Why Fair Value For The S&P 500 Is Not 440

Barry Ritholtz, market veteran and blogger over at The Big Picture postulated today that fair value for the S&P 500 might be 440. He got there by taking trailing 12 month GAAP earnings of $28.75 and applying a 15 P/E ratio to them.

Personally, I expect more from Barry given how strong much of his market and economic analysis has been over the years, but there are glaring flaws in this valuation methodology. First, I don't know very many market strategists who believe fair value on the S&P 500 should be based on the earnings produced by the index's components in the depths of a deep recession. Most people agree that fair value should be based on an estimate of normalized earnings, not trough (or near-trough) profit levels.

Imagine you owned a Burlington Coat Factory retail store. You are ready to retire and have a business person interested in buying your store. What would your reaction be if this person took your store's profit for the month of June, multiplied it by 12, and based his offer price on that level of projected annual profits. Clearly that figure does not give an accurate representation of how much money your store earns in a year because June is probably one of your worst months of the year for selling coats!

The same flaw exists in valuing the stock market based on current earnings. Doing so implies that earnings today represent a typical economic climate, which is clearly not the case.

The second issue with Barry's analysis is the use of "as-reported" GAAP earnings. The reason GAAP earnings have fallen so fast is that they include non-cash charges such as asset impairments. It is common these days for companies to report cash earnings of $1 billion but a GAAP loss of $5 billion due to a $6 billion asset impairment charge. In such a case GAAP earnings (which include the non-cash charge) are understated by a whopping $6 billion. Why should asset impairments be excluded? A stock's value is based on the present value of future free cash flow. Since cash flow is what matters to investors when valuing the market and specific stocks, non-cash accounting adjustments (such as asset impairments) don't really play a role in fair value estimations.

The interesting thing is that you don't have to take my word for it on this topic if you don't want to. The very fact that the market is trading about 50% below its all-time high and yet still trades at 29 times trailing GAAP earnings (S&P 500 at 834 divided by 28.75) is excellent evidence that using GAAP earnings during a recession will not result in an accurate estimate of fair value in the eyes of most investors.

Intuitive Surgical Buyout Talk Likely Overblown, But Stock Could Approach Attractive Levels When Rumors Subside

If you follow the market closely you may know the name Intuitive Surgical (ISRG). The maker of the expensive da Vinci robotic surgical system had been one of the hottest stocks in recent years before the market took a tumble. At its high of more than $350 per share, the stock commanded a startling P/E of more than 70 but the recent market correction brought the shares back down to earth, to less than $100 earlier this year.

ISRG stock has soared well above $100 (it is $107 as I write this) in part due to rumors that Johnson and Johnson (JNJ) was considering making a bid for the company. JNJ has been active in acquiring medical companies lately, but this rumor is one that seems to be started by the hedge fund community more than by industry insiders.

If the same rumor keeps coming up over and over again (like this one) but a deal never materializes, it is usually a sign that it really is just a rumor. In the fast moving trading world, especially with a high flier like ISRG, starting a quick rumor can cause an immediate reaction in the market, and profits for those who start spreading it.

Since ISRG shares have come down so much from their obscene highs, I took a quick look to see if JNJ was even mildly interested, whether the price would be right or not. To my surprise, ISRG stock is not that expensive, thanks to the recent plunge. I am not in the camp that thinks JNJ will make a run at the company right now, but even on a standalone basis ISRG has an impressive cash hoard of $900 million, or about $22 per share, and no debt. I quickly calculated core operating earnings last year to be around $4.75 per share, so applying a very conservative multiple of 15x and adding back the company's cash gets you to a price per share in the mid 90's ($93 to be exact).

Considering ISRG was trading below $100 before these rumors resurfaced, any drop back to that level appears to be a very reasonable price for investors who like the company's prospects. And if a deal does come to fruition (I can't believe ISRG management would be inclined to do a deal at these prices), that would just be an added bonus.

Full Disclosure: No position in ISRG at the time of writing, but positions may change at any time

NYT: You Need $1.6 Million A Year To Live In New York City

It might be one of the silliest stories I have read in a long time. On Friday, Allen Salkin of the New York Times wrote a piece entitled "You Try to Live on 500K in This Town" in which he argues that a family of four needs to earn around $1.6 million just to cover living expenses in New York city.

