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The future is always clearest once it is in the past

For stock market transactions to occur, there must be a buyer and a seller. Consequently, there must always be divergent, and even polar opposite, views despite generally similar information being available to both sides.

You decide which side of the fence you are on

But ask the question about whether the market is expensive or cheap and you stir up a hornet’s nest of opinion. And reaching a conclusion on the affordability of the market is often interpreted as a prediction about its future direction. Argue the market is expensive and one is forecasting a crash. Conclude the market is cheap and you must foresee a rampaging bull run.

Of course, it is entirely possible that the market remains cheap or expensive for a long time. Therefore, a comment on whether it is cheap or expensive is not a prediction about anything. Today, I intend to demonstrate why the market could be cheap and why it might be expensive. I will leave you to decide on which side of the fence you sit and to draw your own conclusions about what happens next.

How big tech prices can be justified

Many of those who point to an overvalued market cite the extreme valuations for some technology companies. Apple, Facebook, Amazon, Microsoft and Google – commonly referred to as the FAAMGs – collectively represent 25% of the entire S&P500’s market value, and the market value of US tech stocks is greater than the capitalisation of all European exchanges. Meanwhile, Apple’s market capitalisation alone is now on par with the market capitalisation of the entire US small cap index, the Russell 2000.

Much of the market’s 2020 rally has been driven by a stampede of investment into these five giant technology companies. In the absence of these five, the S&P500 would be about flat so far this calendar year.

In terms of measuring their popularity, over the last six years, while the famous five’s profits have increased by US$80 billion, their market value has increased by more than US$5 trillion – a multiple of over 62 times. Investors have simply been willing to pay a lot more for each dollar of earnings that these companies generate.

Perhaps this is because while every economic contraction produces challenges for many businesses, there are others that win. And the FAAMGs are indeed winning.

I looked at the returns on equity for each of the FAAMGs for the last five years and discovered something universal. As these companies grew, they became more profitable. In 2016, Microsoft was earning US$20 billion on US$76 billion of equity, or a return on equity of 27%. In 2020, Microsoft’s equity was a little more than 50% higher at US$110 billion but the company earned more than double its 2016 profits at US$44 billion. It therefore recorded a return on equity of 40%. Improvements in profitability, as measured by return on equity, similarly improved for the remaining four of the FAAMGs.

If I gave you a choice of purchasing a bank account with $10 million earning 27% interest or a $15 million account earning 40%, which would you prefer? You will always take the bank account with more money earning a higher return. It is no different with companies and when it comes to equity and returns on equity, too much of a good thing is wonderful (with apologies to Mae West).

As the profit and return on equity has risen these companies have become more valuable. And its unsurprising during a period of low growth and ultra-low interest rates that more valuable companies should also become more popular. Such assets are scarce, and history shows scarce assets always become more popular when growth and interest rates are low.

Of course, investors need to be mindful that popularity can be fickle.

The booming stock market therefore is at least partly due to the popularity of five very large but very profitable companies. While some value investors who predict an immediate crash and an emerging crisis could be right, they must also understand the same conditions also explain the concentration of money into those companies and business models that are actually winning.

IPOs come out of the woodwork

Booming stock markets tend to attract IPOs because the right time to list a company on the stock exchange, and sell out or sell down, is when investors are applauding their listing. Indeed, the appearance of today’s conga line of IPO’s is cited by many as a sign that temperatures are rising and therefore so should investor nervousness.

I have some sympathy with this idea. Experience tells me that we should be tempering enthusiasm when the most popular and oversubscribed IPOs are for companies with no profit and in some cases no revenue.

But the IPO wave has been rolling on for some years. Indeed, there was a bumper crop of IPO’s in 2019 and investors will recall the IPOs of Lyft, Uber, Peleton, Pinterest and Zoom. This year’s crop of listings which includes Snowflake, Unity and Palantir are different however in that they have much shorter histories and less time has passed between private equity capital raisings and an IPO. Snowflake has also seen its value more than triple in six months between the last private equity funding round and its price on the market today.

In Australia there may be a similar level of enthusiasm for the unprofitable. Sixty-three companies in the All Ordinaries index gained 20% or more this reporting season compared with only two companies that were down as much. But what some analysts point out is that out of the top 10 performing stocks in the All Ordinaries index, none made any free cash flow for the period. And of the 20 best performing stocks, only four made any free cash flow at all.

Such unbridled enthusiasm for loss making companies always gives me cause for concern based on the three similar scenarios in history I lived and invested through.

The overall market level is not a bubble

When I instead look at various models for estimating the fair value of the aggregate market, I reach a more sanguine conclusion. Australia, like the US, has experienced a similar expansion of price to earnings (P/E) multiples as a function of ultra-low interest rates and the migration out of cash and into growth assets.

Ultra-low interest rates helped the Australian Treasury sell 31-year Government bonds at around 1.9%. If we add on the equity market risk premium (ERP) of, say, 3%, we arrive at an earnings yield of about 5%. The inverse of the earnings yield is the PE ratio and if we then divide 100 by five, we arrive at a PE of 20 times earnings. At the time of writing, the forward PE for the ASX200 is currently 19.8 times, suggesting it is about fair value, even without factoring in growth. If long term growth is 2.5% (and yes, that may yet prove ambitious) the fair multiple of earnings could be materially higher than 20 times.

So perhaps the market isn’t expensive at all.

The US Federal Reserve has also articulated and demonstrated a desire to do ‘whatever it takes’. Indeed, central banks are aggressively buying an unprecedented range and quantum of listed and unlisted assets and securities. The consequence is the frustration of the traditional price signals that tell investors which businesses are weak and should fail.

What about the zombies?

And that brings me to the final point - the wave of zombie companies that some analysts are citing as a justifiable source for unease.

A zombie company is one that is unable to pay its interest expenses from its EBIT (earnings before interest and tax). The number of zombie companies listed around the world has been rising as a proportion of all listed companies in most western democracies and it has many investors worried.

Among the Russell 2000 – the US small caps index – the proportion of companies unable to meet interest on debts from profits for at least the last three years has risen from 10% in 2017 to 15% today. During the GFC, the proportion of such companies in the Russell 2000 was 16%, so today’s number is almost on par with the experience during the GFC. A similar jump in the walking dead is evident elsewhere almost everywhere. The share of US listed firms more than 10-years-old with an interest coverage ratio of less than one for three years in a row is 19%, in Germany 15%, in the UK 8.5% and in France it is 17%. But while the numbers have been rising steadily it should be noted Japan’s proportion of walking dead is almost double the US at 36%.

Time will tell

There are solid arguments suggesting the market is not expensive and equally solid arguments suggesting it isn’t cheap. The future is always clearest once it is in the past.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

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