A tale of two markets by Vilas Capital
The equity markets, over the last decade, have vacillated between extreme levels of fear and greed. Usually, periods of fear accompany economic downturns while periods of greed appear after many years of strong, unabated economic growth. Ironically, it is during periods of fear and uncertainty where great opportunities appear while long periods of growth lead to stretched valuations and many potential land mines. Occasionally, we find periods of time where a portion of the market is fearful of future economic growth while other parts are extremely optimistic. We appear to be in one of those periods of time today.
In 2008 and 2009, the markets traded as if nearly all companies would eventually go bankrupt. I managed a bond fund and an equity fund through this period. Believing credit spreads were too tight in 2005, 2006 and 2007, I sold most of our corporate bonds and purchased Government backed bonds. In 2008 and 2009, I was able to sell our Government bonds, as they were appreciating, and purchased A+ corporate bonds with yields of roughly 15% to maturity. These included Nordstrom, CBS, Johnson Controls, Fifth Third Bank, Charles Schwab, etc. These bonds were trading at roughly 70 cents on the dollar. Their stocks were extremely depressed as well. Assuming we received the long term average of a 50% recovery rate in bankruptcy, meaning that we would recover 50% of the par value of the bonds, the math was clear that we would “break even” with US Treasuries if roughly 30% of these companies went bankrupt each year. Think about this. The markets in 2009 were anticipating that within a decade, nearly 97% of public companies in America would be out of business. Well, it is almost ten years later and the markets are thriving. Almost none of the large companies failed as the market was anticipating. In fact, corporate earnings have been excellent over this time frame. (As an aside, these moves made this Bond Fund the best performing fund in the Morningstar Short Term Bond category for the trailing 1, 3, 5 and 10 years ended 6/30/2009).
The equity markets have also recovered mightily since 2009. From its depths, the S&P 500 has increased in value by over 250%. Today, credit spreads are again becoming tighter, price earnings ratios are rising, and the VIX index, a measure of market fear, is near an all-time low. What a difference a decade can make.
The interesting part is that the equity market has witnessed a historic divergence in performance between its sectors. Value stocks, including autos, financials, and other economically sensitive areas, are trading at very low valuations when compared to earnings and book values. The Vanguard Value Index Fund, as measured by Morningstar, has compounded at 5.4% per year over the last decade. On the other hand, growth stocks, overall, have performed exceptionally. This sector has been led by technology stocks. The Vanguard Growth Index Fund has compounded at 8.6% per year over the last decade. Thus, an investment in the Value Index would have compounded $1 to $1.69 while the Growth Index would have compounded that dollar to $2.28. So, an investment in Growth stocks would have produced a $0.59 better result for every dollar invested vs Value stocks. If this trend continued for the next 20 years, the differential would rise to over $7 for every dollar invested. Wow. What a result.
However, from the academic research of all the data going back to the first dates that records were kept, Value stocks outperform Growth stocks over long periods of time. So, something must be wrong. Either the old data was flawed, the earnings results of value stocks are permanently impaired for some reason, we have entered a new paradigm of growth driven by technological change and lack of competition, or valuations of growth stocks have risen dramatically in relation to their earnings. We don’t believe that the data is flawed and also do not believe that the earnings of value stocks are permanently impaired. It does appear that the market believes, however, that we have entered a “new economic order” where valuations seem to matter less and less while earnings, especially those reported under Generally Accepted Accounting Principles (GAAP) rules, are deemed to be passé.
As an example, we thought it would be interesting to compare and contrast the cheapest stock in the S&P 500 Index and the most expensive: General Motors vs Amazon. Question: if we use a 10-year time horizon and assume that each group of shareholders needs to earn 10% per year, what would be the resulting share price that should be paid for each stock in today’s market? We will go so far as to assume that GM does not grow its earnings while Amazon grows its earnings at 30% per year over the next decade. At the end, however, we will assume that GM trades at 6 times earnings and that Amazon trades at 20 times earnings. After all, every company eventually sees its valuation return to Earth. Even mighty Microsoft, Cisco Systems, Google and Apple have seen their share prices dip significantly below this level, from time to time, as the businesses mature.
Amazon reported $2.58 billion in GAAP earnings over the last 12 months per Morningstar. We will use that as their starting point. General Motors earned $10.08 billion. In ten years’ time, General Motors will have earned $100.8 billion if we assume that they neither grow nor decline. Because they are not growing, we will assume that working capital needs remain constant and depreciation equals capital expenditures. We will also assume that GM pays out all this net income in dividends, for simplicity, as the company already has $14 billion of excess cash held for a rainy day. Amazon, on the other hand, will have earned $142.9 billion and we also assume that these earnings will be paid out as they are earned over the next decade in annual dividends, again for simplicity.
If, at the end, we assume GM has the same share count while Amazon, due to its very heavy use of stock based compensation, sees its share count expand by 1% per year, GM will continue to have the same 1.558 billion shares outstanding while Amazon will have 537 million shares, up from today’s 486 million. Note that if Amazon’s stock were to decline appreciably, as we will discuss later, their equity based compensation will accelerate the dilution to shareholders.
The results of this exercise are somewhat staggering. The Net Present Value of the cash flows for General Motors suggests that an investor should pay $54.72 per share today to earn 10% per year over the next decade. Thus, the stock should instantly increase 67% from today's price of $32.78 and then remain constant as dividends are received.
On the other hand, this illustration finds that an investor should pay $650 for Amazon stock today to earn 10% per year over the next decade. Thus, Amazon’s stock should fall 32% from today’s price of $967.
Importantly, the assumptions behind these results are somewhat realistic in