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.

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.
  

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.
•  ...you 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. 

Bond vs Equity

We are at economic inflection point; when business as usual returns and what is usual is being figured out as we go. How quickly the world economy returns to normal—and indeed, what “normal” is going to be—will depend on hard-to-predict factors such as the fluctuations of consumer and business confidence, the actions of governments, and the volatility of global capital markets.

Credit normalization is the key to equity performance over the next little while. Without access to financing equity prices will remain under pressure. If you believe that bond professionals are better than equity analysts, which I do, then yield behavior of credit instruments should provide some clues. In addition, cost of debt is an important metric for equity valuation, the higher the cost of capital the lower equity value should be. 

The bond and equity markets have diverged over the last few months. One was priced for hooverville and the other for normal recession. Then, the reverse occurred, equities woke up to the realities of the economy while the bond markets recovered some bit. Now with the market rallying some 25% since its lows, the question is does the bond market agree with equities?  

Well the answer this time is somewhat difficult than in the past. Debt markets have been mostly flat during the recent equity rally. Actually you can argue that the treasury yield rise is positive for equity, as investors shift money from non yielding assets to equities. Another point is the elevated spreads on corporate and other instruments are now pricing risks appropriately, as historical low spreads leading to the credit crises were an aberration.

The credit environment is much better than last November on all fronts:  

 

• Corporate spreads have seen improvement since Dec 08 but did not participate in the recent equity rally and stayed mute for the most time.
• High Yield spreads remain high as evidence of defaults and low recoveries are starting to appear in bankrupt company data. However the market is far better for Q4 2008 and deal are being done even for the riskiest companies, see here. 
  
• Sovereign debt is stable and bodes well for Emerging Markets. Actually sovereign debt has been on a tear since Dec 2008.
  
• Commercial mortgages spreads remain elevated except for AAA rated paper.  
• Bank loan markets improved since last Dec 2008. Deals are being done, see here.

The consensus right now is we are going to have to revisit the lows and equity to head down. However, credit has improved so much form November of last year. Although I do not see any sustainable rally we may just languish in range bound market. Yet again who knows?? 

General Growth Properties Bankruptcy

This is one of the biggest bankruptcies in commercial real estate history; Olympia & York is close second. This is also one of the most complex as well. The company is operating relatively well but is being crushed by a mountain of debt that can't be refinanced. Their operating metrics are not stellar but they are not bad either. 

Bill Ackman, the famed hedge fund manager, have bough into all levels of the capital structure. His fund not only bought sizable portion of the common but only some senior debt and he is the Debtor In Position financier. Many retail investors have been following him by buying the common. The question is: is there value in owning the common shares? 

Examining the most recent supplemental and 10K, we find 2008 total NOI (Net Operating Income) of $2,576.51M. Assuming a 5% decline in NOI in 2009, our NOI estimate is $2,447.2M. The 5% is realistic for two reasons: 

1. their more recent quarter have seen their NOI drop by 4% from 2007 quarter and 
2. The retail environment have gotten worse since the Q4 of 2008 with sever retail sales declines in Q1 2009  
   

To calculate the value of GGP we use potential cap rates that are appropriate in this environment. I think a range between 8-10% is appropriate. The value of commercial real estate is simply NOI/ Cap rate. Under the different cap rate the potential value for GGP is as follows:

	8%	9%	10%
Value	30,587	27,189	24,470
Add: Other Assets	3,833	3,833	3,833
Less Liabilities	30,500	30,500	30,500
Value per share $	12	2	-7

So unless market cap rates go up beyond 9.5% then there is value in the common equity. However there are many other considerations:

• The bankruptcy will be a long process which most retail investor do not have the attention span for.
• complex and not transparent process.
• GGP's debt is owned by many CMBS holders that might not play ball like large lenders and could negatively affect the outcome of restructuring. 
• Equity holders have no voice and no ownership in CH 11, so GGP's bond holders can strike deals that may wipe out equity regardless of value.
• Legal fees and other bankruptcy fees will eat a lot of the cash generated from restructuring. Lehman Lawyers so far have reaped over $ 150 million. The fees alone can wipe out any value for the commons. Some other bankruptcies like Enron costs more than $250 million. 
• Bill Acman can make good return on his debt even if the equity is wiped out so he is different from you and I owning only equity.
• The game of distressed investing is a different ball game and require set of skills and legal expertise that many of us do not have.

