in order to earn long term equity returns, you can't really try to go in and out. Some people do it well, but the proof has been than most people don't do better...

      I think Buffett said something similar this year; he never thinks about macro factors when considering buying a business. If he understands it and likes the price, he buys. He and Munger never discuss macro issues. I think previously, he also said he doesn't worry about the stock market. He doesn't go, I like the business and the price it's offered at but the market is overvalued so let's wait until the market corrects and then buy. He said he has never done that.

      Greenblatt had a great essay on this issue too about how much stocks to own and on how many people are regretting not paying more attention to the macro factors. He disagrees with that notion. I tried to find that essay but it's not at the magic formula website. The gist of it was that people should own as much stock as they can bear going down 50% because markets will go down 50%. Greenblatt agrees with Buffett and thinks that if you can't bear a 50% decline, then you shouldn't own stocks in the first place. Greenblatt said to own just enough so that if the market goes down 50% it won't bother you. The problem is when people try to come up with ways to try to *avoid* those 50% declines in the markets (using various methods). That just won't work.

      Anyway, again, I see your point and we are not in disagreement. It is a fascinating topic for me. Great discussion.

    5. Actually, now that I think of it, Greenblatt's point was more that the mistake in 2008/2009 was not that people didn't pay attention to macro factors (he doesn't believe in market-timing) but that people owned too much stock. The market went down 50%, they freaked out and sold out. Others did just fine watching it go down and then coming right back up. So the moral of the story is not that we should refine our market-timing skills, but that we should calibrate our stock ownership so that we can tolerate the declines that will inevitably come (and won't be able to time our way out of).

      As professionals investors, holding on to some excess liquidity in pricey times is a good idea but that is a sort of not risk-free either; it comes with a cost (Vinick/Magellan).

      Again, great discussion. Not really arguing here, but clarifying.

  3. Great discussion guys.

    I especially like the point about owning only as much stock as you can bear moving down 50%. I largely agree with the Buffett statement that if you can't take volatility, you shouldn't be in this business anyway, because no matter how intelligent you are, you will end up doing something stupid at some point.

    Reminds me of J.P. Morgan's "sell down to the sleeping point", which will usually be good advice.

    The way I look at the CAPE, it's more of a tailwind/headwind thing than anything else. When it's low, the chances are overwhelmingly in your favor as an investor, because maybe even a scattershot approach will work. When it's high, then individual stockpicking will be ascendant, because for every 1 good, inexpensive stock there will be 9 others that are not. So I'd say the current environment (not even counting the macro issues) is a very tricky one.

    KK, with regards to margins, yeah, I've wondered about this too. The companies I've been looking at have tended to see increasing margins, but not to the extent that I see in that chart. I don't really understand it myself. Part of it has to be structural I think, with outsourcing and what not. Another contributor, the layoffs of 2008-2009 and companies not raising wages. Or maybe the much lower cost of capital. Not quite convinced that's enough though, because commodity prices have marched upward, which should have resulted in a more restrained move. Not really a macro guy though, so am probably missing something.

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