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Market Dregs, Low P/Es
Where are we Going

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By kitkatklub
June 30, 2004

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Saeculum is the Latin word for secular. It does not mean cycle but is used to designate a long period of time. It may have been used to describe the period of a long human life. If we are currently entering the initial stages of a secular bear market, lets hope that's not the true definition.

There have been seven secular bear markets and seven secular bull markets since 1800. The average returns for the bear markets has been 0.3% and the average returns for the bull markets has been 13.2%. If you take the average return over those 204 years you get 6.7%. This is the oft-quoted return on long-term investments that has been lifted from Ibbotson. According to John Mauldin, actual corporate earnings grow roughly in line with the gross domestic product (plus or minus inflation as applicable) and that is around 6%--close to the Ibbotson figure. Profits double about every 12 years. Unfortunately, PE ratios are not very closely tied to the GDP. From 1964 to 1981, the DJIA grew by one tenth of one percent. The GDP grew 373%. It was the wrong time to be in the market for the long haul--17 years of small returns on equities.

The bull market from 1982 to 2000 saw the DOW rise 1239% from 875 to 11,723. A great time to be in the market. And the economy? It grew at 196%. The two cycles together took 35 years.

The average length of bear markets is 14 years and the average for bulls is 15 years. Where are we now? If you believe that the market must revert to the mean as Mauldin, Grantham and a few other bears do, you would have to say we are entering in to a secular bear that started in 2000 and has another 10 years to run. This would be in keeping with the cycles that have been occurring for 200 years. The 18-year bull was fun, but I think its over.

Unfortunately, if we do not have time to wait out two cycles (the rest of this bear and the next bull) we may not realize the average return of 6% on our portfolios. I (and you) would need 10 years of the bear to lose everything now invested and then 15 years of the bull market to make it back. I don't have the 25 years to be long term buy and hold; but if you are only 20 to 30 years old, you probably do. Overall, bear markets have returned 0.3% and bull markets have returned 13.2% (from Michael Alexander: Stock Cycles: Why Stocks Won't Beat Money Markets Over the Next Twenty Years)

However, the stock market rarely yields average returns year over year.

     
      Secular Bear       Secular Bull          Secular ????      
Year  Annual return      Year   Annual return  Year  Annual return 
1964      15%            1982   20%            2000  -6% 
1965      11%            1983   20%            2001  -7%
1966     -19%            1984   -4%            2002  -17%
1967      15%            1985   28%            2003   25%
1968       4%            1986   23%
1969     -15%            1987    2%
1970       5%            1988   12%
1971       6%            1989   27%
1972      15%           1990   -4%
1973     -17%           1991   20%
1974     -28%           1992    4%
1975      38%           1993   14%
1976      18%            1994    2%
1977     -17%            1995   33%
1978      -3%            1996   26%
1979       4%            1997   23%
1980      15%           1998   16%
1981      -9%           1999   25%



For more information on secular bull and bear markets, I highly recommend Crestmont Research's website.

They have some excellent graphs, charts and insights.
The fact that 1964 to 1981 was a secular bear market did not prevent returns from individual years from being pretty good--1975 wasn't bad. And the presence of the bull from 1982 through 2000 didn't prevent declines . The years 2000 through 2002 were three down years alleviated by a very good 2003. Thus far 2004 has been relatively flat. Was 2003 a bull market rally in the midst of a secular bear?

If we are at the beginning of a secular bear market, it will be a difficult time for buying and holding stocks. There is a lot opinion that the current P/E of the market is at record high levels and there are those who opine buying equities with very high P/Es at the start of a correction is a bad idea. The stocks bought at these prices will not deliver high returns (or much of any return according to some).

Merrill Lynch economist David Rosenberg estimated that the increase in P/E from 1980 to 2000 was 70% price appreciation and only 30% came from growth. Investors decide how much they are willing to pay for a dollars worth of investments and the more they pay, the higher the PE grows. In many cases, the price has very little to do with earnings and everything to do with investor sentiment, emotion and expectations.

