Stay Focused: Don't Bet on the Fed!

"Bulls Bet on Something Big From Fed" read the headline at the top of Yahoo! Finance yesterday. That sounds exciting enough! It might even be relevant for people who speculate on stocks on a daily basis. However, don't get confused: If you are an investor, the outcome of today's Fed meeting -- or the next one -- will have absolutely no impact on your long-term returns and should have no bearing on your investment decisions.

Is this relevant?
The Fed has said that it expects to maintain short-term interest rates at zero through 2014. The investment management industry invests extraordinary amounts of time, energy, and resources trying to anticipate whether this will be necessary and what other tricks the Fed might have up its sleeve (ruminations the financial media cover assiduously.) Here's a simple question: What proportion of today's stock prices are attributable to expected earnings through 2014? These are earnings estimates for the S&P 500's earnings:

 

2012 (Q3 and Q4)

2013

2014

S&P 500 Index

$51.85

$111.92

$105.50

Source: S&P Capital IQ.

Now you can't just sum those three numbers; a stock's intrinsic value is equal to the present value of expected future cash flows, discounted at the appropriate rate. For the S&P 500, the discount rate I used is the sum of the current 10-year Treasury yield (the "risk-free" rate) and the historical equity risk premium for U.S. stocks (link opens PDF), or the premium that U.S. stocks have historically earned above bond returns (4.10%). That gives the following result:

 

Present Value of Expected Pre-2015 EPS

Current Index Value

S&P 500 Index

$252.11

1,357.98

Sources: S&P Capital IQ and author's calculations.

In other words, pre-2015 earnings explain only one-fifth (19%) of the S&P 500's current value. Four-fifths of the S&P 500's value will be generated beyond the zero-interest-rate-policy horizon! Note also that the government's borrowing rate has virtually no effect on that percentage. If we were to assume that the 10-year Treasury bond yield rose to 4% tomorrow (from the current 1.62%), the pre-2015 percentage of value would only drop to 18% (all other things being equal, of course).

How the blue chips stack up
I performed the same exercise with the stocks in the blue chip Dow Jones Industrial Average (INDEX: ^DJI  ) . Exactly half of them had pre-2015 earnings that account for one-fifth or less of their current prices. Not surprisingly, they include some stalwarts that have been generating generous cash flows -- and returning some of that cash to shareholders -- for decades.

With the possible exception of Johnson & Johnson, I expect the five companies in the following table to continue doing just that for several more decades. (I exclude J&N because I simply do not know it that well and I have some concerns regarding the industry in which it operates.)

 

% of Current Stock Price Attributable Pre-2015 Earnings

Dividend Yield

Johnson & Johnson

18%

2.45%

Procter & Gamble (NYSE: PG  )

17%

3.61%

3M (NYSE: MMM  )

19%

2.70%

McDonald's (NYSE: MCD  )

17%

3.10%

Coca-Cola (NYSE: KO  )

14%

2.68%

Sources: S&P Capital IQ and author's calculations.

How fast will you get your money back?
My analysis also presented some interesting results at the other end of the spectrum. There are only two Dow stocks for which pre-2015 earnings account for more than a third of the stock price: JPMorgan Chase (34%) and Hewlett-Packard (52%). In other words, if Hewlett-Packard can achieve its earnings estimates over the next 2.5 years, an investor will have "recouped" half of his investment (based on the current price). I use quote marks because that's a theoretical interpretation -- earnings are, in a sense, "phantom" cash flows, as they are not fully distributed to shareholders.

Both of these stocks have suffered horrendous headline risk (HP for several years now, JPMorgan for several months only). For contrarian/special situations/deep value investors, those are the sort of numbers that should set your "value gland" salivating. Not, mind you, that one should immediately go out and buy the stocks with abandon, but these are types of situations that alpha-hounds should be looking at.

Traders, not investors
But back to the article I referred to in my opening paragraph. The author tips his hand in the last line and makes it very clear which audience he is addressing, and it isn't fundamentals-oriented investors (emphasis mine): "Still, every trader knows you 'don't fight the Fed' and hope springs eternal on Wall Street for more action from Ben Bernanke."

Investors, your mission, should you choose to accept it...
As I have written before, equity investors shouldn't fight the Fed, nor should they align themselves with the Fed. Their fight is elsewhere entirely: Their mission is to purchase at reasonable prices the shares of companies that are able to earn consistently above their cost of capital and hold the shares long enough for stock returns to track underlying economic gains. If you call yourself an investor, don't let anyone -- least of all the financial media -- distract you from that critical mission.

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on LinkedIn. The Motley Fool owns shares of Johnson & Johnson, Coca-Cola, and JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Coca-Cola, McDonald's, Johnson & Johnson, 3M, and Procter & Gamble. Motley Fool newsletter services have also recommended creating a diagonal call position in 3M and a diagonal call position in Johnson & Johnson. The Motley Fool has a disclosure policy.
We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (4) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 21, 2012, at 11:02 AM, Teacherman1 wrote:

    Alex

    I have been noticing some comments about (Fannie, Freddie, FHA ?), perhaps "loosening" their requirements for mortgage purchases, and requiring fewer "buy backs", in order to get the lenders to "lessen" ( the now fairly stringent) requirements to qualify for a home loan, and thus "stimulate" a quicker rebound in the housing market.

    Do you have any thoughts on that, and what role the FED may play in that?

    Don't know if you have any interest in this area or not, but thought I would throw it out for what it's worth.

  • Report this Comment On June 21, 2012, at 2:16 PM, TMFAleph1 wrote:

    @Teacherman1

    That would make sense -- the FT reported yesterday the number of people who are choosing to re-finance their mortgages in inconsistent with current rates (i.e. the number of refinancings should be much higher.)

    In the UK, the Bank of England is embarking on a program aimed at increasing lending to businesses. The BoE will lend to banks at low rates on a sliding scale that is a function of amounts lent out.

  • Report this Comment On June 25, 2012, at 1:01 PM, Mega wrote:

    Good article.

    "Their mission is to purchase at reasonable prices the shares of companies that are able to earn consistently above their cost of capital and hold the shares long enough for stock returns to track underlying economic gains. If you call yourself an investor, don't let anyone -- least of all the financial media -- distract you from that critical mission."

    This describes the Buffett style of investing, but is not the sole definition of investing.

    The Graham "cigar butt" style of investing involves holding shares long enough for stock returns to align with the intrinsic value of a company, not necessarily to track any economic gains.

  • Report this Comment On June 25, 2012, at 2:51 PM, TMFAleph1 wrote:

    @MegaShort

    You're right, but I wouldn't recommend Ben Graham-type investing widely, as it demands more greater skill and time.

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