With the Standard & Poor's 500-stock index up 79% since its March 2009 low, it's fair to wonder whether value investors should take a vacation from the market for a while.
The Shiller price-to-earnings ratio—a measure created by economist Robert Shiller that divides the price of the S&P 500 by the average inflation-adjusted earnings from the prior 10 years—stood at 21.65 on Apr. 8, which shows the market overvalued by about 35% compared with the historical average of 16.4 going back to 1880, according to David Rosenberg, chief economist and strategist at Toronto-based wealth management firm Gluskin Sheff & Associates. In an Apr. 21 e-mail newsletter, Rosenberg said the higher-than-normal valuation isn't justified by low inflation and low interest rates since "real bond yields are not that far from their long-run averages," unlike stock valuations.
Citing the liquidity crisis that caused many sectors to be so cheap, John Schneider, a former value fund manager at Pimco and founder of JS Asset Management, describes the stock market as "a coiled spring," with equity valuations moving sharply higher once the economic recovery took hold.
Schneider, whose firm is the subadvisor for the Highland All Cap Equity Value Fund (HEVAX), which launched Apr. 8, predicts aggregate first-quarter earnings for the S&P 500 will be up roughly 40% from a year earlier thanks to cost-cutting and revenue growth from pent-up demand for products and services. Selling, general, and administrative expenses are down by 5% on average across the companies in the S&P 500, and he believes costs will continue to be contained by high unemployment and companies' hesitation to hire.
Since earnings are the main driver of stock prices, many value fund managers say they aren't worried as long as expectations for substantially higher profits this year remain realistic. With the current earnings estimate for the S&P 500 at $80 for 2010, the index, which closed at 1,208.67 on Apr. 22, is trading at a multiple just above 15 times projected earnings.
The 2010 earnings forecast isn't the right number to focus on since the market is more forward-looking than that, says Bill Nygren, manager of the Oakmark Fund (OAKMX). "The market is typically sold at 15 times [projected] earnings and is now trading at 12 times earnings if we look out two years, so it's not high by historical standards," he says.
It helps that yields on alternative investments such as bonds and money-market funds aren't that enticing, providing minimal competition for equities, adds Nygren.
Given how depressed results were in the first quarter of 2009, company executives shouldn't be too boastful about large year-over-year profit increases, says Lawrence Creatura, who manages $440 million in value funds and separately managed client accounts at Federated Clover Investment Advisors. More important, he says, will be how much courage management teams work up to give forward earnings outlooks for the next year or two, which were noticeably absent during the financial crisis.
Greg Estes, manager of the $22.5 million Intrepid All-Cap Fund (ICMCX), says his cash levels are pretty high because he hasn't found a new value idea to excite him in some time. Given how far stock prices have come, speculation about future earnings growth isn't enough to make him believe stocks are undervalued.
What he wants but isn't getting is "more clarity" on future results from companies that would give him reason to raise his free cash-flow estimates for 2010, which he's kept very conservative. Take Total System Services (TSS), for example. On its Apr. 20 earnings call, the electronic payment services company said its transaction volume—a key metric for the company—was up 0.6% from a year earlier and up 4.3% when same-client debit- and credit-card purchases were factored in, after showing no growth for two years.
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