Tag Archives: earnings-center

Fundamental Items Rarely Affect Valuation

By Rupert Hargreaves Almost all fundamental investors based their research, analysis and investment decisions on the assumption that some positive relationships exist over time between equity valuation and key financial metrics. However, while a large amount of investment activity is based on the assumed relationships between the aforementioned factors, research conducted by S&P Capital IQ, shows that for the past decade it has been impossible to prove a strong statistical relationship between commonly referenced fundamental financial statistics and the direction of the equity market, momentum, and valuation: “Whether we are looking at various measures of profit margin, reported revenue and earnings growth, or even estimated future sales and earnings growth, the past decade’s correlations between price-to-earnings (P/E) valuations and a variety of commonly referenced fundamental financial statistics randomly range between strongly positive and negative readings.” – S&P Capital IQ Global Markets Intelligence Valuation versus fundamental data items Any investor that’s been watching the market for more than a year or two will know that the relationship between the valuation assigned to equities by stock market investors and underlying fundamental characteristics, over time, is extremely complex. There are many internal (stock specific) and external factors that can affect valuations. According to S&P Capital IQ ‘s research on the matter, the only net positive correlation relationship with P/E multiples since 2005 is related to selling, general, and administrative expense margins or the ratio of non-price of goods sold expenses to revenues. The best way to explain this relationship is with a table. (click to enlarge) P/E Valuation vs. Fundamental Data Items Based on a decade’s worth of data, S&P Capital’s research shows that a change in a company’s selling, general, and administrative expense margin is the only factor that will consistently impact earnings multiples across sectors. There is a clear reason for this correlation. Higher expenses will compress profit margins, weigh on profit and ultimately investors will abandon the company, driving the P/E lower. However, it’s unclear why a similar relationship doesn’t exist across other fundamental metrics. Prime example The tech sector is a prime example of an industry where the average P/E does not reflect the underlying and improving fundamentals. After the tech stock market bubble burst in 2000, the S&P 500 technology sector entered the economic recovery cycle in the first quarter of 2002 with a forward 12-month P/E valuation ratio of 54x. Between 2002 and 2010, tech sector valuations continued to be consistently marked down, although, the sector’s earnings growth averaged 23% per quarter throughout the period. The sector’s forward P/E reached a low watermark of 10.7 during Q3 2011 and has only recently started to readjust higher – as shown below. (click to enlarge) Interesting trends Aside from the obvious disconnect between P/E multiples and underlying fundamentals, S&P Capital IQ’s data highlights some other interesting trends. For example, the energy sector is currently trading at a forward P/E multiple of 33, exceeding the levels recorded while exiting the 2001 recession. The energy sector exited the 2001 recession with an elevated forward P/E of 24 that steadily declined to 8.6 by Q4 2005, well into the economic recovery and actually half way through the Fed’s tightening cycle, which took place between June 2004 and June 2006. The sector’s P/E bottomed in 2005, steadily increasing as the price of crude oil continued to rise from $50-$60 per barrel in the final quarter of 2005 to as high as $145 in July 2008. The sector P/E reached a peak of 15.3 in Q4 2008. These historic trends show that the current extreme forward energy sector P/E ratio reflects severely depressed anticipated future earnings per share relative to existing share prices, not unlike the excessive valuations seen at the tail-end of the tech stock market bubble in 2000. The excessive valuation now needs to be worked off as revenue and profit growth slowly becomes aligned with market pricing. The consumer discretionary sector illustrates more contemporary equity market valuation-related issues. Specifically, between mid-year 2004 and mid-year 2006, as the Fed continued to raise short-term interest rates at every Federal Open Market Committee meeting, investors became more cautious toward the consumer discretionary sector, pushing the sector’s P/E multiple down to 18.4 in the second quarter of 2006, from 19.4. Over the same period, sector earnings grew at an average of 8.8%: “Moving ahead to current valuations, the consumer discretionary sector’s forward P/E ratio has averaged 19.1x in the past two years while sector earnings per share growth has averaged 10.5%. Interestingly enough, this figure is close to the average P/E of 19.4x recorded by the sector during the prior period of Fed tightening when earnings grew by 8.8%. From this perspective, investors appear to be comfortable with a prospective Fed tightening cycle, as they were during most of the prior tightening cycle, as long as consumer discretionary sector earnings continue to grow at a healthy pace.” – S&P Capital IQ Global Markets Intelligence

