Relative Value
Smead Capital Management
By Bill Smead
August 22, 2012
Dear Fellow Investors:
Everyone
wants to wait for the perfect time to buy into the stock market or into
any major investment market. They want to enter at historically
cheap prices or at “absolute values”. We at Smead Capital Management
believe that these people are kidding themselves and everybody else. At
the time of historical lows and “absolute value” those same folks are
too mortified to pull the trigger (think March
of 2009) and always come up with the reason that “it’s different this
time”. Inertia rules the day.
Therefore,
we have to deal in the world of “relative value”. Thanks to a recent
article in the Financial Times by Peter Tasker, we have access to
some terrific long-term graphs on the value of a wide variety of
investments and products priced in gold. In fact, Tasker references the
website, http://pricedingold.com/, which has a treasure trove of information about where things are priced currently compared to history in the form of ounces
or grams of gold.
This
got me thinking a great deal about pricing common stocks today by
various popular measures. For example, if you prefer to be bearish on US
stocks,
you whip out the ten-year Schiller numbers and compute the S&P 500
Index PE ratio on a “smoothed” basis. Since we’ve had the deepest
recession since the 1930’s, one of the slowest recoveries ever and a
housing depression, the ten-year Schiller PE ratio is
higher than the historical average at 18.8 PE. On that basis, you’d
want to be extremely cautious with US common stocks.
On
a consensus estimate basis, stocks look historically under-priced at
around 13 times earnings. This compares to a multiple of 15-16 PE over
the
last 50-100 years. The bearish argument to that positive is that
S&P profit margins are the highest they’ve ever been and must revert
to the mean. When the reversion happens, earnings will be far lower and
stocks will go nowhere or so say market bears. To
get our opinion on this subject refer to our missive entitled “Stock Picking in a World of Profit Margin Mean Reversion”.
However,
thanks to Peter Tasker’s thoughts, we need to have a discussion about
the places that money is currently stored and compare them to the
S&P 500 Index from a long-term standpoint. In the article, “Cash
Out of Gold and Send Your Kids to College” here is how he got my
thoughts and shopping comparisons started:
This
makes sense. For most of human history, gold existed as an alternative
to conventional finance, a “store of value” that could be relied on
in times of distress and crisis. Gold bugs may hate to admit it, but
those days are long gone. Gold has become just another financial asset,
as vulnerable to the shifts of investor sentiment as an emerging market.
It is symbolic of today’s world that one of the largest exchange traded funds is invested in gold bullion, not equities.
Tasker
pointed out that gold has always been a place that folks store some of
their assets. Unfortunately for gold bugs, we believe it is getting
severely out of whack with the price of important assets and goods
which gold can be traded for. Its relative value is out of line.
The
current bull market saw the gold price rise from $280 an ounce to
$1,900 in 10 years. This is a rate of ascent comparable to some of the
great
historical bubbles, such as Japanese stocks in the 1980s, Nasdaq in the
1990s and Chinese stocks more recently.
In
inflation-adjusted terms, gold remains within spitting distance of the
all-time high it reached in 1981. After that it embarked on a 20-year
bear market, which delivered a loss of 80 per cent in real terms and a
far greater opportunity cost as other financial assets soared in price.
Even
now the total market value of all the gold in existence – which,
remember, generates a return of precisely zero – exceeds the combined
capitalization
of the German, Chinese and Japanese stock markets, with all the
productive capacity they represent.
Then Tasker got me really excited and my economic academic discipline began boiling up inside of me with this paragraph:
According
to the website pricedingold.com, gold is at a 120-year high (at least)
relative to U.S. house prices. Likewise, it is at a 74-year high
relative to U.S. wages, at multi-generation highs relative to wheat,
coffee and cocoa and at the same price relative to the cost of a Yale
education as in the first decade of the 20th century.
He
didn’t include the S&P 500 Index, but at pricedingold.com you’ll
find it is at the lower end of the last 60 years when priced in gold.
My
mind quickly moved to the other liquid asset classes where folks store
their money beside gold and US common stocks. This would include US
Treasury
Bonds, Bills and Notes, Certificates of Deposit (CDs) and other
longer-term bank savings deposits, money market funds, corporate bonds
(both high-grade and junk), commodities/commodity indexes, foreign bonds
and international common stocks. Many of these are
owned through mutual funds or ETFs, but for the sake of our discussion,
they will be lumped together.
For
the purpose of this missive, we will frame our relative value view of
what Warren Buffett calls “currency investments” to the income they
provide
currently compared to the income they have provided historically. On
both an absolute basis (interest rates lower than any time in the last
50 years) and a relative basis (as compared to the dividend yield on the
S&P 500 Index) earning interest through the
vehicles listed above is at an extreme. The opportunity cost of not
owning interest-bearing securities is the lowest in US history.
Ironically, both institutional and individual investors have poured
money into these categories over the last five years.
It
is even more exciting to compare US large cap common stocks to interest
bearing securities if you normalize dividend payout ratios for the
S&P
500 Index. In 2011, the payout ratio was 26%. Howard Silverblatt, the
historian for S&P, reports that the average payout ratio from 1990
to 2010 was 46% and the 75-year average was 52.3%. He also shared that
the current payout ratio is close to what it was
in 1936 during the Depression. You think people might have been scared
then? At a 52.3% payout ratio, the S&P would yield over 4% today! If
something happens to cause leaders of the S&P 500 Index companies
to normalize payout ratios in the next ten years,
stocks could be attractive on an income basis for years. And they could
be very competitive on an opportunity cost basis with “currency
investments” as interest rates rise.
We
have shared how over-priced we believe commodities are on a long-term
basis in previous missives, so we won’t belabor the point. We also
believe
the international stock market won’t be good competition to the US
large cap stocks until lower commodity prices have been priced into all
the BRIC and BRIC-related equity markets around the world.
In
summary, most of the places to put money among the liquid asset
categories are very expensive relative to US large cap stock ownership
at this
time. It could be that US large cap stocks are incredibly undervalued
and/or some combination of both. If the long-term charts at
pricedingold.com are any indication and these historically low interest
rates end, these next ten years could be a great deal
of fun for common stock investors in the US on a “relative” basis.
Best Wishes,
William Smead
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities we recommend will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
(c) Smead Capital Management