The article is aimed at criticizing the Obama administration's proposal to limit the base salary of top executives at AIG, Bank of America, and Citigroup to $500,000 per year as long as their companies are staying afloat thanks to government aid. The argument is kind of short-sighted anyway, given that the executives in question already have net worths in the tens (or even hundreds) of millions of dollars, and therefore forgoing huge salaries for a couple of years is not going to result in their lavish Manhattan apartments being foreclosed on.

Nonetheless, the idea that the very executives who are largely to blame for the financial crisis should not have to make any financial sacrifices, like the rest of the country is being forced to, is pretty ridiculous. I highly doubt the content of this article is going to win any sympathy from the vast majority of people reading it, but maybe that's just me. What do you think of Mr. Salkin's argument?

Strong Arguments Can Be Made Against Mark-to-Market Accounting

One can make the case pretty easily that mark-to-market accounting has played a huge role in the deterioration of the nation's leading banking franchises. Essentially, many banks across the country are being forced to write down the value of investment securities even if little or no loss has been, or is expected to be, incurred. Such writedowns are forcing banks to raise capital to cover losses that in many cases are never going to occur. Does that make any sense, or should banks report losses when they actually lose money? That is the key question surrounding the mark-to-market debate.

Consider the following example. Bank of New York Mellon (BK) presented at the Citi Financial Services Conference on January 28th and included the following slide in their presentation:

As you can see, the company wrote down its securities portfolio by more than $1.2 billion in the fourth quarter but based on the principal and interest payments these securities are producing, they only expect to lose about $200 million. Mark-to-market accounting rules are forcing them to take more than $1 billion in writedowns in excess of what they they believe will really be lost. Practices like this are undoubtedly putting more stress on the banking system than is necessary.

I have no problem requiring firms to write down assets before a loss is actually taken if they believe they will actually have a loss in the future. But to require them to take losses based on wildly volatile market prices (which are often inefficient in turbulent times like today) rather than the actual cash flows being generated from the securities seems like a poor way of disclosing the financial position of our banking system.

Full Disclosure: No position in BK at the time of writing, but positions may change at any time

Economy Continues to Deteriorate, But Stock Market Treads Water

Market strategists call it a "bottoming process" or "building a base." The chart below shows the S&P 500 over the last three months and you can see what they are talking about. Earnings estimates keep dropping, job cuts keep pushing up the unemployment rate, GDP continues to contract, but the S&P has been going sideways in a range between 750 and 950, even in the face of three months of bad news. No rally has been sustainable, but the market isn't getting significantly worse.

Some think this trend is a good thing, others would like to see the market rising in the face of bad news, but it is too early for the latter. There is no doubt that it is a positive sign that the market seems to have come to grips with the reality that job losses will continue, corporate profits in 2009 will stink, and the unemployment rate is headed well over 8% this year (from 7.2% currently). Since the market discounts future events ahead of time, current market prices appear to have priced in the consensus economic forecasts for 2009. Of course, we don't know if those assumptions will prove accurate or not. Only time will tell on that front.

For those looking for a large market advance, we likely won't get one that is sustainable until the economy shows signs of stabilizing. Just like stocks hit bottom before the economic statistics got worse, stocks will begin to rise before the economy begins to grow again, but we are likely facing months of stagnation before that happens. As a result, the last three months of sideways market action makes sense. Things might not get too much worse than most are expecting, but a recovery is going to take time.

U.S. Economy Can't Truly Recover If Policies Turn Protectionist

What a shame. The $800 billion+ stimulus bill being crafted in Congress isn't that impressive. Sure, there are some very good ideas that made their way into the legislation that will create jobs and improve the efficiency of our economy (infrastructure spending on roads, bridges, and the power grid, for example) but it seems for every good idea there is a bad idea to match it. Thank goodness they took funding for STD prevention out of the bill. There is nothing wrong with supporting the measure, but it certainly does not belong in an economic stimulus bill.

The part that is perhaps getting the most attention is one that would require that all infrastructure projects be completed using 100% American made materials. Somebody even proposed an idea that requires U.S. companies to fire foreign workers first, before letting go of any U.S. workers. These kinds of protectionist policies are absolutely horrible ideas.

