As I research different companies across various sectors and review where they are trading, I can’t help but think: Wasn’t this company trading at 6-8x EBITDA 3 years ago and now its trading at 9-11x?! Its true. Much has been written about valuations expanding and as the WSJ reported in 2015, buyout multiples now exceed 10x on average — the highest level in 20 years! Is this justified? Are we heading for a crash? How should we position ourselves now?
The argument for “Keep Calm and Carry On”
One thing we need to remember is that these multiples are based on future expectations of cash flows and multiples are essentially short cut ways of expressing a DCF. NYU’s Stern school has a good presentation on the linkage should students want to dive in further. So one thing to consider now versus the past 20 years is that interest rates and therefore our discount rate are at all time lows. That in itself will raise the multiple as the net present value of future earnings are worth more when the rate is lower.
Secondly, low interest rates have made it increasingly difficult to find returns from normal avenues. Savings accounts used to yield 5% alone and now yield next to nothing. Now, a significant amount of junk bonds yield 5-7%. This has forced investors to go down the risk spectrum and buy a riskier asset for the same return, therefore pushing up multiples. “There is no alternative” or TINA has been coined for the phenomenon we are in today – “we can’t buy bonds and earn money, we must buy stocks”.
A third argument for multiples being this high is that earnings growth may be higher than what we’ve seen in the recent past, driven by tax reform, business deregulation, the US exiting the choppy growth phase following the great recession and this earnings growth will help pay for the high multiple we’re paying today. Or, growth going forward may actually be slower due to demographic changes (e.g. baby boomers aging) so each dollar of earnings will cost more…
The arguments “for” are endless… This happens in every cycle. If I could offer one thing to think about, read this snippet from an article in 2007 from Forbes, before the market crash. Does it sound familiar in any way, perhaps aside from housing?
“The world is awash in financial liquidity mainly due to appreciated house values, the negative U.S. corporate financing gap and the American balance of payments deficit. Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the 2000 to 2002 bear market. So, investors are accepting more risks to achieve expected returns. And then there’s the insatiable U.S. consumer, who, thanks to the booming housing market, continues to spend freely.”
Are these acceptable arguments? What’s an investor to do?
I don’t think so. Remember that history does not repeat itself, but can offer important lessons. I feel like our new short-term focused environment has led us to lose sight of the exact same things that happened just 10 years ago.
Remember that the Fed had intervened in the market significantly following the early 2000s recession and kept rates at historically low levels. This propped up one of the most significant bubbles in human history. Following that bust, the Fed again intervened and slammed rates down to the floor to help the economy recover. I fully believe this was a necessary action and showed we learned from the missteps that followed the great depression. However, we are now approaching 10 years since the previous market high and we are still in a scenario where rates are near nothing. Yes, inflation has been week, but I have to ask myself a chicken and the egg question here: are low rates supporting low inflation? I for one feel like I need to save more rather than spend since I know I earn less on investments. Companies have more dry powder to invest in new capacity. Supply can outstrip demand and drive prices lower. (Maybe I’ll touch on this more on that in a later post)
The point of this quick summary is for us to reflect on the Fed’s (and other central bank’s) unprecedented involvement in the markets. Despite political turmoil, high valuations, and plenty of uncertainty, the markets keep humming. This sort of complacency is exactly what led us into the last cycle. Ignoring things we know to be true, but fearful of missing out on the opportunity as the markets ride high.
Look no further than high yield (i.e. junk) bond spreads. The sort of complacency we are witnessing is hovering around the lows preceding the last crisis.
Whats a value investor to do?
What do we do? Do we sell everything?
Well, for one, we must remain diligent and core to our fundamentals. The market is an emotional beast and part of the emotion is not only buying correctly, but knowing when we should sit on the sidelines as well.
However, as much option value I enjoy from holding cash for the right opportunity, I can never advocate moving 100% to cash. JP Morgan put together a great chart of missing the best number of days in the market since 1997. If you somehow missed each of these days it would significantly hurt results! Calling the macro requires not only calling what event occurs, but how the market will react to it! I prefer to find mispriced securities in each environment, and when negative market reactions occur, either buy more or buy other assets that go on sale.
As Seth Klarman said, “Given the choice between holding mostly cash awaiting the periodic market tumble or finding compelling investments which earn good returns over time but fluctuate to a certain extent with the market amidst turbulence, we choose the latter. Obviously, we could not have earned the returns we have from investing, without investing.”
It is for this reason that I remain extremely selective right now. And to be honest, I am holding more cash. We can’t just buy something because we think that cash is burning a hole in our pocket. Sometimes cash and short term securities offer good option value compared to other investments.
Where should we invest?
The market has been so starved for profit growth, is it any wonder why the market is chasing companies that are reporting strong earnings growth? (Today that sector is tech). When everyone looks right, I want to look left and I think where we are in this cycle will favor value names or those names that are already at cyclical trough. And the best part of value investing is instead of having to accurately predict that Company XYZ’s earnings growth can not only stay strong, but also meet high guesstimates from Wall Street, we just have to wait for the gap between price paid and true value to narrow.