Investing
Kass: 11 Good Omens
Doug Kass
03/18/08 - 11:59 AM EDT
This blog post originally appeared on RealMoney Silver on March 18 at 8:04 a.m. EDT.
"It's a couple of years ago, I'm having lunch with one of my favorite people, Greg, who runs Mega, a $2.5 billion long-short equity hedge fund. Greg is the best! He is about 60 years old, worth at least a half a billion dollars, with a formidable reputation, but he is just as driven as he was when I first met him 30 years ago, when he was just another attractive, compulsive, young guy on the make. Now, a third of a century and a fortune later, four nights a week he sleeps in a small room off his New York office. Greg remains one of the most intense players of the money game, and part of his charm is that he wears his heart on his sleeve. If Mega is doing well, he tells you about it. If it is doing badly, he moans and groans. If one of his people has screwed up and lost him money, he doesn't keep it a secret. He is totally transparent. He is a charming, loquacious maniac." -- Barton Biggs, Hedge HoggingI rarely leave my trading desk during market hours; I did yesterday, however, in order to have lunch with Greg (from "Mega"). Greg is a pseudonym that conceals the identity of a very real hedge fund manager (who, in many ways, is larger than life) employed by Barton Biggs in his wonderful book, Hedge Hogging. To be honest, I am shameless in my respect and admiration for Greg. I worked for him about fifteen years ago, but, quite frankly, like a 19-year-old kid coming up from AA baseball to the major leagues, I wasn't ready (emotionally, physically, etc.) for the challenge. Fortunately, I have matured a lot since then, and I now can go head-to-head with Greg; he seems to be respectful of my views and input. Stated simply, Greg, The Chief, Putnam's Larry Lasser and Johann Gouws (Kidder Peabody's head of research in the mid 1970s) were among my most important mentors over the past 30 years. Greg is the complete hedge hogger, a consummate stock picker, obsessive about his investment performance and with a work ethic that has served as a model for me and others over the course of his career and in the 25 years I have known him. Before starting "Mega," he ran the investment research and management department of one of the premier Wall Street firms and was consistently voted the top-ranked strategist for the Institutional Investor magazine annual all-star team. Importantly, he remains as thoughtful and thorough as ever in his analysis of macro and micro trends and of the companies in which he invests. He is a hands-on investment manager who often knows his companies better than the their chief financial officers know their own balance sheets and income statement. (I am not kidding!) And, importantly, he is remarkably generous, especially to the institutions he grew up around in his old neighborhood, though he does not flaunt his generosity to others.
His market view is always balanced, as early in his career, he took the advice of one of his former Wall Street partners (who became Treasury Secretary) to objectively list all the positives and negatives when assessing the outlook for a company, sector of for the economy. History helps Greg to formulate his views, and charts of market/economic relationships serve to support that history. (For similar reasons, I write my tomes, as they help to crystallize my investment ideas, and it's a good personal and financial discipline.)
Greg's current market view is upbeat. He is not an unabashed bull but rather a realist who thinks that many of the problems facing the economy are well-known and are discounted.
Body of Evidence
Over a feast at his swanky country club's dining room -- I had what was arguably the best sausage and cheese omelet I have had in years! -- in Boca Raton yesterday afternoon, Greg went through a series of charts, which he entitled, "What's Good About the Investment Outlook? (We All Know What's Bad!)." I would like to briefly share his views.-
Exhibit 1: Corporate America -- Very Liquid, Quality of Earnings Good.
Greg's first chart showed that corporate debt as a percentage of capital has consistently dropped from two decades earlier. Peaking at about 49% in 1990, debt is now under 38% of capital. Cash as a percentage of assets bottomed back in 1990 at about 4.5% of assets but has more than doubled, and now the percentage stands at nearly 9%. Importantly, the quality of earnings remains above trendline, with reported S&P earnings at around 87% of operating profits. Exhibit 2: S&P 500 Dividend and Buyback Combined Yield.
On a four-quarter-trailing basis, the dividend and buyout yield of almost 6% compares favorably to the yield on the 10-year Treasury note of 3.35%. Exhibit 3: Earnings Growth and P/E Expansion in a Bull Market.
It has been 65 months (and 63.9% in price) since the trough in the stock market. (The average historical duration has been 37.5 months, in price 102%.) The previous attribution for share price advances from troughs to peaks was 31% derived from earnings growth and 69% from an expansion in P/E multiples. By contrast, in the October 2002 to March 2008 interim interval, earnings growth contributed 83% of the price advance. Exhibit 4: S&P Dividend Discount Model Valuation.
Based on a 4.00% bond rate (a conservative input as the current yield is 3.35%), a 3.25% risk premium, 2008 EPS of $95.00 and 2008 dividends of $30.25 (among other assumptions), the theoretical or fair market value of the S&P stands at $1,550. Exhibit 5: Market Valuation.
Assuming stocks' valuation is 50% correlated to bond yields and 50% correlated to inflation, stocks are nearly two standard deviations undervalued. Twelve-month forward S&P earnings less the 10-year bond yield (of 4.00%) also suggests undervaluation. The P/E of about 15 times on Mega's 12-month forward profit forecast is below the average P/E since 1961. Exhibit 6: S&P P/E and Inflation.
An analysis of the relationship between the year-over-year change in the CPI and P/E ratios indicates market undervaluation. On average, from 1960 to 2006, the market P/E has averaged 14.8 times; it stood at 13.4 times on March 10, 2008. The average P/E ratio when the CPI change is in the range of up 1% to 3% is 17.14 times. Exhibit 7: S&P 500 P/E and Forward Return.
When the S&P's forward P/E is in the range of 14 times to 16 times, the subsequent 12-month share price return is 14.9%. Exhibit 8: Valuation and Market Peaks and Troughs.
At market peaks, the earnings yield less the 10-year yield has averaged down 1.1%, less the long-term corporate bond yield is down 2.1%. At market troughs, the earnings yield less the 10-year yield is up 1.5%, less the long-term corporate bond yield has averaged up 0.4%. We now stand at up 3.2% and up 0.4%, respectively. Exhibit 9: Stocks vs. Other Assets.
Since March 24, 2000, almost every asset class has outperformed stocks. During the eight-year period, the S&P has declined by 16.6%, and while operating earnings expanded by 64.5%, P/E ratios contracted by 49.4%, the dividend yield rose by 98.0% and the yield on the 10-year U.S. note dropped by 44.4%, gold has risen by 242%, copper by 372%, wheat by 360%, crude oil by 281%, home prices by 41.4% and the euro by 57%. Exhibit 10: Historical Bear Market Cycles.
Since 1948, the average bear market, from peak to trough, has declined by 26.3% in price and has taken 12.9 months. We are currently down by about 20%, which has only taken about four months. Exhibit 11: Household Debt.
Similar to myself, Greg sees this series as a headwind to advancing stock prices. Household debt as a percentage of nominal GDP of 100%, household home mortgage debt as a percentage of GDP at 75%, household debt as a percentage of debt at over 19% and debt service payments as a percentage of disposable personal income at 14% are all at record high levels.