It is a shame that our elected officials seem to write laws without ever consulting those who are educated in the area they are trying to legislate. Any economist or CEO will tell you that such policies will backfire. Congress seems to think that requiring Caterpillar to use U.S. steel in their industrial equipment will stem job loss in the U.S. because more steel workers will be needed to produce the steel. Sounds logical if you halt the analysis there.

In reality, though, Caterpillar will have to raise the prices of their equipment under such a scenario because domestic steel is more expensive. All of the sudden, Cat's prices are above those of their competitors and their customers will start buying from other companies instead to save money. As Cat's sales drop, they need to fire more workers, hardly the original intent of the policy.

The problem is we are in a global economy and the U.S. is no longer the fastest growing, most financially strong nation in the world. If U.S. companies ignore their foreign customers and competitors, our future will be bleak.

Someone will probably soon suggest that we protect jobs at home by requiring the Big Three automakers use materials made exclusively in the U.S. If that happened, U.S. car prices would be higher than their foreign competition, U.S. consumers would have fewer reasons to buy U.S. cars (in the long run, supporting your country by making a poor financial decision hurts the U.S. more than it helps it) and the Big Three would sell fewer cars, not more of them.

I think most people agree that a properly structured stimulus bill could be helpful for our economy, but couple the pork projects that would do little to boost jobs and growth with protectionist policies and any good measures in the bill could very well be quickly offset by bone-headed decisions elsewhere. From what we know so far, it doesn't look like this upcoming bill will be anywhere near as good as it could have been, which is truly a shame.

Amazon Shares Look Expensive, Long Term Future Returns Appear Limited

In November of 2004 I wrote a piece entitled "Sleepless in Seattle" which postulated that shares of Starbucks (SBUX) were trading at such a high valuation (forward P/E of 48) that even if the company grew handsomely over the following few years, the stock's performance was likely to be unimpressive. I projected an aggressive three-year average annual earnings growth rate of 20% and a P/E of 40 by 2007. I warned investors that even if those aggressive assumptions were attained, Starbucks stock would only gain 6% per year over that three year period.

The analysis proved quite accurate. Starbucks continued to grow its profits nicely, but the stock's valuation came back down to earth. After three years had passed, Starbucks stock was actually trading 12% lower than it was when I wrote the original piece.

Today, shares of online retailer Amazon.com (AMZN) remind me of Starbucks back in 2004. Despite a cratering stock market and weak retail market, Amazon stock has been quite resilient. After a strong fourth quarter earnings report (released yesterday after the close of trading), the stock is up $7 today to $57 per share. Profits at Amazon for 2008 came in at $1.49 per share, which gives the stock a P/E of 38, which is very high, even for a strong franchise like Amazon.

I decided to do the same exercise with Amazon. I wanted to make assumptions that were both reasonable but also fairly aggressive. I decided that an average earnings growth rate of 15% over the next five years fits that mold. Projecting the P/E in January of 2014 is not easy, but given that Amazon's growth rate should slow as the company gets larger, I think a 20 P/E ratio is reasonable given where other retailers trade (less than 15x). By 2014, Amazon's growth rate should be more in-line with other retailers similar in size, so I chose 20 to be higher than average, but not in nosebleed territory like the current 38 P/E.

After some simple number crunching, we can determine that Amazon would earn $3 per share in 2013 in this scenario. Twenty times that figure gets us a share price of $60, versus today's quote of $57. Even if the company hits these assumptions, shareholders will make a total return of 5% (only 1% per year!) over the next five years. I would be willing to bet the S&P 500 index far outpaces that rate over that time.

Obviously these assumptions could prove inaccurate, but I think this exercise is helpful in illustrating how hard it is for stocks that trade at lofty valuations to generate strong returns over the long term.

There is one interesting thing about Amazon's business that I think is worth pointing out. You may recall that one of the bullish arguments for an online retailer like Amazon was that they could have a lower cost structure by eliminating the expenses associated with renting and operating large brick and mortar storefronts. Having a 100% online presence was supposed to result in higher profit margins, and therefore investors could justify paying more for Amazon's stock.

