i agree -s-
Old ways of valuing stocks outdated
By Kathy Kristof
Los Angeles Times
May 11, 1999
This is the second part of Investing 201, a multipart series by Kathy Kristof that looks at the changes in the investing landscape over the past few years. Trying to figure whether stocks are still worth buying at today's steep prices?
So is Warren Buffett. The renowned billionaire investor recently acknowledged that his holding company was sitting on $15 billion in cash because he couldn't justify buying stocks at today's prices.
Traditionally, measurements such as price-to-earnings ratios and dividend yields have been used to gauge stock valuations. By history's standards, today's prices look exceptionally lofty.
In the old days, stocks were considered pricey when their per-share market prices exceeded 18 times their earnings for the past four quarters. And they were considered expensive when the annual dividends they paid to shareholders dropped to 3 percent or less of their per-share market values.
Today, stock prices average about 30 times earnings - almost twice the norm - while dividends paid to shareholders amount to less than 1.5 percent.
"The market is dramatically overvalued by all historic measures," says Michael Murphy, editor of the California Technology Stock Letter and author of Every Investor's Guide to High-Tech Stocks and Mutual Funds.
A lot of seasoned investors are anxiously wondering when - or if - they should sell to avoid the bloodletting that often follows periods of high stock valuations.
But another segment of the investment community says the old ways of looking at stock values are simply outdated. A technological revolution has created opportunities for continued low inflation, expanding profits and rising productivity.
Thanks to these factors, the United States may be able to enjoy an extended period of expanding stock prices, they say. Jumping out now would leave you poorer than you might become if you have some faith, they add.
"The same valuation argument was being made in 1994," says Bernie Schaeffer, chairman of Schaeffer's Investment Research in Cincinnati. "If you had listened to it, you would have missed out on one of the greatest bull markets of all time."
Adds Hugh Johnson, chief investment officer at First Albany Corp. in New York: "If you look at things the way you ordinarily do - if you assume that things are not different today - you would say that the market is overvalued. But clearly, to say that nothing has changed would be myopic. It is different."
What's so different today?
Companies are buying less brick and mortar - those expensive assets needed to house employees, branch offices and retail locations. Instead, more and more firms are looking for sales growth through the Internet, where you can sell to people who are thousands of miles from your nearest store.
Even banks, which once believed they needed a branch on every corner so their customers would have ready access to cash, are opening on the Net.
Even in the offline world, instead of going into a branch when you need to buy something, you use a plastic card in a kiosk to get cash, or swipe your card through a point-of-sale terminal that simply debits your bank account when making purchases. The result of these sorts of shifts: The assets companies own are generating more revenue per dollar spent, Johnson says.
Technology also has made it possible for vast international companies to communicate better and faster.
A partner at accounting firm Ernst & Young notes that working on international deals used to be ponderous because huge time differences among Los Angeles, London and Hong Kong, for example, required a variety of late-night and early-morning phone conversations, faxes and Federal Express shipments of documents.
Even then, executives might miss the person they needed to communicate with as often as not - forcing them to send things by FedEx back and forth for weeks. Today, the company's intranet system - a secured network allowing Ernst employees to communicate with one another - allows them to send documents over phone lines, eliminating the delay and expense of international shipping. That allows partners on both sides of the ocean to make better use of their time.
Meanwhile, labor shortages, which used to drive up wages and prices and fuel inflation in strong economies, are mitigated by workplace flexibility. When companies can effectively communicate with workers all over the globe, they can hire people who want to work from home - or from another state or country.
That reduces the need to pay premium wages to get workers to move to a high-cost state - or to simply woo them away from home.
Even acknowledging these advances, many analysts fear that today's stock valuations are unsustainable.
"I worry about the argument that says these higher multiples are reasonable. If you changed the names and a few of the details, you would have heard that same argument in Japan in the late 1980s," says Marshall Schield, president of Schield Management Co. in Denver. Japan's market subsequently crashed and has languished for nearly a decade.
"There are some differences today, but I don't think that the laws of gravity have been denied, canceled or revoked," he says.
Still, even if you're not a raging bull, seasoned investors say there are still opportunities. Perhaps unfortunately for Buffett, these opportunities are not for those investing billions. Why? They're in the smaller-company end of the market.
"It is a market of stocks - not a stock market," quips Bob Doll, chief investment officer at Oppenheimer Funds in New York.
While the nation's biggest stocks - those with the most weight in the S&P 500 - were recently selling at about 40 times earnings, the rest of the index was going for about 22 times earnings, he notes. Although 22 times earnings is a high multiple by historical standards, it looks reasonable next to 40. And valuations are lower for companies too small to make the index.
"This market has been completely focused on a narrow band of large companies that are very liquid (easy to buy and sell because they trade millions of shares daily)," agrees Stuart T. Freeman, chief equities strategist at A.G. Edwards Inc. in St. Louis. That trend has pushed the prices of big-company stocks into the stratosphere, while the prices of small companies are arguably cheap, he adds.
Why can't investors like Buffett and big pension funds buy small-company stocks? They have too much money. For an investment to make a difference in Buffett's multibillion-dollar portfolio, for example, it must amount to at least $100 million, Doll says. Many small companies don't have that much stock available.
Moreover, Wall Street is based on supply and demand. When a big investor like Buffett buys shares in a small company, it's almost certain to affect the market price - and not in his favor. While he is buying, it will tend to push share prices up, and while he is selling it will tend to push prices down.
But individual investments of a few thousand dollars - even a few hundred thousand - don't have the same market-moving power. That nimbleness makes it easier for you to take advantage of supposed bargains in smaller stocks.
"If you are a long-term investor looking for cheap stocks, they are not hard to find in the small-cap and middle-cap market," says A.G. Edwards' Freeman. "They are littering the countryside."
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