“My message is as follows: stocks stink and will continue to do so until they’re priced appropriately, probably somewhere around Dow 5000, S&P 650, or Nasdaq God knows where.”
That’s what Bill Gross, the usually mild-mannered managing director of Pacific Investment Management Co., wrote in a widely discussed letter to clients last month. Gross is the manager of the best bond fund around, Pimco Total Return, and in the world of fixed-income investments he’s broadly and deeply respected.
In his letter, Gross admits that stocks aren’t his specialty. “Okay,” he writes, “what’s a bond guy doing talking about the stock market?” Adam Lashinsky, writing on the CNNMoney.com Web site, has an answer: “He’s selling bonds.”
Maybe, but I will take Gross at face value. His prediction, while frightening, isn’t so far-fetched. After all, in two years, the Dow dropped by more than one-third from its high of 11,723. What’s so crazy about dropping another one-third? The Dow stood at 5000 as recently as 1995; it was below 3600 in 1994 and below 2500 in 1991.
As I am reminded from time to time, I wrote a book in 1999 with economist Kevin Hassett with the title “Dow 36,000.” That book, like Gross’s letter, was not so much a prediction as an explanation of how stocks should be priced — and whether, for the long term, they are undervalued or overvalued. With the Dow headed for its third consecutive year of decline (something that hasn’t happened since 1941), this is a good time to examine the important issue of stock valuation.
Is Gross right? Others think not. For example, using a quick-and-dirty model based on consensus projections of interest rates and profit growth, the Web site Economy.com recently estimated that the benchmark Standard & Poor’s 500-stock index should be valued at about 1260. The equivalent level for the Dow would be about 12,000. So is it 5000 or 12,000? Or 36,000, for that matter?
Start with the basics. We value most investments by looking at how much money they put in our pocket, especially how much regular income they generate. If you are buying rental property, you need to know the monthly rent you will receive as landlord. If, after expenses, the rent comes to $1,000 a month, or $12,000 a year, and the price of the property is $200,000, then you are making roughly 6 percent on your investment (12,000 divided by 200,000). Is 6 percent a good deal?
To answer, you need to examine a few more factors:
The risk. Is the property in a bad neighborhood? Is someone likely to build a noisy factory, or a competitive housing development, next door? Is the local or national economy declining so that you’ll have a hard time finding tenants?
The interest rate environment today and in the future. For example, if a 10-year Treasury bond is yielding 8 percent, your real estate investment does not look like a good bet in comparison.
The potential for growth. Will you be able to raise the rents to keep up with inflation, or even to surpass it?
So there you have the five keys to any investment: price, yield, risk, interest rates and growth. Call them by the acronym PYRIG.
Few investors analyze stocks this way. Instead, they think: “This looks like a good company at a good price, and it helps diversify my portfolio. I think it will go up, so I’ll buy it now and maybe sell it sometime in the future to someone who will pay more.”
Behind such calculations, however, lies PYRIG. The stock price is unlikely to rise if, for example, interest rates shoot up or if profit growth slows. Also, while it’s true that investors price stocks in the short term out of fear and giddiness, they price them in the long term according to PYRIG. Warren Buffett, chairman of Berkshire Hathaway Inc. (BRK), recently paraphrased his mentor, the late Benjamin Graham: “In the short run, the market’s a voting machine, and sometimes people vote very unintelligently. In the long run, it’s a weighing machine, and the weight of business and how it does is what affects values over time.” In other words, PYRIG counts.
In his letter to clients last month the essential argument that Gross made was that the Y part of PYRIG was extremely low, and that stock prices will have to decline to get in line with yield. This is not an easy concept, but I’ll explain it in a second. First, though, we have to understand what Y really is.
Like rental property, bonds throw off regular income, so it’s a cinch to calculate the yield. If a bond pays $50 in interest a year and it’s priced at $1,000, then the yield is 5 percent. With stocks, the matter is not so simple.
Stocks pay dividends — quarterly payouts to shareholders. The dividends come from a company’s profits, also called “net income” or “earnings.” A company needs to plow part of those earnings back into the business to build new factories or buy new machines, and most companies want to keep another part of the earnings for a rainy day (as a cash cushion or to buy other companies or to hold and eventually give back to the shareholders). Also, companies sometimes buy back their own stock, thus reducing the number of shares and boosting the value of the remaining shares.