So GGP may have value but the margin of safety and parameters are out of the scope of my competence. And if this is the same for you you should stay away.

Consumer Brands as Competitive Advantage

Brands names have been considered as a competitive advantage for companies. Companies like Kraft, Heinz, P & G, Coke, Pepsi...etc all own the who's who in consumer brands. But do all brands count as a competitive advantage? The answer is no.

Case Study: Packaged Foods Brands

Packaged or consumer food products have limited value or competitive advantage on its own. In order for brands to be a competitive advantage it must be coupled with any of the following (see my earlier post here):

• low cost producer or economies of scale,
  
• high switching costs, or
  
• consumption habits.
  

However with the exception of soft drinks, the brand is coupled with consumption habit, most consumer branded food items lack any competitive advantages. Most brands are higher in price because companies want to bill the quality in the minds of the consumer, it is expensive then it must be better mentality. But that is not the case and consumer are better informed and can't afford not to be.

P&G products, for example, are about 40% more than the store brand, but perform the same. If you shop compare, for example, laundry detergents Tide is nearly $20 for 96 loads(used to be $14), Costco's store brand, Kirkland, was $12 for ~120 loads with similar quality.

The Kirkland Butter is $1.44 per pound and as good as Land O Lakes that goes for $3.24 at the supermarket. The Kroger, Meijer and Spartan brand butter is gross and still over $2 per pound, all three come from the same plant, 324 is I remember the label correctly where Kirkland comes out of 55-307.

The proof is in market share and consumer buying habits.

• Kroger  has had significant success with its private-label program, with 27 % of its grocery sales and 35% of unit volume coming from its store brands in the fourth quarter, up from 26% and 32%, respectively, in the prior year.
  
• Safeway  intends to drive corporate brands harder if packaged food companies do not lower their prices.
  
• Wal-Mart is revamping its Great Value brand by introducing new products and reformulating 750 other products. Great Value is the country’s largest food brand in both sales and volume.
  
• ConAgra's consumer-foods segment, sales volume -- the amount of food sold -- fell 4ConAgra Foods had to cut the prices of its Pam cooking sprays, Wesson cooking oils, Egg Beaters and some other products to compete.
• Kraft Foods Inc. lost about 2.5% of its sales volume in the fourth quarter because people bought fewer of its products. Since then, the Northfield, Ill., company has lowered prices on some nuts, cheeses and coffee.
  
• Sales volume at H.J. Heinz Co. declined 6% in its most recent quarter as consumers and retailers bought fewer Heinz products.
• Nielsen data from the Private Label Manufacturers Association ahsows that private-label sales of food and other grocery products in the U.S. grew 10.3% to $82.9 billion in the twelve months ended in November.
  

Moreover, packaged foods are at a disadvantage as...

All the major packaged food companies make at least 10% of their sales to Wal-Mart, so it is a concern that as Wal-Mart increases shelf space for its own products, it is likely to reduce space for national brands from packaged food companies.

Packaged foods companies need a shift in their product strategies. There has to be a revamp in their marketing and operations to  address the following:

• Rethink their pricing strategies. A clear question need to be answered is what is their value to consumers, a brand is not value that can command a premium; it must be combined with something.
• Infinite customer segmentation that drives costs higher and leads to lower sales. Store brands are generic and one size fits all and they seem to be taking share from branded foods.
• How to deal with excess capacity? Brand companies make private label goods to fill in excess capacity at factories; even at a loss. The problem is that this is very low margin business and sales go to retailers who go bankrupt with regular frequency. Message to branded firms: use capacity to lower the costs of your products.

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Sources:
http://www.researchrecap.com/index.php/2009/03/31/store-brands-squeezing-us-packaged-goods-companies/

http://online.wsj.com/article/SB123807261203947597.html?mod=wsjcrmain

http://myvalueidea.blogspot.com/2007/12/brands-and-competitive-advantages.html