Wading Through Valuations

May 11, 2021

Anytime you see a major market moving event (like Covid), it will be followed by earnings estimate changes from analysts both on individual companies as well as indexes such as the S&P 500. It truly becomes a game of cat and mouse, as the analysts scramble to adjust their earnings forecasts based on information from the companies on this years and next year’s sales. The chart below shows the change in consensus of forward EPS (Earnings Per Share) over the course of the year, in each of the past 20 years.

As you can note, the change in EPS for 2020 (due to shutdowns) were over (24%) and so far, this year analysts have the 2021 Estimate at a growth rate of about 24% and trending higher. 2021 Earnings estimate is the highest revision on this chart, and I suspect if we could go back further, it’s probably the best since the Great Depression. It displays the magnitude of Covid’s impact on the economy, and how quickly things can rebound.

This leads me to today’s topic which is how do you value stocks? P/E (Price to Earnings), P/FE (Price to Forward Earnings, P/S (Price to sales), P/B (Price to Book), P/FCF (Price to Free Cash Flow), or how about the PEG ratio (Price to Expected Growth)? It sounds confusing just trying to determine which metric to use, let alone when the metric is changing so much as earnings surprise to the upside. Well, the simple answer is all of the above based on what type of company it is. Small cap companies that have the capacity to double sales in short periods of time will have a super high P/E. Some won’t have a P/E because they are not profitable yet, therefore no earnings. Some companies are in industries that are developing new products that are in clinical trials and you don’t even know what the sales would look like, while others have consistent same store sales growth, that makes predicting what their earnings will be in any one quarter much easier.

Uncle Ben Graham (Warren Buffett’s mentor), wrote the bible on this topic titled, Securities Analysis. For decades, this book helped some of today’s most successful investors determine which stocks to own and when. More recently however it’s losing its position as the go-to book to teach the new generation of Analysts and Portfolio Managers. Research once extremely hard to come by is now everywhere for basically free. Trading that was extremely hard for the individual investor to do is now not only easy but is offered for free at a lot of firms. But most importantly, the speed of innovation, and access to capital provides an atmosphere for creation to revenue in warp speed.

Speaking of the Oracle of Omaha, the weekend past was another of the Berkshire Hathaway shareholder meetings. Once a celebration of capitalism was again this year via Zoom. None of the fanfare of the years past where all of the products under the Berkshire umbrella got to showcase their products to the world. This year is consisted of 90-year-old Buffett (Chairman on Berkshire) and 97-year-old Charlie Munger (Vice Chairman), sitting at a desk for over 4 hours fielding questions from the investors. There’s a good clip from the meeting, click here if you want to watch some of the highlights.

And as always, I’ve attached their annual report that has Buffett’s letter to investors starting on page 3. It’s always a great read. Click here to check it out.

The one take away for me is although his/their quotes are timeless, I question whether their underperformance to the S&P 500 for the past few years is somewhat related to the “new age” companies in indexes. I covered this some time back, but I think it’s worth reiterating. Growth orientated companies make up substantially more of the S&P 500 index today than they did say even a decade ago, let alone to 1965 when Berkshire started. The percentage of intangible assets sold now from companies in the S&P 500 is over 90%, compared to just 30 years ago when it was less than 10%. Think about the profit difference from a company that provides software over the internet that can be downloaded and used mostly without limitation on how many people use or watch it, to companies that need a brick-and-mortar warehouse to create, build, assemble and ship their products. It’s a new age…

Valuations do matter and given where we are priced on a few of the small cap growth names, I believe for at least some of them, the rapid movement up of the sales, profit, and share price is unsustainable. So, if I’m right then one of two things will happen; the stock price will fall, or the stock price will stay the same while earnings catch up. (This is what we are seeing presently).

We are proceeding with caution from this point….

With that, here’s the buy/sell. Have a great week.

Mick Graham, CPM®, AIF®

Branch Manager/Financial Advisor at Raymond James in Melbourne, FL

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Mick Graham and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

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