In other words, with a stock there are several kinds of yield: earnings yield (based on officially reported profits), “cash yield” (based on the money that a company could give to shareholders if it wanted to) and dividend yield (based on money that it actually pays shareholders each quarter). With a bond, there’s just one kind of yield, stemming from plain old interest.
So here’s the tough question: When you are trying to value a stock, do you look at the dividends to determine yield, or do you look at the earnings, or at the free cash flow?
The dividend is more valuable, since it’s money in a shareholder’s pocket, but it doesn’t tell you everything you need to know. For example, Dell Computer Corp. (DELL), a highly profitable company that generates gobs of earnings and free cash, has never paid a dividend. At last report, Dell was sitting on $4 billion in cash and short-term investments — money that, presumably, could be paid out to shareholders but isn’t, partly because of the curious American system of taxing dividends twice, at the corporate and personal levels. The tax bite on profits used as dividends can total 60 percent. No wonder companies are instead retaining their earnings, or using them to buy their own shares or the shares of other companies.
Throughout most of stock-market history, dividends have represented about half of reported earnings. In other words, a company would make $1 million a year and send $500,000 out as checks to shareholders. But since the early 1990s, dividends have represented only about one-third of total earnings.
Gross notes that stocks pay an average dividend today of 1.7 percent. He believes that, to be properly priced — and specifically to be attractive enough to compete with bonds — they need to yield about 3 percent. So let’s assume an individual stock is priced at $100 and pays a dividend of $1.70 for a yield of 1.7 percent (1.70 divided by 100). How can it yield 3 percent? Well, if the dividend stays the same at $1.70, then the price has to fall to about $57 (1.70 divided by 57 equals 3 percent). In other words, this stock — and, by Gross’s reckoning, the entire market — needs to drop from $100 to $57, or about 40 percent. That gets him to roughly 5000 on the Dow.
If you don’t follow the math, don’t worry. In his discursive and often hard-to-follow letter, Gross is simply saying that stocks don’t yield enough right now. In other words, they are too expensive for their piddling dividends. But Gross is missing a big point: He assumes that dividends equal earnings and cash flow. They don’t. As Lashinsky points out, seven of the 48 U.S.-listed companies with market values greater than $50 billion — many of them very profitable — don’t pay dividends at all. So “you’re comparing 2002 apples to 1920s oranges.”
One way to handle the dividend problem is by looking instead at earnings yield — that is, a company’s earnings per share as a percentage of its price. (By the way, this figure can also be expressed as E/P, or the inverse of the price-to-earnings ratio.)
According to Barron’s, with the Dow Jones industrial average at about 8000 recently, the 30 stocks that make up the Dow average were expected to earn about $400 this year. So the earnings yield of the Dow is roughly 5 percent (400 divided by 8,000). The dividend yield at the time was about 2.3 percent. For the broader S&P 500 index, which includes more companies that have lost money over the past year, the earnings yield was 3.2 percent and the dividend yield 1.9 percent (Gross uses 1.7 percent, but let’s not quibble).
In fact, let’s return to the Dow, which was the subject of the headline on Gross’s analysis, “Dow 5000.” Assume that the Dow’s profit yield lies halfway between earnings and dividends at, say, 3.6 percent. In other words, as a shareholder in a Dow company, your “income” (the free cash that is either sent to you or held on your behalf by the company) currently amounts to $36 for every $1,000 invested at today’s prices.
Now, at last, we can get back to PYRIG.
We know the price, and we know the yield. What about the other three factors?
Risk: Just how risky are stocks compared with bonds? My reading of history is that, in the short term, stocks are far more risky, but that, in the long term, stocks carry roughly the same risk (with a government bond, you will certainly get your principal back, but inflation typically erodes it far more than it erodes a stock investment). But hasn’t the world itself gotten riskier, with threats of terrorism and war? And isn’t the global economy on shaky ground? These are questions you will have to answer yourself. My own view is that long-term risks have not increased and that the economy is sound. As Buffett says, stock markets “are way out of sync with the economy.”
