NEW YORK, April 15, 2013 - Is it safe to keep capital invested in the stock market?
Or, are we close to a tipping point that could lead to a correction worse than the near-death experience of September 2008 through March 2009?
Reasonable people disagree. I recently gained fresh perspective by taking an unusual mental trip.
Notes from a Brief Journey along the Space-Time Continuum
What passes for educated wisdom on Wall Street can be thin gruel as this edgy British send-up made plain in 2008:
Watching the jocular interplay during earnings season among executives, stock market analysts, regulators, pundits and many journalists reminds me, at times, of the “dude…sweet” paradigm expressed to hilarious comic effect in this movie trailer:
Senior executives of large corporations manage mind-numbing complexity. They and those who follow financial results can be reduced to glancing, in cursory fashion, at evident, surface level trends while ignoring much more important structural issues.
Earnings calls and first-pass research reports written before anyone has a fair chance to read through detailed public filings can therefore become one part “dude”, the other “sweet”.
In truth, determining the “intrinsic” value of publicly traded common stock is straightforward. The initial step is deciding what base level of cash flow an investor will receive during the first year. The next step is determining the expected long-term growth rate in cash flows available to the investor each period. The final step is deciding how long the investment will be held and what is a reasonable rate of return to demand over the holding period.
In the current market environment where nominal interest rates have been so low for so long, the most challenging aspect of arriving at “intrinsic” value determinations is selecting an appropriate rate of return (or “discount” rate). The second most challenging part is determining what is a reasonable growth rate to expect in cash flows available to the investor.
Two test cases deserve brief treatment.
The Strange Case of Amazon.com, Inc.
In its Annual Report on Form 10-K, Amazon explains that it “opened its virtual doors on the World Wide Web in July 1995 and offers Earth’s Biggest Selection”.
Unlike many other publicly traded firms, Amazon has produced nifty revenue growth. Since 2008, Amazon’s revenues soared at a compounded annual rate of 33.6% per annum.
Funny thing though—Amazon’s 2012 net income was actually a loss of $ 39 million, down from recent peak net income of just $ 1,152 million achieved in 2010. Free cash flow in 2012 was a miniscule $ 395 million—this figure was 0.6% of revenues and a tiny fraction of the sales tax rates land-locked competitors collect.
Now the fun part—as of Friday April 12, 2003, the quoted market value of Amazon’s publicly traded common shares was $ 124 billion, a figure that does seem indefensibly high.
It has proven dangerous to bet against Jeff Bezos and he is quite active outside Amazon in preparing for the commercial exploitation of outer space.
Perhaps I am being too hide-bound in restricting my evaluation of Amazon’s financial worth just to its Earth-based opportunities?
The Irrepressible Imagination and Valuation of General Electric
This Friday, Jeff Immelt and his crew will take us through yet another tour de force presentation that likely will charm invited guests and overwhelm journalists rushing out to enjoy the spring weekend.
Prior to 2008, analysts used to joke about the “great-o-meter” they would informally use to keep track of the number of times management used that word in their investor presentations. The truth is that running GE to produce attractive financial results for non-management investors is an enormous challenge.
Before rushing to praise management for improvement, if any, seen in Q1 2013 compared to Q1 2012, please remember that results for full-year 2012 were well down from prior years.
By our calculations, U.S. revenues excluding GE Capital were up just 0.3% in 2012, while U.S. pretax profit was down 45.6%. International revenues on the same basis rose 5.4% yet international pretax profits were essentially flat, falling 0.1%. Total cash flows (excluding GE Capital) were down 19.3% and free cash flows fell 28.1% to $ 5,407 million.
A simple way to assess GE’s traded market value is to assign a valuation to GE Capital using metrics commonly applied to the financial industry. We respectfully suggest that a multiple close to 1.0 x of GE Capital’s tangible net worth might be a fair starting place. If we subtract the resulting benchmark valuation for GE Capital of $53,3 billion from GE’s market capitalization on Friday April 12, 2013 of $ 243.9 billion, we conclude that market participants accord a value of $ 190.6 billion to GE’s non-finance businesses. This equates to 35.3 x 2012 free cash flows for businesses that have recorded highly volatile financial results under external conditions that certainly have been supportive.
Preparing for the Busy Week Ahead on Planet Earth
Back on solid ground, news anchors and pundits across the “left-right” political divide remain enthusiastic over record-breaking moves in stock market indices.
Since March 2009 lows, the index of 30 “blue-chip” Dow-Jones components has climbed a whopping 127 %. The broader Standard and Poor’s composite has soared 138 %.
It is tough to stand in the way of such impressive progress. Last week, JPMorgan’s Tom Lee recanted his February 2013 warning to wait for a better re-entry point.
Yet, some resolute veterans continue to sound alarums. If you have listened to none of the Cassandras, please devote some time to this clip where famed “gravedancer” Sam Zell tells Maria Bartiromo that conditions in the stock market remind him of the real estate market back in 2006.
The biggest lift for share prices has been basement level interest rates and a theory that America and other large nations can regain growth trajectories in private labor incomes so that consumption can kick start the interconnected global economy.
Despite massive fiscal stimulus and precedent shattering monetary easing, private sector incomes per household have actually declined in America.
In 2007, private wage income and proprietors’ income were $ 6,423 billion combined. That year, the census department estimates there were 116.8 million households so private labor income was $ 55,000 per household. In 2011, private labor income grew to $ 6,623 billion, but the number of households rose to 121.1 million so private labor income per household declined 0.5% to $54,700. Adjusting these figures for inflation, per household private labor income dropped 10.1% from $ 55,000 in 2007 to $ 49,426 in 2011 (translating 2011 dollars to 2007 dollars).
This disturbing trend should resonate with President Obama—his household income in 2011 was apparently 85.7% below peak levels achieved in 2009. In 2012, President Obama’s family income dropped another 22.9%.
Dude, where’s our economy?
We are two weeks away from when the adage “sell in May and go away” will be firm in the minds of experienced professionals.
As you react to breaking news, consider Lewis Carroll’s poem “The Walrus and the Carpenter” and ask yourself whether you want to join all the other young oysters for a long walk and bitter end on the beach.
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