It seems that argument has not been realized. Amazon's operating margins in 2008 were 4.3%. If we look at brick and mortar retailers that are similar in business line and/or size, we find that Amazon's margins are actually lower than their offline competitors. Here is a sample list: Kohls (KSS) 9.9%, JC Penney (JCP) 7.6%, Macy's (M) 7.2%, Target (TGT) 7.8%, and Best Buy (BBY) 4.6%.

Maybe online retailers have to spend more on research and development and call center staff than offline stores do, thereby cutting into the margin advantage. Amazon also offers free shipping on orders of $25 or more, which many say they could eliminate to boost profits. Maybe so, but sales would be affected to some degree if they did that, not to mention customer loyalty.

Nonetheless, to me these statistics help make the case that a 38 P/E for Amazon is way too high. As a result, returns to Amazon shareholders over the next several years could very well be unimpressive, just as was the case with Starbucks five years ago.

Full Disclosure: Peridot Capital was long Best Buy and Target at the time of writing, but positions may change at any time

Obama Team Discussing Bad Asset Purchase Program, But It May Be Too Late

I have written here previously that I didn't understand why former Treasury Secretary Henry Paulson abandoned the original plan for the Troubled Asset Relief Program (TARP); buying troubled assets from banks to free them up to have more lending flexibility. CNBC reported Tuesday evening that the Obama economic team is preparing a plan to do just that. While it is the better idea, it is also a shame that we have already plowed through $350 billion in preferred stock investments in the banking sector.

The preferred capital injection idea was doomed from the start because it did two things that hampered the banks. First, the preferred stock carried interest rates of 5%-10%. A bank taking $10 billion from TARP might have to pay out $1 billion in annual interest to the government. Sure, that helps the government get its money back sooner, but it requires the banks to hoard capital to ensure they can pay out the interest on time. When capital is so scarce, making the banks pay out more in interest is not going to help them.

But the banks can lend out the vast majority of the TARP money they receive, right? Not really, which brings us to the second problem; with the troubled assets still on the banks' books, they need to hoard capital to cover future losses that will be incurred on those assets. Without helping to relieve the banks of the sub-prime assets that are causing most of their losses, the new capital is just going to be eroded away as further losses mount. If someone comes into the emergency room with a dislocated shoulder, you don't just give the patient painkillers, you pop it back in place to help relieve the source of the pain!

The first part of TARP simply treated the symptoms of the problem, not the source. As a result, we have blown through $350 billion already and don't have much to show for it. It is encouraging that the Obama team is trying to find a solution for the troubled assets even though it is a complicated idea, but it just might be too late. We'll have to see what the plan looks like (if it even comes to fruition), and more importantly, how receptive the nation's largest banks are to participating in it.

With Consumers Paring Back, Netflix Business Gets Stronger

If people are looking to cut back on discretionary spending, the Netflix (NFLX) mail order DVD service can obviously help. Rather than spending $30 at a theater for a couple to see a movie and order some snacks, a Netflix subscription can cost half that for an entire month. Not surprising, fourth quarter sales and earnings at Netflix (reported last night) were very impressive and the stock is soaring today, trading up near $35 per share.

Despite being relatively recession-proof, Netflix stock at current levels doesn't get me very excited from a value standpoint. One can certainly justify a 2009 P/E north of 20, as it is today, but as a value investor that is not cheap enough for me to get overly excited, despite the strong business fundamentals. I will, however, continue to make good use of my Netflix subscription, and I highly recommend it.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

Home Inventories Drop Meaningfully in December, Trend Needs to Continue

Updating our long-running chart of existing home inventories, we see a sharp drop in December. The chart below shows 2007 and 2008. You can see that monthly inventory drops in the past have been temporary, and not the beginning of a new trend. Hopefully this can change going forward.

In order for the economy, our financial system, and the markets to produce real, sustainable stability we need the housing market to halt the price declines. Stable home prices require a reasonable supply-demand balance. The median existing home price in December fell to $175,000 from $207,000 the year before. That price decline brought out some buyers, which reduced inventory to the lowest levels since mid 2007.

Price declines will continue for some time, but if we can get inventories down to 6-7 months supply, those price declines should begin to moderate. A stable housing market would do a lot to support stable prices for mortgage-backed securities, which in turn would ease the pressure on bank balance sheets and boost confidence in our financial system. As a result, we should cross our fingers that the December inventory decline continues in coming months.