Maximising Shareholder Value Has Nothing To Do With Maximising The Share Price

The idea that directors should seek to maximise shareholder value has come in for a lot of flak in recent years. James Montier of GMO even wrote a piece on it called ‘ The World’s Dumbest Idea ‘. One of the most prominent criticisms of maximising shareholder value is that it causes directors to focus too much on their company’s share price, which leads them to underinvest in the company’s long-term future in order to boost short-term profits (and therefore, the share price). This is not so much a failing of the concept of shareholder value maximisation as it is a failure to understand what shareholder value is and what directors can do in their attempts to maximise it. True shareholder value is a measure of long-term value The value of a company is essentially the value of all the cash it will return to shareholders over its remaining lifetime. Let’s assume that Sainsbury ( OTCQX:JSAIY ) ( OTCQX:JSNSF ) will survive another 100 years before closing its doors for the last time. In that case, the value of the company today is the value of all dividends paid out over the next 100 years plus any cash returned to shareholders, when the company is wound up (which we can ignore because it is usually zero). A dividend today is preferable to a dividend in 50 years’ time, so future dividends are usually “discounted” by an annual discount rate. If you want a 10% annual return on your Sainsbury investment, then you would discount the value of future dividends by 10% each year, in which case a 100p dividend 10 years from now would have a “present value” of about 42p. Add up those discounted future dividends and hey presto, you have the present “shareholder value” of Sainsbury, at least according to an investor who wants a 10% rate of return. A different discount rate would provide a different shareholder value. Because the company’s shareholder value is the discounted sum of 100 years of dividends, only a fraction of Sainsbury’s value today comes from dividends paid in the next 10 years. Most of its shareholder value comes from dividends that are expected to be paid more than 10 years in the future, as is the case for most mature companies. This is the true meaning of shareholder value; a multi-decade stream of dividends, which directors should be attempting to maximise, without taking unnecessary risk. True shareholder value maximisation should be much more about working to improve and expand the business for the next 10 years and the 10 years after that, rather than hitting short-term profit expectations. Share prices have almost nothing to do with shareholder value Those who believe in the wisdom of crowds might say that yes, the true shareholder value of a company is indeed the discounted value of its future cash returns to shareholders, but we can never know those cash flows and therefore can never calculate an accurate figure for shareholder value. They might go on to say that our best estimate of shareholder value is the market value or share price of a company, and so it is entirely sensible for directors to pay attention to share price and to be paid according to its performance. Utter drivel, is what I would say to that. The share price or market value of a company is, at most, a combined “best guess” by investors as to what a company’s shareholder value really is. However, calling it a “best guess” is wildly optimistic as a large portion of equity trades are carried out by traders who don’t even know the names of the companies whose shares they are buying and selling (especially the computer-driven High Frequency Traders who own shares for thousandths of a second). Even if all market participants were long-term dividend-focused investors, they still wouldn’t have the faintest idea what dividend Sainsbury will be paying 10, 20 or 30 years from now, and therefore no idea what its shareholder value is (and the same would be true for pretty much all companies). Rather than an estimate of shareholder value, share prices are more closely connected to factors like current dividends, current earnings and any and all combinations of news, noise, expectations and emotions; none of which have anything to do with true shareholder value. So the idea that maximising shareholder value means maximising the share price is a joke, which means that compensating executives with one-way bets on the share price (otherwise known as stock options) is equally daft. If executive directors are to be compensated by share price movements at all, it should be by insisting that they invest a significant amount of their own money into the company and to keep it invested for as long as they are on the board. In addition, they should be encouraged to focus on maximising true shareholder value rather than the company’s market value. As Lawrence Cunningham describes in the introduction to his book, The Essays of Warren Buffett : “The CEO’s at Berkshire’s various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their businesses as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies.”

Dual ETF Momentum November Update

Scott’s Investments provides a free “Dual ETF Momentum” spreadsheet which was originally created in February 2013. The strategy was inspired by a paper written by Gary Antonacci and available on Optimal Momentum . Antonacci’s book ” Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk ” also details Dual Momentum as a total portfolio strategy. My Dual ETF Momentum spreadsheet is available here , and the objective is to track four pairs of ETFs and provide an “Invested” signal for the ETF in each pair with the highest relative momentum. Invested signals also require positive absolute momentum, hence the term “Dual Momentum”. Relative momentum is gauged by the 12-month total returns of each ETF. The 12-month total returns of each ETF is also compared to a short-term Treasury ETF (a “cash” filter) in the form of the iShares Barclays 1-3 Treasury Bond ETF (NYSEARCA: SHY ). In order to have an “Invested” signal, the ETF with the highest relative strength must also have 12-month total returns greater than the 12-month total returns of SHY. This is the absolute momentum filter which is detailed in-depth by Antonacci, and has historically helped increase risk-adjusted returns. An “average” return signal for each ETF is also available on the spreadsheet. The concept is the same as the 12-month relative momentum. However, the “average” return signal uses the average of the past 3-, 6-, and 12- (“3/6/12”) month total returns for each ETF. The “invested” signal is based on the ETF with the highest relative momentum for the past 3, 6 and 12 months. The ETF with the highest average relative strength must also have average 3/6/12 total returns greater than the 3/6/12 total returns of the cash ETF. Portfolio123 was used to test a similar strategy using the same portfolios and combined momentum score (“3/6/12”). The test results were posted in the 2013 Year in Review and the January 2015 Update . Below are the four portfolios along with the current signals: (click to enlarge) As an added bonus, the spreadsheet also has four additional sheets using a dual momentum strategy with broker-specific, commission-free ETFs for TD Ameritrade, Charles Schwab, Fidelity, and Vanguard. It is important to note that each broker may have additional trade restrictions, and the terms of their commission-free ETFs could change in the future. Disclosure: None.