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Whitney Tilson’s Friend Waxes a Sell Side Analyst

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t2 partners logoFrom Whitney Tilson:  As an example of how stupid (and dangerous) this market is, see my friend’s comments (below) on this note from a Morgan Stanley analyst:


Could the Multiple Go to 10x?


Adam Parker

US Equity Strategy

Morgan Stanley

JULY 5, 2011


Is the market cheap? A number of investors have recently asked about the valuation of the S&P500 as the market multiple has contracted from 13.5x to 12.7x in the first half of the year. The bull case on valuation takes three forms: multiples vs. history, high cash balances, and attractiveness relative to bonds. We provide the facts and conclude the multiple is likely to trend lower.


1) The multiple: While the market is near ten-year lows on price-to-forward earnings, it is in the 43rd percentile versus history, just slightly cheaper than average (Exhibit 2). Because profit margins are high, valuation is less compelling on price-to-sales and price-to-trailing earnings (Exhibit 3). Moreover, dividend yields are quite low vs. history (Exhibit 4) and the mega caps (top 30 by size) are so cheap that the remaining stocks (cap. 31 – 500) are trading right at their long-term avg. (Exhibit 5).


2) Cash: Cash balances (Exhibit 6) of nearly $1.5 trillion are at historically high levels. However, net debt is at pre-Internet crisis levels (Exhibit 7) and interest rates are low, meaning cash generated in interest income is not at the atmospheric levels the cash balances would indicate. Moreover, investors have been rewarding cash with increasingly lower premiums over time.


3) Best house on a bad block: The market’s attractiveness often comes down to its equity risk premium (ERP). We did an analysis based on current CFOs’ views of the ERP and concluded that even with EPS growth rates below historical median values, the future multiple will be lower. If EPS growth comes in above median, but well below analyst forecasts, the multiple is expected to contract meaningfully.


Changes to views (sentiment) about growth and inflation are important contributors to the market multiple. We think growth will be lower in the future than the past (see Exhibit 1, sidebar right).

My friend (who’s now out of the business) comments:


Re MSFT/Large Caps, he mentions that excluding the 30 largest caps, the market is at an average multiple (on well above average margins)…  I used to refer to this as the portfolio managers’ excuse to buy Beta.  This occurs when the market multiple in total “Seems” OK, but it’s because a few large cheap stocks offset a group of wildly expensive stocks.


So, instead of buying the cheap stock, the average PM says “gee the market is reasonably valued, I will go buy some beta” – so they go buy MORE of this stuff that is wildly expensive already, making things worse, not better.  It is a market of individual stocks, it’s not a single market.  And the average PE thing is really distorting.  You need to really go industry by industry, stock by stock.  Then tell me if “market” is cheap or expensive.  And I really think it’s stock by stock.


Then it’s even worse if you owned MSFT and were short some high-P/E, low-quality junk because even if you’re dead right on the fundamentals, unless you’re also dead right on the timing, you could get killed, given the degree of volatility. This is what really used to drive me nuts about what the market had turned into.  If you’re a long/short manager, the value of timing overwhelmed the value of understanding a business and its longer term fundamentals, and what a reasonable valuation was given the mid/longer term opportunity.  There are a lot of things I miss about the business.  This is not one of them.  Actually, besides my friends I am not exactly sure what I miss ;-)


This end of month/end of quarter action illustrates the phenomena – no news on any of these stocks:


A bit of talk the past few days around the moves in RVBD (+26% in a straight line) and ARUN (+30% in a straight line) (FFIVhas jumped a meager 17% and APKT 20%). The chatter around RVBD the whole qtr was how well things sounded while the chatter around ARUN most of the qtr was how things didn’t sound all that good…then a few sell side upgrades and comments from the ARUN CEO and the stock took off. Feels like there have been real buyers in RVBD (positive chatter all qtr) while part of the move in ARUN was a squeeze as it still feels like a consensus / goto short. The bulls in RVBD like to compare its PE multiple to its peers (ex FFIV) which indicates a stock that is “cheap” relative to its peers, while the ARUN bulls prefer to look at EV/sales where ARUN trades at a discount to its peers. You can’t look at ARUN on a PE basis as it makes no sense. Looking at the two names one gets the impression although there could be risk to the set up around the RVBD qtr it’s a name investors will buy on dips while ARUN is a name the short are going to continue to come for.

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