May 28, 2009

PE Valuation Cycles

I tend to view markets in PE cycles rather than most widely used price cycles of bear and bull markets. This means I follow PE expansion and compression cycles. Why? As investor and I look at valuation to allocate capital rather than price. Moreover, capital appreciation or return is made up from two sources: PE expansion and earning growth. So it follows that PE trends should determine bear and bull markets rather than price action. 

For the purpose of this post there are two cycles an PE expansion cycle and PE compression cycle. There has been 8 secular cycles, including this one, measured from PE trough to peak, throughout the period from late 1800. There were 4 PE expansion cycles and 4 compression cycles, including this one from 2000 to date. 

I used Prof. Robert Shiller data for my analysis and the most interesting findings are in the following table:

Here are few observations:
  • There are secular cycles lasting many years from PE trough to PE peak and vice versa.
  • 10 yr Yield peak and trough coincide with PE cycles; rising yields does impact valuation. So the prospect of rising yields in today's market will negatively impact equity valuation.
  • Average PE compression cycles is some 13 years; we are 9 years in this cycle.
  • Average annualized returns associated with PE compression cycles is almost double the upside move in the PE expansion cycle, -17% vs 10%.

Here are some valuation implications, if I use typical cycles averages to the current PE compression cycle:
  • According to the data, the long term average of PE of 16.34x, it seems that at the current market levels the S&P is fairly valued at 15x.
  • Given the size of the credit event occurred in 2008 and the disruption to world economy also the succession of various bubbles: Internet, housing and credit, a retrenchment in PE by 80% is realistic. So far PE compression is 65% from its 2000 peak. In the secular PE compression seems that a move of 80% down is typical. Therefore another 15% compression is highly likely. 
  • The current compression cycle should end around 8-9 times 10 years real earnings, as most compression cycles ended in single digits. If we use the current S&P 10 yr earnings of $57.67 per share then that puts the price target of the S&P at 519, some 40% decline from the current level.
  • There is an expected Bear market in treasuries due to high supply of paper as governments to try to finance deficits, thereby increasing yield, another sign of secular PE compression, as any PE. 
Although history does not repeat itself but it rhymes. History can rewrite the averages here, but events that transpired are not unique to history and has occurred in the past, so we will work them out. And equities will experience another bull market, but I doubt it is going to be now.

May 25, 2009

Credit and PE Cycles

Credit availability, not leverage, underpins equity valuation. Actually it underpins a lot of economic output but for the purpose of this post I will stick to equity valuation.

Having lower yields on treasury bills affect stock valuation positively, as you discount future dividends, cash flow or earnings streams by lower discount rate, thereby increasing valuation. The opposite have negative affects on valuations; higher rates mean lower value. The concern is for equity valuation going forward is the rapid increase in treasuries yield. 

The massive debt being accumulated in the US and elsewhere is what will cause yields to rise quickly. Here is an excerpt from John Mauldin letter, which can explain why  yields will have to go up very quickly:
The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year.  US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn't do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let's be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

I am not concerned about where the money will come from, it will come, as supply creates its own demand at the right price. What price may that be, you ask? I bet you it is going to be at much higher yields. I suspect somewhere around 6%. Yields have already began to move upwards in a hurry. Look at the the 10 yr Treasury from Yahoo:

So here some observations: 
  • The yield rise is not a good sign for a sustainable PE expansion in equity. Given that cyclically adjusted PE, Data from Prof. Robert Shiller, have not dipped under single digit, as historically no sustainable bull market have began from double digit PE. Please look at the second graph.
  • Bull markets or PE expansions have been associated with low yields and the prospect of bear market in treasuries do not give me confidence in any PE expansion for the next few years. Observe the 70s era in the second graph.
  •  PE compression takes awhile. PE have been compressing since the burst of the Internet bubble in early 2000. That is 9 years only and that is not long enough period. If history holds we can be looking for another 5-10 years of range bound market prices.

