Valuation Overdrive
And splits all around

by Jeff Fischer (TMFJeff@aol.com)

ALEXANDRIA, VA (Feb. 17, 1999) -- The Nasdaq stock market continues to be as volatile as Martin Short at an improv club, falling 2.8% today in the wake of strong results (yeah, they were strong) from Dell Computer (Nasdaq: DELL). The S&P 500 and Dow Jones Industrial continue to slosh back and forth, too, like a certain Kennedy on a Tuesday night. (Or any night.)

Meanwhile, anchored within the hundreds of past columns written here on the Fool is the message that you are the best one to manage your own money; that you're the Fool who can do better than the pros; that only you have your own best interests in mind, and with some knowledge, you can outperform the stock market more readily than any mutual fund. Or else, you can buy an index fund and match the stock market, while outperforming 90% of mutual funds and sleeping soundly.

So the question is: Where do you fit in? Are you an Index Fund Fool? A Foolish Four Fool? A Rule Breaker or Maker Fool? A Drip? Or are you all of the above?

The Hall of Portfolios has two new pages to help you keep track of (and learn from) the Fool's six real-money portfolios. On the Web, the new pages are available from the main Portfolios page. The first is a Portfolio Quick Fact page, the other is a more detailed Portfolios Info Page. We hope that both are helpful to running your own personal portfolio (which you can also track on the Fool, of course).

There was little joy found in tracking this portfolio today. We took a club to the head and woke up seeing -2.8% circling our eyes. Amazon (Nasdaq: AMZN) and America Online (NYSE: AOL) carried us lower. Trump Hotels (NYSE: DJT), voted America's Least Admired Company by Fortune Magazine, declined, too. ("Nice doggy, good doggy.")

The largest news related to us arrived after the stock market closed. The Federal Communications Commission (so serious, our government, even in its naming conventions) approved the AT&T (NYSE: T) acquisition of TCI. This was expected, but it is still a relief to shareholders and it might have something to do with shares of @Home (Nasdaq: ATHM) rising today and tomorrow. (Assuming that it rises tomorrow -- how Wise of me.)

We lacked other news, but we have several stock splits upcoming. America Online's stock should split 2-for-1 next week, on February 22nd, and Amgen (NYSE: AMGN) will split 2-for-1 February 26th. Lucent Technologies (NYSE: LU) also announced a 2-for-1 split, effective April 1. Please see the Fool's FAQ if you have questions regarding splits (or anything investment related).

In other happenings, this portfolio will announce its annual Foolish Four switch next Monday; the trade will be made next Tuesday. To answer a common question: we first invested in the Foolish Four during a different month than the Fool's real-money Foolish Four Port. That port reconfigures its holdings in December, as do many Foolish Four investors. We're on a different cycle.

Valuation Overdrive

Last Wednesday (see link below) we continued to consider valuation theories and we briefly previewed a theory offered in a book due out this summer from James Glassman and Kevin Hassett. The book is titled Dow 36,000.

The authors propose that if inflation and interest rates are low, and corporate and economic growth is modest but consistent, and if bonds yield about what they have the past years, the valuation granted the stock market in order to equalize stocks to long-term bonds (valuation wise) requires stocks to trade at P/Es of around 100.

How is that, you ask? And what is the math?

First, both long-term bonds and stocks generate income. Bonds are a perpetuity, which is an annuity that lasts indefinitely. If you assume that stocks are a perpetuity, too (they are, if you buy the right companies and hold them), and if you assume the conditions hinted at above, then the cash flow generated by stocks must be valued at 100 times earnings in order to equal what we pay for the cash flow generated by common 30-year T-bonds. Note, however, that risk wasn't mentioned.

Risk has always been an accepted aspect of investing in the stock market. Always. In fact, maybe it's a bit too accepted, don't you think? Because if you're investing for more than 20 years in the right companies, history proves your risk is low to non-existent. The more risky venture, in fact, might be to not invest in stocks and risk losing to inflation while your money sits in a savings account.(Looked at correctly, a savings account might be the riskiest long-term investment available.) Yet, stocks have always been viewed as having the most risk, and thus they've always traded like risk-inherit investments, meaning, lower than they otherwise could.

Glassman and Hassett will probably propose that the risk of owning equity is created by one's own mis-actions (being short term), and that the actual risk present is greatly inflated by misconception. There is short-term risk, but that doesn't apply to long-term investors, be they investing in bonds or stocks. Therefore, stocks deserve higher valuation multiples -- the same multiples granted to the cash flow derived from bonds. (That's what I'm assuming they'll propose, at least.) The math and further explanation they give follows:

"Our calculations are based on the following assumptions: a long term bond rate of 5.9%, a 2.8% long term inflation rate and a 2.1% long term real growth rate. The growth and inflation rates are from projections by the Congressional Budget Office. The present value of a perpetuity (an annuity that lasts forever and returns an amount that increases at a constant rate) is calculated by dividing 1 by the rate of return minus the growth rate, 1/(r-g) where r equals the interest rate on a riskless T-bond and g equals the nominal growth rate of the economy. (See Brealy and Meyers, 1996, Principles of Corporate Finance, p. 39 for a discussion of this principle.)

