No reason to believe the stock market is overvalued
But it’s still highly unpredictable
I nstead of beating around the bush for half a paragraph, I’ ll answer your question right away: No one knows what the stock market will do in the short term. So let’s get to the second query I most often hear these days: “Is the stock market overvalued?”
This is a more important question. The answer — positive or negative — won’t change the fact that the market is unpredictable. It can stay overvalued for many years and stay undervalued for many years (as it was from 2008 to 2012). But investing in overvalued securities will eventually yield low returns. So we will start this column by looking at general valuations prevailing in the stock market these days.
First, let’s take a look at the Dow Jones industrial average. At just over 16,000 points, the Dow Jones is down about three per cent this year. But the combined earnings of those 30 blue-chip stocks making up the index are up an estimated six per cent from last year. The price to earnings ratio (P/E) is at 14.4, a very reasonable level, “reasonable” when compared to bond yields. The 30-year U.S. Treasury bond yields less than 3.5 per cent. So at 14 times earnings, the Dow Jones’ earnings yield is seven per cent, twice the bond yield.
We could arrive at similar results for the broader S&P 500 Index. At its current level of just above 1,800 points, the P/E of the index is 15 times the earnings level estimated for 2014. So, even after its strong performance over the last few years, the S&P 500 is still attractively priced. It only means that stocks that were very cheap from 2008 to 2012 are now fairly valued (hardly the same thing as “overvalued”).
What is “overvalued” in today’s market? In my opinion, some popular companies seem what I call “ahead of their time.” In my last an- nual letter to partners at Giverny Capital, I highlighted the optimistic valuations of four outstanding companies: Facebook, Netflix, LinkedIn and Tesla Motors. I want to note that I chose four great businesses with great management.
The enthusiasm of Wall Street is warranted by strong fundamentals and great growth prospects. But at some point, the price investors pay for such prospects can be too high. These four stocks have decreased roughly 27 per cent from their recent highs. Still, they trade on average at 87 times their estimated earnings for 2014 (Facebook has the lowest P/E of the four at 46 times). In my opinion, at these prices, the margin of safety is still too thin.
But the beauty of the stock market is that you don’t need to predict the performance of the 20,000 or so publicly listed companies in North America. You can select 20 or so outstanding companies that trade at reasonable valuations and eventually end up with a very decent return (and if the selection has been done wisely, with a betterthan-decent return).
An example I’ve used lately is IBM. Big Blue is an outstanding business — one of the most solid in the world — managed by great people. The company is going through a remodelling of some of its operations, and for that reason revenue growth is nil. But the company can grow its earnings per share (EPS) by about 10 per cent a year through a share buyback program.
When combined with the two per cent dividend yield, this is a very decent performance. And the great news is that the stock only trades at a P/E of 11 times, which is close to a 30 per cent discount to the S&P 500’s P/E. Big U.S. banks are also very attractive: JP Morgan trades at 10 times and Wells Fargo at 11 times.
Many companies that I’ve recently discussed in this column have seen their valuation contract a bit lately. CarMax, for example, trades at 17 times estimated earnings. CarMax, in Richmond, Va., owns and operates a chain of 131 used-car superstores. In the last decade, the company has grown its EPS by 15 per cent a year. And the next decade looks as promising. The stock, in my opinion, warrants a higher valuation.
Another great growth stock, from my perspective, is Valeant Pharmaceutical, a Laval-based company. The stock is down 20 per cent from its February high. But growth prospects are still intact, to my knowledge, and the stock is reasonably priced at 14 times estimated EPS.
So there are no reasons to believe that stocks in general are overvalued. Yes, there are a few pockets of “overvalued” stocks (although I prefer the term “ahead of their time”), but we can find lots of undervalued companies. And if the market goes down more in the short term — like I said, no one knows — it only means that the lower-cost stocks would be more attractive.