edamo: An Interesting Article On Valuations from The Philladelphia Newspaper.....FYI....
Never fear these price-earnings ratios 4/6/99
Some companies' shares are priced well above traditional levels, with respect to earnings. But the rules have changed, several experts assert.
By Miriam Hill
INQUIRER STAFF WRITER
Faster than their toughest competitors. More profitable than the rest of the Standard & Poor's 500. Able to leap from country to country in a single bound.
They're SuperCorporations - and a small but prominent group of investment experts thinks these companies will propel the American stock market to even loftier heights.
The thinking of these experts defies the conventional wisdom that the stock market generally is overvalued and that the biggest companies are the most overvalued of all.
Instead, these experts say, big companies such as Microsoft, Intel, Pfizer, Wal-Mart and Coca-Cola constitute a sort of corporate superclass among the most profitable the market has ever seen.
"Microsoft, Intel and these companies that are selling for 40, 50 and 60 times earnings - they're worth it," said Jeremy Siegel, finance professor at the University of Pennsylvania's Wharton School and author of Stocks for the Long Run.
In reaching this conclusion, Siegel compared the 20 largest companies in the S&P 500 today with the 20 largest in 1964, a year chosen because the economy was similar to today's - with low inflation, low interest rates, and a strong stock market. He focused on the 20 largest - as measured by market capitalization, the total value of outstanding stock - because they have the greatest effect on the overall value of the S&P index.
Of the 20 largest stocks in the S&P today, 17 are growth stocks. That compares with five in 1964.
The top 20 companies today have average five-year earnings growth rates of 23.1 percent, compared with 8 percent for the top 20 companies in 1964, Siegel said. That means today's top 20 are more profitable than their predecessors - and worth more to investors who, in theory, base the price they pay for a stock on the value of its future earnings and dividends.
There is also reason to believe that the top 20 will continue their dominance, Siegel said. They are projected to increase their earnings 17.2 percent on average over the next five years, compared with only 7.2 percent for the entire S&P 500.
The top 20 are beating their smaller peers now and their predecessors in the earnings race for three reasons, Siegel said.
First, their size makes them the first name that consumers think of when looking to buy a particular product. People seeking networking solutions turn to Cisco first, for example.
Second, they sell around the world. Thirty-five years ago, companies earned most of their revenue in the United States.
And third, they profit from being in relatively young industries - telecommunications, pharmaceuticals, computers - that have higher earnings potential than more mature businesses such as building cars.
That dominance explains why Microsoft, the biggest company in the S&P 500, can sell for 74 times earnings, why No. 2 General Electric can sell for 40 times earnings, and why No. 20 Bristol-Myers can sell for 41 times earnings, Siegel and others say.
Most experts, however, consider these ratios stratospheric because stocks have sported average price-to-earnings ratios of 14.4 since 1872.
"The issue is how sustainable are those prices, particularly in a low-growth environment," said Matthew Brown, who oversees equity trading for Wilmington Trust. "We would suggest that over a much longer period of time, it can't be done."
Siegel's thinking isn't conventional, but he's not alone. Ralph Acampora, chief technical strategist for Prudential Securities, has been making the same case for much of the 1990s - and the recent runup in stock prices has only made him more bullish on owning the big names.
"It seems that we keep looking to the same few names as we make the drive toward Dow 10,000," Acampora told clients March 22 in Prudential's weekly advisory letter. "While we agree that market leadership is narrow, it is important to keep your eye on the ball in terms of sticking with the areas of strength."
Such prognostications worry the camp that believes recent stock-market history will be repeated.
John Campbell, an economics professor at Harvard, and Robert Shiller, an economics professor at Yale, have done research showing that the S&P 500 could be worth a third less than it is today if price-to-earnings ratios return to traditional levels over 10 years. The value of the S&P 500 index is weighted according to the size of the companies in them, so the 20 largest stocks exert a powerful influence. The prices of many of those companies would have to fall for the overall index to do the same.
"In the past, when it's been at the upper end of the range, the stock market tends to fall," Shiller said.
Siegel's thesis depends entirely on the accuracy of analysts' earnings forecasts, which tend to be overly optimistic, Campbell and Shiller said.
"Jeremy [Siegel] raises an interesting point and it might be right, but it's not persuasive, either," said Shiller, who has done research with Siegel. "Claiming that the present time is unique may require more careful research than he's presented so far. Statisticians looking over the numbers will always find something unique about the present."
Robert Turner, cohead of Berwyn money manager Turner Investment Partners, agrees with Siegel that the biggest companies have immense earnings power.
"They compete across the world," Turner said. "They can negotiate on pricing with their suppliers."
Two years ago, Turner created its Turner Large Cap Fund - up 45 percent in 1998 - to capitalize on the gains offered by these largest stocks. Turner still recommends that investors own some small and medium-size companies, but says the profit potential makes the biggest undeniably attractive.
Earnings aren't the only force driving these stocks higher, though. With 70 million baby boomers saving for retirement and their children's educations, more dollars are going into the stock market. In many cases, boomers are buying mutual funds that mimic the performance of the S&P 500. That means more dollars chasing the largest stocks.
"With these big stocks, it's a little bit self-fulfilling. They're part of the index. Probably, Microsoft accounts for 4 percent of the total market value of the S&P 500, so 4 cents of every dollar invested in [an S&P 500 fund] goes to Microsoft," Turner said.
Microsoft, MCI Worldcom, Merck and the other companies among the S&P 500's 20 largest are simply faster-growing than their historic predecessors, Siegel said.
"It used to be big manufacturers; the autos, the oils were very prominent [in the S&P]," Siegel said. "They were big, profitable companies, but they were not growing any faster than the economy. General Motors, for example, was in a mature industry."
A few companies in today's top 20 are in relatively tame industries - Coca-Cola, for example - but many are pioneers.
"The new top 20 are growing at two to three times the rate of the entire economy," Siegel said. "There have been new developments in technologies and breakthroughs where there's tremendous potential for profit both in the United States and around the world."
Siegel even says there is historical precedent for the high valuations of today's big firms. It's just that people have misinterpreted the history, he said.
Critics of the high valuations of large companies often point to the Nifty Fifty, a group of stocks that attained lofty heights in the early 1970s, only to crash and burn and, in some cases, never achieve prices that high again.
Siegel, however, traced the returns of these companies - including Coca-Cola, Disney and General Electric - and determined that an investor who bought them at their peak in 1972 and held them through August 1998 would have earned almost the same rate of return as an investor who owned the entire S&P 500 index. Over that period, the S&P returned about 12.7 percent yearly, compared with 12.5 percent for the Nifty Fifty.
"These companies lived up to and exceeded their promise in 1972," Siegel said. "They went down to a tremendous undervalued state for a while after that, but history has vindicated the price of many, many of those stocks. Pfizer, Merck, Coca-Cola, Bristol-Myers - many of them are still the top performers, as they were back then."
Siegel acknowledged that some Top 20 companies will fail to generate market-beating returns. And some have reached such high prices that even Siegel can't rationalize them.
He can't make sense of the market's valuation of America Online, the 18th-largest stock in the S&P 500 - and the only Internet stock in the top 20. Trading at 742 times its most recent 12-month earnings and at 482 times analysts' 1999 estimates, AOL makes Microsoft look like a value stock.
Overall, Siegel said, the top growth stocks are good values. "If they ever break down [in price], I'm going to stuff my portfolio with them.">> |
