Disclaimer: The information and opinion expressed here are solely the opinion of Tellsons Investors LLP and should not be construed as advice nor form the basis of any investment decision.
We wanted to revisit this theme which we first commented on last November (2013). At the time, we cited an historically expensive valuation of the S&P500 on the measure of a cyclically-adjusted Price/Earnings of 24 times, (CAPE as devised by Robert J. Shiller, Professor of Economics at Yale University). We suggested that previous valuations of this magnitude had preceded the great market falls of 1929, 2001 and 2008. After years of efficiency drives, we called for “heroic” levels of revenue growth to justify these valuations. In the year to the end of September the S&P500 had risen +14.0% in USD terms (source: Bloomberg, Total Return), a CAPE of 26 times. We consider below what appears to have driven these market gains. The UK FTSE 100 had risen by a more modest +6.7% (GBP) and while direct comparisons are not appropriate, we think the US experience is significant for the wider market.
Revenues did indeed grow amongst the biggest 500 US public companies by 3.6% in real terms in the twelve months to end September this year. This number includes the contraction of activity during the US’s worst winter on record and certainly revenues recovered somewhat in the second quarter, as we expected. However, as corporate profits remained static as a percentage of GDP, Earnings Per Share (EPS) have grown by a rather more impressive 8.3%, and it is the story behind this that we feel is rather more revealing.
Companies have been issuing cheap debt in this low interest rate environment in order to finance the highest pace of share buybacks since 2007. The IT sector has been the most active and it has also enjoyed the highest investment gains in the year so far, up +29.3%, over twice the broader market (source: Bloomberg, Total Return). Apple, the world’s largest company by market capitalisation (c.US$ 600bn) and accounting for about one sixth of IT sector valuation, has seen its gains higher still – up 51.3% – approaching its historic high of almost $100/share of September 2012. The biggest buyback programme in the US market over the past year has been for Apple’s own stock……at $33bn….. and its fellow tech giants IBM, Microsoft, Oracle, Cisco, Qualcomm have accounted for another $57bn (according to research from Barclays and Birinyi Associates cited in The Wall Street Journal: “Companies Stock Buybacks Help Buoy the Market” Sept.15, 2014).
When a company buys back its shares or pays a dividend, a company transfers cash to its shareholders. This does not change the underlying value of the firm, which continues to be driven by expectations about its future real earnings growth potential. As a result of a share buyback the amount of shares outstanding declines, and this takes earnings per share higher. For most top executives this is a primary performance indicator and also happens to be a key driver of their long term incentive plans. Stock buybacks are a more tax-efficient way of giving cash back to investors than dividends – and borrowing to do this is even more tax efficient – while keeping cash balances high and credit ratings stable. Incidentally all Endeavour investments in the US made share buybacks this year, with Citibank the one exception and even they are seeking the regulator’s permission to get cash back to shareholders. In contrast, only two of our investments outside the US completed share buybacks.
Earlier this year we noted in our February 2014 Monthly Report that rising corporate cash balances and sluggish corporate investment were clear indicators for us that CEOs had little confidence in growth markets and that the new post-crisis business cycle was yet to get under way. Now it looks as though even EPS growth and consequent multiple expansion are more a function of corporate financial engineering than rising revenues and profits.
We would question this as a sound basis for current market valuation. Thankfully, the developed world financial sector is considerably stronger, chiefly in the US, than it was when Lehman Brothers collapsed in September 2008. But areas of concern remain, especially core capital provision and regulation in the European banking system, including the UK. The economic recovery remains uncertain, ‘real’ unemployment remains stubbornly high, productivity growth is virtually non-existent, inflation something of a chimera, and the rewards for taking risk dangerously low. Rather than veteran investor Sir John Templeton’s famous dictum about markets ‘climbing a wall of worry’, this one feels like it’s being hauled up on a rope from above and shoved and shunted by the fire brigade from below. It may sound like a paradox, but maybe a move to more normal borrowing rates is a pre-requisite for the next wave of real investment and the beginning of the next business cycle, but it’s hard to see how we get there and likely it’s going to be a while longer on this uncomfortable ride.