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Strategies & Market Trends : Stock Attack II - A Complete Analysis

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To: Gersh Avery who wrote (38193)	7/21/2002 11:56:56 AM
From: Haim R. Branisteanu	Read Replies (5) of 52237

Misconception of historical P/E Much verbiage was spent recently about stock valuation and historical P/E average of around 15. Unfortunate this valuation yardstick is not taking into account the various changes in the way business is done not to mention inflation and the velocity of money. First of all business return on investments increases with the money velocity which increased during the last 10 years as a result of "just in time" inventory. Will try to explain with a macro example. Manufacturing on average has two capital intensive investments equipment and inventory which is divided in raw material, WIP and finished goods. Those are the most "at risk" investments a manufacturing business faces. Those investment represent so called "book value" and at a P/E of 15 that book value "historically" equaled to sales more or less, resulting in an average 6.6% of sales to the bottom line. Or in other words around 6.6% return on investment, not taking into account leverage - e.g. borrowing funds from the bank. What has changed during the last 12 to 15 years is the fact that inventory turns more than doubled, from an average of 4 to 6 inventory turns a year to 12 or even 18 times a year. At this time the "just in time" concept is completed from the lowest level of supplier of raw material to the retail / end user outfit. As such retail stores go with lower inventory and mining companies mine as needed and leave most of their assets in the ground. This in effect increased the money velocity and increased the profit per invested monetary unit by a factor of 3/2 if assuming that investment in equipment is the same (which is not true as it is lower!) and in inventory at a factor of 50% less. The net result is that to achieve the same return on your money of 6.6% of sales your investment is only 2/3 from what it was before. In other words if in 1985 for every 1000 monetary units you earned 66 units today in theory for every 666 monetary units you earn the same 66 units thanks to "just in time" concept. So we make 10% in profits from our sales now or 50% more right? ..... no wrong...... Why? because competition is at our heels and our margin shrink ........ Oh that's it ...... well may be.... because lower prices induce lower inflation and enable higher employment. The net result is that if inflation on average was around 4% to 5% in 1985 it is now half and if the threshold inflationary of employment was 6.5% in 1985 it is now below 3.5%. What that all means are two things 1. Due to lower inflation by 50% the P/E ration should increase accordingly 2. Due to the higher threshold of inflation as related to employment the nation is more productive and budgets deficits shrink which in turn lower income taxes which in turn leaves more for savings and investment. To be simplistic I have not taken into account the issue of increased manufacturing quality - e.g. Lower waste of raw material, WIP and manufacturing resources with a direct implication on workers productivity. Many related the productivity issue to computer power ---- wrong, or only partially correct. The ability to spot malfunction or degradation in the product made quicker saves substantial amounts of capital and lower the cost of goods. Just think of the continuos casting process for example or let say the consistency of copper wire or even spaghetti. How much will the spaghetti manufacturer save by spotting trouble in real time and not after examining it's production in the lab twice daily. Empirically lets add another 5% decrease in cost of manufacturing widgets. The conclusion of those effects add substantially to the output per worker, lower budget deficits by 50% for same level of service, cuts inflation and as such the need of higher returns from investments Well that is quite substantial difference and the "historical" P/E ratio must be adjusted from 15 to something more close to 25 or 30 ..... and that is just IMHO. As such the market may not be as overvalued as many think and may be the ultimate BEAR bottom will be not at an P/E of 7 as it was 25 years ago but possible 18 or even 20. Any comments ? (hope this post will be as right as the one I posted over 2 years ago as we came down a long long way siliconinvestor.com In aproximation to put the whole think in some perspective I would like to mention that a nation consisting of around 6% of the world population controls about 2/3 of the world's financial assets and is responsible for around 80% of the trade imbalances. As a guideline the world GDP is estimated around $35 trillion. US Stock market capitalization around $17 trillions, US National debt around $6 trillion and corporate and personal debt more than double this amount. the stock market is down over 8 trillion, the commercial debt market is down around the same amout with over 2/3 trillion going "puff" but on the other hand the GDP grew by around 1 to 2 trillion budget deficits are 1.5% instead of 3% (in 1990) so we are closing in into some sort of balance.

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