Robert Shiller in Irrational Exuberance believes emotion drives the stock market and that stocks with low dividends and high PE ratios will provide low returns. There is at least a connection between high P/Es and low returns if not causation. Jeremy Grantham believes we are at the tail end of a bubble and that the currently high market P/E of 26 has to revert to trend (a lower PE) as all of the other bubbles have. He says there are no exceptions to this reversion and the long-term PE he cites for the market is a P/E of 14 to 15. The trend for US markets that Grantham is looking for is based on dividend yield, Tobin's Q, the price of stocks to the 10 year real earnings average, and the ratio of market cap to GNP. By all these measures, he thinks the market is overvalued and the P/E is going to have to come back towards 14 to 15. If that's the case, a lot of equities have a long way to fall. Jeremy Siegel has pointed out that no investor has made money long-term on a large cap stock with a P/E ratio of 100 such as Yahoo!, Cisco and AOL.

The following link is to the Clipper Fund. James Gipson is a well-regarded value oriented fund manager. The link shows the P/E trends for the market over time. It is interesting to note how long it has been since the P/E has been anywhere near the trend line. It is also worth looking at the tendency to over correct after the highs. This graph does not include 2003, but at the end of 2003, market P/Es were nowhere near 14 and were closer to 25. Where do we go from here? Do we repeat history and Grantham's prediction that all bubbles revert to the mean or is it "different this time"?

A recent work by Damodaran also cites some studies (Fama and French) showing that the higher P/E stocks in general tend to deliver lower returns. On average, the lowest P/E stocks tended to earn almost twice the returns of the highest P/E categories.

So should you run out and buy equities that have the lowest P/Es? The answer brings me to the reason I started these thoughts on P/E and the answer is no. Low P/E stocks are often low for fundamental reasons that make them unattractive holdings. The price to earnings ratio can be the function of fundamental characteristics of the business as well as a product of momentum, hype, emotion and greed. It is necessary to check the low P/E businesses for flaws that may be contributing to a well-deserved low price. In looking at the P/E ratio, you should always consider growth, risk and return on equity.

Many mature low growth companies like utilities and some financial services will have low P/Es. If the low P/E is a result of stagnant or declining growth, you will probably not want it in your portfolio.

High-risk companies also may trade at low P/Es and not make good investments. There are various ways to measure risk. You could use the beta or the standard deviation in the stock's price. If you are looking at risk through debt, then you might consider the debt to equity ratio. Also, Standard and Poor's and Moody's will assess risk on companies that have certain forms of debt (corporate bonds) and grade them.

And finally there is the quality (and quantity) of earnings. Companies with low returns on equity (ROE) also may deservedly have low P/Es and make poor investments. Assessing the quality of earnings of a company is essential. Do they have reasonable margins? Do they take yearly "one time or unusual charges"(bad)? Do they restate earnings? Do they grant a lot of options? For this evaluation, it is necessary to examine the 10K and management discussion of earnings.

In a recent Wall Street Journal, there was an article that speaks to this very issue of finding low P/E stocks in an overvalued market:

Buying Market Dregs Could Put You on Top
Eastman Kodak, AT&T, HCA
And Bristol-Myers May Show
Big Upside if Perceptions Change


Since I own three of the companies in the headlines and have thought about Eastman Kodak, this caught my attention. Some snippets:


They are the most despised stocks on Wall Street. Analysts hate them. Investors are betting against them. The media is all over them.

Despite all that -- and maybe because of it -- some of these ugly ducklings could be attractive investments. Sure, analysts stick their lowest ratings on these stocks. And things are looking so gloomy that the companies are seeing the most short selling, or wagers by investors that their stock price will tumble. But sometimes those kinds of stocks have the biggest upside.

Betting against the consensus on Wall Street has been a big money maker in recent years. The performance of companies receiving the worst ratings by Wall Street's research analysts has actually topped the performance of highly rated stocks in each of the past four years, according to Zacks Investment Research, a Chicago money-management and research firm. And it is happening again this year: The 1,000 lowest-rated stocks were up 2.1% through May, while the 1,000 stocks with the highest ratings were up just 1.3%.


This would seem to go hand in hand with finding companies with low P/Es that might have good enough fundamentals to make reasonable investments. The trick is to avoid the companies that are cheap because they have serious and unfixable problems and to find those that may be suffering a temporary setback and may be on the road to recovery. Most of these companies are cheap because investors hate them and refuse to pay high prices for them.

There is often good reason for Wall Street to shun a particular stock and in those cases, it is wise to heed the consensus. Winn-Dixie Stores has dropped almost 50% in the past year. There is a tremendous amount of short-selling against it and the analyst rating is second from the bottom. They are feeling the heat from WalMart and that is unlikely to cool or be a fixable problem for Winn-Dixie. This would be a stock to avoid at present. Univision is one of the most heavily shorted stocks at present and the earnings can't support the buyback required to close the shorts. It faces heavy competition from NBC's Telemundo and may have difficulty surviving the challenge.

