One of the most important issues facing today's Value Investor is
whether or not the Market itself is overvalued.
There is no question that Market p/e's and other standard benchmarks
of Value, all other things being equal, are at the high end of
historic norms, and, in some cases, at all time highs.
But, Bulls argue that other things aren't equal. For example,
today's leaner and meaner corporations face lower inflation and
interest rates, less government interference, a more flexible work
force, stronger balance sheets, outsourcing, better technology and
inventory management, and a moderately but steadily growing economy.
Hence, the common stock of these companies should be valued at higher
p/e's than in the past.
Bears retort that the earnings data themselves have been inflated by
various accounting distortions and, thus, p/e's are really much
higher than they appear. Furthermore, the good-times factors listed
above have always been temporary in nature. Therefore, they
argue,the Market is headed for "The Big Kahuna".
Hence, the issue is whether or not corporations are more efficient
than in the past, and therefore accurately valued at higher ratios
of price to other other financial items, like revenues, earnings, and
book value.
GADR has done some research on this question by making some rough
calculations on financial data for most of the DJIA components. Our
methodology was inspired by an analysis done by Benjamin Graham in
his classic work on Value Investing: "The Intelligent Investor" (4th
rev. ed. 1973, pp. 176-177).
We have provided an abbreviated version of our findings in the table
below. The data was taken from Value Line, which is available in
many public libraries. The average of the 3 peak years of the last
economic cycle (1987, 1988, and 1989) was compared with that of the
most recent 3 years of the current cycle (1995, 1996, and 1997).
[In the worst case scenario, these last 3 years will prove to have
been the peak for the current cycle.]
The 3 financial items that were chosen are capital spending (i.e.,
plant and equipment), debt, and revenues. These 3 items, by their
nature, resist large scale accounting distortion, especially when
averaged over a 3-year period. When 2 such spans are separated by 9
years, significant trends in either direction would be very
difficult to reverse or neutralize through the "cooking" of books,
subject as they are to annual audit.
Twenty-five of the current DJIA companies were chosen for this
survey. The other 5 are retailers and financial institutions, for
which Value Line does not provide data on capital spending. (In the
case of financial institutions, "capital spending" is a slippery
concept, since capital is, essentially, what they are buying and
selling in their day-to-day operations. In the case of retailers,
however, we feel this item is highly relevant, and hope that Value
Line will some day include it in its presentations.)
The remaining 25 Dow stocks represent perhaps 25% of the total
market capitalization of the NYSE. Thus, they reflect a significant
sampling of the Market as a whole.
Our basic conclusion is that while the improvement in corporate
profitability may not be as spectacular as the most ebullient Bulls
would have it, the trend has been markedly positive. Specifically,
it would appear that while profit margin expansion has been modest,
return on capital employed has been substantial.
What first struck us about the data is how little any of the
3 items, in the aggregate, have grown over the past 9 years. Note
that the 9-year average annual growth for capital spending and for
debt has been 2.6% and 3.6%, respectively. This appears to be within
the margin of measurement-error for inflation over the same period.
In other words, in inflation-adjusted dollars, capital spending and
debt have remained more or less constant over this span.
The 9-year average annual growth for revenues, however, is a hair's
breadth under 5%. (There is a certain amount of overlap in the data
for capital spending and revenues, since one Dow component's capital
spending may be another Dow component's revenues.)
This higher growth rate for revenues could be explained as the
average annual rate of inflation plus the annual rate of
increase in the population. One wonders where are the revenues from
the purportedly vast expansion by large Dow multinationals into
emerging markets? The revenue growth, then, is consistent with the
view that though the overall population has expanded, real per
capita spending, like corporate spending on capital equipment,
has not grown significantly, if at all, over the past 9 years.
Assuming a constant rate of savings (the measurement of which is a
raging controversy in itself), this would imply that real rages have
not risen over this time frame. This inference is consistent with
the prevailing view on wage growth. And, it is also consistent with
the conventional wisdom that the growth in labor productivity, at
least in the manufacturing sector, has likewise been anemic.