Interest rates: They’re lower than they have been since the 1950s. On Sept. 25, the yield on a 10-year Treasury note was just 3.7 percent, roughly the same as the profit yield on Dow stocks. Two-year Treasurys were yielding less than 2 percent. If stocks were yielding 3.6 percent and two-year T-notes were yielding 6 percent (as not long ago they were), then stocks would not look particularly attractive. But at these rates, stocks appear extremely inviting.
Growth: This is what makes a stock different from a bond. Stocks increase their earnings and dividends over time while bonds pay the same interest year after year. On average, businesses increase their profits at about 6 percent a year. Which would you rather own, an investment that paid $36 every year or one that pays $36 this year, $38 next year, and on and on?
Here’s an example in real life. Caterpillar Inc. (CAT), the world’s largest producer of earth-moving equipment, has a tradition of paying out a large portion of its profits to shareholders, so let’s focus on the dividend alone. Currently, it is $1.40 per share, and Caterpillar’s recent price was $38, for a dividend yield of 3.7 percent. In 1994, the dividend was just 32 cents a share; in 1997, only 95 cents. The rate of growth of earnings and dividends for the past 10 years has averaged 16 percent, but let’s assume growth drops to merely 6 percent. In another 10 years, Caterpillar’s dividend would be $2.51 a share.
Let’s put it another way: An investment today of $10,000 in Caterpillar stock would pay total dividends of about $370, roughly the same as an investment of $10,000 in a 10-year Treasury note. But, 10 years from now, even assuming a growth rate of just 6 percent, we project Cat stock will pay $660 in dividends, while the Treasury is still paying $370.
What about Cat’s stock price? Well, if we can estimate that 10 years from now the yield on Caterpillar is the same as it is today, the stock should rise to $68 from the current $38. (I got this result by dividing the projected 2012 dividend of $2.51 by 3.7 percent.)
There is, of course, a difference between a stock and a bond. Caterpillar’s profits aren’t guaranteed, the way a bond’s interest payments are. In fact, the company suffered some serious losses in 1991 and 1992, and its earnings today have been hit by the global economic slowdown. So the question is whether the higher yields from stocks, thanks to growth, make up for the added short-term risk?
My answer is “yes” — which is the answer that many simple valuation models give as well.
In 1997, Ed Yardeni, an economist now with Prudential Securities, identified as “the Fed Model” a simple formula that the Federal Reserve indicated it was following to determine whether stocks were overvalued or undervalued. The model compares the yield on a 10-year Treasury note with the earnings yield (for the year ahead) on the S&P 500 index.
The Fed Model has been uncannily accurate — especially when it shows stocks as undervalued, as it did notably in 1998 during the Russian debt crisis. Yardeni carries a simple calculator on his Web site that allows you to use your own estimates of S&P earnings and interest rates. Based on consensus projections, Yardeni on Sept. 25 found the market undervalued by a whopping 45 percent. My own, more conservative estimates found the market 41 percent undervalued, while a similar model on the Economy.com Web site produced an undervaluation of 54 percent.
Where does that leave us? Far, far higher than a Dow of 5000 — unless risk levels vastly increase, profits tank and interest rates rise. All of those things could happen, of course, and I would never try to bully or cajole any fearful investor into the market. But history and reason are firmly on the side of stocks for the long run.
Todd McCallister, a managing director at Eagle Asset Management, recently analyzed Gross’s commentary and found it flat-out “wrong.” Instead, he offered this advice to investors:
First, “it is critical to look at the total cash a company earns and not the dividends.” He uses the example of Merck & Co. (MRK), currently yielding 3.1 percent but generating profits far in excess of its dividends. Merck has a cash yield of 6 to 7 percent, McCallister says, and “good management will give it back [to investors] in an intelligent way.”
“If you don’t trust management to make those decisions,” he says, “you shouldn’t buy the stock.”
Second, “Buy stable, good businesses. . . . A portfolio full of 6 percent to 7 percent cash-flow yields with growth is better than 4.5 percent interest on bonds.”
And, finally, the market is, at the very least, “fairly valued” right now. If Merck is a good example, “cash-flow yields exceed interest rates by a 2 percent or 3 percent margin. Historically, that type of disparity marks a good time to buy stocks.”
No, contrary to Bill Gross’s admonition, stocks don’t stink. In fact, they’re enticingly fragrant.