May 3, 2009

Strategic buyout Mistakes

I typically do not like companies to undertake spectacular acquisitions or mergers. Large mergers and acquisitions have so many inherit risks that could derail them. Actually any merger of any size has the same issues and risks that can scuttle the transaction but with smaller acquisition the impact can be negligible. 

Mergers can appear wonderful on paper as they offer new markets, synergies...etc. However their success or failure rest on implementation and execution of the integration plan. And I think the biggest threat for the success of these mergers is the resistance to change. It is human nature to keep at the same ways of doing things; you are comfortable and you have the know how, why change. This is a big hurdle to overcome. And that is why most mergers fail. 

Management execution plans must be set with the mindset of "plan to fail and manage for success". In the book "Billion Dollar Lessons" the authors detail some of the misguided actions and red flags to the management's strategic plans. Those red flags can serve investors as well in assessing the value of their investments.

Illusion of synergy
Trying to archive a better distribution network, economies of scale, cutting overhead...etc are all good reasons to undertake an acquisition. But rarely do these synergies materialize. The authors offer these red flags:
  • The synergy may exist only in the mind of strategists and not in the mind of customers.
  • ....overpaying for an acquisition
  • ....clashes of culture, skills or systems can mean that synergies that seem easy to achieve can be impossible to get.
Rollups strategy
Some companies adopt the strategy of rollups in fragmented industries. It makes sense for a company to operate more efficiently by merging tens or hundreds of smaller businesses given them economies of scale:
  • better bargaining with suppliers,
  • lower cost of capital,
  • lower overhead costs as you spread them over many entities, 
  • more efficient distribution networks,...etc
However unless the industry are of the right characteristics and management have the skills to execute, this again will mount to nothing. Some red flags offered by the authors:
  • Rollups went for scale that would not produce economies. sometimes, rollups wound up with diseconomies of scale. 
  • Rollups required an unsustainably fast rate of acquisitions
  • Companies did not allow for tough times- and it seems that every rollup runs into tough times at some point.
  • Companies assumed that they could get the benefits both of decentralization and of integration. ...[they] often found, that they could choose either decentralization or integration but not both.
Adjacent markets
Companies, often, to achieve growth expand to adjacent markets and products. For example  a passenger bus transportation company moving to ambulance services as both businesses are about moving humans from point A to B. More often than not management are surprised that these adjacent markets are not similar at all to their core business and the venture end up costing them dearly. Some takeaways from the book:
  • The move is being driven more by a change in a company's core business rather than a great opportunity in the adjacent market. 
  • The company lack expertise in the adjacent market, leading the company to misjudge acquisitions and mismanage the competitive challenges of the new market.
  • the company overestimates the strength or importance its core business capabilities will have in the new markets.
  • A company overestimates its hold on customers, leading to expectations of cross-selling or up-selling that won't materialize.   
Fumbling technology
Following the "killer app" vision can be tremendously costly and horribly unsuccessful. The desire to lunch the next Netscape or Ipod can lead to disastrous results. Management has to think what business are they in rather than what technology or idea is more sexy.
  • They [companies] evaluate their offerings in isolation or at a single point in time, rather than in the context of how alternatives will evolve over time.
  • They confuse market research with marketing, allowing their entrenched interests and hopes to colour the analysis of true market potential.
  • They find false security in competition,...presence of rivals equates to a validation of the potential market.
  • They design the effort as a front-loaded gamble, foreclosing possibilities for adaption and severely limiting the option to stop.  
Consolidation in distressed industries 
Maturing industries or more bluntly in trouble industries like News papers,  news print media and news print paper more often consolidate. These industries are facing decreased demand for their products and industry overcapacity. Most adopt the consolidation strategy to cut overcapacity, achieve economies of scale and raise prices if they can. The trouble is :
  • you may not be buying the assets you think you are buying; you may also be buying problems. 
  • ...there may also be disconomies of scale because of increased complexity.
  • may not able to hold onto customers.
I tend to not like serial acquirers or vision builders but I sometimes get suckered into the sales pitch of management. The above list should give me a solid checklist to keep the analysis honest.