On the other hand there are companies like Eastman Kodak. Yes, they suffered from immeasurable amounts of lunacy thinking the digital thing would probably go away and deciding to stick with film. But, they realized it eventually and have taken aggressive steps to repair the damage.

From the article:
Eastman Kodak, the lowest-rated stock in the S&P 500 with an average rating of "sell," is struggling as U.S. sales of photographic film slow, and consumers shift to digital cameras and picture-taking mobile phones. But the company is still expected to earn $2.21 a share this year, giving the stock a skimpy price-earnings multiple of 11. Even the bearish analysts predict earnings will grow to $2.44 a share next year. If the company can grab a piece of the digital market, or film sales somehow stabilize, the stock will look cheap.

I took a long look at Kodak in March and found things to hate and things to admire. The balance swung in favor of not buying at the moment. They have huge amounts of debt and a poor rating from S&P and Moody's. I used this as a measure of high risk. Their price has been volatile (52 week range $31.55 to $20.39). On the other hand, the pension fund is caught up and they intend to start expensing options. They also continue to generate large amounts of revenue. I felt if they made good on their promise to pay off $800 million in debt this year, they would become a buy.

AT&T is the fourth -lowest rated company by analysts. This one is more of a dilemma that may not be solved. A recent Supreme Court ruling upheld the Baby Bells right to refuse to provide service at below cost prices to companies like AT&T. They have also backed services out of seven states.

From the WSJ:

AT&T Corp. is planning an even broader retrenchment in the consumer phone business, on the heels of last week's announcement that it would stop marketing residential local and long-distance service in seven states, according to people familiar with the matter.

The nation's largest long-distance carrier by customers and revenue has begun notifying companies that provide it with marketing services, such as call centers, that it won't be needing them, or will be sharply reducing the services it buys, these people said. Accenture Ltd. is one of the outsourcing vendors that has been informed of a cutback, these people said.

AT&T's decision comes in the wake of a regulatory setback that will increase its costs for providing most of the local phone service it sells along with long-distance.

An appeals court struck down the rules that govern what AT&T and other companies pay to rent lines from the regional Bell carriers that own the lines reaching into most homes.


The company is trading at a current P/E of around 7 and has a per share earnings of $1.01 this year, and pays a dividend of 5.5%. Unfortunately, the price competition looks like it will keep putting pressure on the company and because this is regulated by the government and the FCC, the pricing structure is beyond their control and may not be a problem AT&T can fix.

"AT&T is trading at unusual discount to distributable earnings," says Erik Hess, an analyst at International Strategy & Investment. "Nobody likes it so no one is left to sell it, and you're being compensated for holding it" with the generous dividend." The question remains, will earnings continue to support the dividend?

Bristol-Myers Squibb is another unloved stock that analyst's hate. They are considered to have one of the worst pipelines in the business and recently suffered an embarrassing set back when they went head to head with Pfizer's Lipitor. Their troubles really started when the price was slashed in half due to accounting scandals in 1999 through 2001. However, these problems may be of the fixable variety. The accounting scandal is beginning to wind down (they recently took what we hope is the final charge related to reserves for the legal proceedings) and a pipeline is a work in progress for most companies and is potentially fixable for Bristol Myers. They continue to pay a high dividend (yield 4.5% ) and generate substantial amounts of free cash flow.

"We think the current condition is not reflective of the future, if there's any pipeline there will be upside" to the stock, says John Goetz, managing principal at Pzena Investment Management LLC, a New York money-management firm whose firm owns shares of Bristol-Myers.

And last but not least and also unloved is HCA. HCA is the biggest US hospital chain. Hospital stocks have been hit hard by losses on uncollected patient bills and they have had to increase loss reserves enormously. This of course has to come right out of earnings. However, perhaps the problems can be addressed.

Mr. Goetz also has been a buyer of HCA, the hospital operator that has seen heavy short selling. HCA stock has suffered amid worries about looming pressure over health-care costs and billing problems. But Mr. Goetz is betting HCA will start doing a better job of screening patients, to reduce the number who can't pay their bills, making the stock cheap.

Buying the cast offs from the market may point you to some low P/E stocks, but each company needs careful consideration to discover why they are trading below the market average and whether the problems they face are terminal. You want to avoid the cheap stocks that are likely to die in your portfolio.    

>^..^<


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