Nevertheless, at the end of the day, corporate revenues have
grown faster than either capital spending or debt. And, the
interest burden, relative to revenues, of discharging this debt has
fallen even further, because interest rates have fallen. Thus, a
dollar of capital spending is producing 23% more revenues in the most
recent 3-year period than in the one 9 years earlier, without
weighing down the balance sheet with debt in doing so. This is
an unambiguously positive development.
What should this tell us about the financial bottom line, which is
profitability? Profits, by definition, are revenues minus expenses.
A business enterprise has basically 3 sources of costs: labor,
capital, and taxes.
Labor (the largest component of corporate spending), by all
accounts, has not been getting an increasing share of profits. And,
capital, is, relative to inflation and interest rates, neither more
expensive to replace nor to finance. The third component, the rate
of corporate taxation, is up only slightly since the late 1980's.
Thus, it is hard not to believe that profits as a percentage of
higher revenues (profit margin) and as a percentage of capital costs
(return on equity) have increased since the last economic peak.
There does appear to have been lackluster growth in
inflation-adjusted revenues above the rate of population increase
(and, by implication, labor cost increase). But, the increase in
revenues has been significantly higher than the cost of replacing
and expanding capital equipment. Therefore, it would appear that the
increase of profits as a percentage of capital has been much greater
than the increase in profit margins.
Bulls argue that with more productive capital equipment at their
disposal, workers will inevitably become more productive themselves.
Bears argue that labor productivity can't rise as fast as wages will
rise with job growth continuing to exceed the rate of population
increase, and that therefore profit margins will begin to shrink.
GADR's view remains "cautiously optimistic".
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25DJStk 87-9cs 95-'7cs 87-9dbt 95-7dbt 87-9rev 95-7rev
Alcoa $865.83 926 1,766 1,468 9,491 13,037
AlledSg 585 732 1,988 1,643 11,656 14,263
AT&T 3,692 6,440 7,838 8,858 34,973 61,631
Boeing 931 897 261 4,108 17,531 29,399
Cat 782 755 1,714 5,146 9,914 17,173
Chevron 2,687 3,480 6,826 4,320 26,881 34,732
Coke 385 1,010 704 1,074 8,321 18,477
Disney 543 1,478 578 8,893 3,636 18,608
duPont 3,774 3,541 3,494 5,255 32,973 43,624
Kodak 1,894 1,306 5,789 618 16,246 15,224
Exxon 6,016 7,281 6,328 7,421 80,876 114,374
GE 1,939 2,113 4,256 1,796 39,719 46,077
GM 5,946 5,466 28,872 38,941 115,161 168,299
Goodyr 759 610 3,097 1,134 10,528 13,226
H-P 669 1,995 208 2,133 9,940 37,611
IBM 5,370 5,536 7,734 10,102 58,796 75,562
IntlPap 710 1,370 2,038 6,896 9,558 20,013
J&J 641 1,347 1,023 1,476 8,923 21,062
McDonld 1,309 1,965 3,232 4,796 5,534 10,661
Merck 352 1,132 143 1,260 5,850 20,080
MMM 951 1,198 3,832 14,810 10,667 14,299
PhilMo 1,221 1,818 11,583 11,912 34,732 69,110
P&G 968 2,152 2,895 4,658 19,245 34,827
UnCrbd 653 669 2,413 1,424 7,994 6,181
UntdTch 896 808 1,819 1,479 18,234 23,676
Total $44,539 $56,024 $110,431 $151,620 $607,378 $941,227
incr. 95-7/87-9cs= 25.79%; 95-7/87-9dt= 37.30%; 95-7/87-9rv= 54.97%
9yr-avg. = 2.58% = 3.58% = 4.99%
87-9rv/cs = 13.64 95-7rv/cs = 16.80
95-7rv/cs//87-9rv/cs = 23.17%
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Reynolds Russell
web.idirect.com
"There are no sure and easy paths to riches in Wall Street
or anywhere else." (Benjamin Graham) |