"Investing in a bond is similar to purchasing a perpetuity and investing in the entire stock market can be viewed as buying a growing perpetuity. Assuming that corporate earnings grow with the growth of the economy, the fair valuation (or P/E) of the stock market that would equalize the cash flow from stocks and bonds is 1/(.059-.049) = 100.... [A] risk premium for stocks (perhaps caused by a short time horizon) would reduce the fair P/E of the stock market.

"A risk premium can be added to the present value calculation such that the present value equals 1 divided by rate of return minus the growth rate plus the risk premium. A 3% risk premium would lead to a P/E of 1/(.059-.049+.03) = 25, or approximately the current P/E. [As of 11 months ago.] However, as Jeremy Siegel explains in his book, Stocks for the Long Run (1984), the proper long-term risk premium for the stock market may be approximately zero. Although we are not predicting that P/E of the market will rise to 100, we are simply suggesting that the cash flow associated with stocks is not so low as to suggest the market is clearly overvalued."

Slightly math-heavy paragraphs, those, so if you wish to discuss the topic or ask questions, visit the Rule Breaker message board. The notion of changing how the stock market is perceived and actually valued is certainly Rule Breaking material. In the future, I still want to address how investing (and therefore, perhaps, the rules) has changed this decade.

For more reading tonight, visit the Fool's recent article on day trading at Intellectual Capital. If you read it, please share your thoughts, especially if you're a day-trader. Finally, the Bore Port discusses the decline of Dell Computer tonight, the most active stock of the day, and the best performer (of all, perhaps) this decade. Does today present opportunity?

Fool on!

Harry Jones missing?

02/17/99 Close

Stock  Change    Bid 
AMZN  -5 1/8   93.50
AMGN  +  1/4  122.50
AOL   -7 1/4  152.88
T     -  1/4   84.25
ATHM  +4 1/4  100.00
DJT   -  1/8    4.19
DD    -  5/16  52.50
XON   +  1/16  68.63
IP    -1 7/16  40.50
IOM   -  3/16   6.19
LU    -2       96.25
SBUX  -1 7/16  46.56
TDFX  -  1/8   11.25
                   Day   Month    Year  History  Annualized 
      R-BREAKER  -2.78% -13.07%  -2.49%  878.75%   65.34%
        S&P:     -1.43%  -4.34%  -0.10%  180.59%   25.54%
        NASDAQ:  -2.81% -10.25%   2.56%  212.27%   28.53%
 Note:  Yearly, historical and annualized returns for the 
S&P include dividends

    Rec'd    #  Security     In At       Now      Change
   8/5/94  1100 AmOnline       1.82    152.88    8310.35%
   9/9/97  1320 Amazon.com     6.58     93.50    1321.14%
  5/17/95  1960 Iomega Cor     1.28      6.19     383.24%
  10/1/96    84 LucentTech    23.81     96.25     304.27%
  8/12/96   130 AT&T          39.58     84.25     112.87%
  12/4/98   450 @Home Corp    56.08    100.00      78.32%
  4/30/97 -1170*Trump*         8.47      4.19      50.55%
 12/16/98   290 Amgen         85.75    122.50      42.86%
  2/20/98   200 Exxon         64.09     68.63       7.08%
  2/20/98   215 DuPont        59.83     52.50     -12.26%
  2/20/98   270 Int'l Pape    47.69     40.50     -15.08%
   7/2/98   235 Starbucks     55.91     46.56     -16.72%
   1/8/98   425 3Dfx          25.67     11.25     -56.17%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  1100 AmOnline    1999.47 168162.50  $166163.03
   9/9/97  1320 Amazon.com  8684.60 123420.00  $114735.40
  12/4/98   450 @Home Corp 25236.13  45000.00   $19763.87
 12/16/98   290 Amgen      24867.50  35525.00   $10657.50
  5/17/95  1960 Iomega Cor  2509.60  12127.50    $9617.90
  10/1/96    84 LucentTech  1999.88   8085.00    $6085.12
  8/12/96   130 AT&T        5145.11  10952.50    $5807.39
  4/30/97 -1170*Trump*     -9908.50  -4899.38    $5009.13
  2/20/98   200 Exxon      12818.00  13725.00     $907.00
  2/20/98   215 DuPont     12864.25  11287.50   -$1576.75
  2/20/98   270 Int'l Pape 12876.75  10935.00   -$1941.75
   7/2/98   235 Starbucks  13138.63  10942.19   -$2196.44
   1/8/98   425 3Dfx       10908.63   4781.25   -$6127.38

                              CASH  $39332.55
                             TOTAL $489376.61

Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends). For a history of all transactions, please click here.


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