What if I told you the S&P is now trading at 13.3x earnings? Would you consider that to be attractive? Obviously that would be very attractive as the market hasn’t traded at that valuation in a long time. It might imply slowing cash flows and a weak economy. If the S&P were indeed trading at 13 times earnings it would be low by average historical measures and even lower with interest rates at this level and earnings growing so quickly. Yet we don’t have a slowing economy or weakening cash flows. But what if the S&P really was trading at 13.3x earnings….with just one small tweak.
In 1999, I was hired as an analyst at Putnam Investments for my first job after college. The dot com bubble was near its apex and the team of portfolio managers for whom I worked were convinced that we were in the midst of a “new economy.” It was thought that companies like Yahoo, Qualcomm, and Commerce One could grow exponentially and valuations were justified because of this hyper growth.
Immediately, I was thrown right into the mix of the dot com storm and was told to build a discounted cash flow model for Yahoo. I spent 3 weeks working on the model and at the conclusion of my work I determined that the company was sharply overvalued.
Math was math and I couldn’t get close to justifying any reasonable return for Yahoo over the next few years given the valuation at which Yahoo was trading. I brought this conclusion to my portfolio manager, but the portfolio managers really wanted to own that stock. After all, it was a new economy. After a one-sided discussion (if being told what to do could be called a discussion), I dramatically increased the estimated growth rates for Yahoo in my model in order to generate a higher valuation and the desired result. This included increasing the growth rate well into the teens 10 years into the future, a ridiculously aggressive assumption. Unfortunately, even with this increase in the forecasted growth for Yahoo the valuation still didn’t indicate enough upside for the portfolio manager to be justified to buy it. In fact, at that level of growth it was fairly valued. I was asked (told) to bump up the growth rates further to justify valuation and ownership. I made another round of changes to the model and presto, Yahoo was undervalued. Amazing.
While it was technically possible for Yahoo to achieve those really high future earnings, that would imply a very best case scenario for the company. Predicting into the future by 1 or 2 years is a very difficult task, but estimating revenues and earnings 10 years out is almost foolish. Yahoo, along with many other stocks, was priced for perfection. The stock was purchased on the basis of this trumped up valuation, and for the next 6 months was the best performing stock in the portfolio of more than 120 holdings. In fact because of Yahoo’s performance our fund finished first among its peers in our class. In just 6 months, Yahoo was up about 200%, and I received a laughably glowing end of year review for recommending Yahoo, (which I obviously didn’t deserve).
Just one year later, by the end of 2000, Yahoo was down nearly 90% from its year-end high and its price fell to less than half of where our fund had paid for it. Towards the end of 2002, it was down another 40%, falling to $4 a share from over $100 at its peak. The fund itself, a 120 stock “diversified” strategy, was down about 75% from peak to bottom and the “new economy” was officially dead (along with the job of my portfolio manager). I left Putnam in the middle of 2000, before the mayhem began, but I did continue to track the fund’s progress. Several years after I left, it was shut down.
Growth stocks, which had outperformed value stocks in 1999 by a staggering 30%, underperformed value in 2000 by the same staggering 30%. There was no new economy. While the market today does not have the absurd froth of 1999 there is a growing spread in valuations and a few pockets of exuberance.
Based on 2018 earnings projections, FANG stocks trade at a weighted P/E of over 69 while the S&P 500 is trading at a P/E multiple of 17.9x. IF we look at 2019 earnings expectations, FANG stocks are trading at 49 times earnings while the S&P is trading at 16.3. If we exclude the FANG stocks, which make up nearly 10% of the weight in the S&P 500, the remaining S&P’s P/E falls to 13.3 for 2019.
This. Is. Cheap.
Perhaps you think it’s a little unfair to exclude 4 S&P stocks from within the S&P. But it’s really fair and useful because it demonstrates how cheap the market is if we exclude a handful of companies that happen to make up nearly 10% of the weight of the index. It is becoming harder to justify valuations of some of the FANG holdings just as it became increasingly difficult to justify dot com valuations in 1999.
Netflix is now trading at 85 times its 2019 expected earnings. Yet just a year from now Disney will be pulling all of their content from Netflix (a serious blow) and shortly thereafter will be offering a competing subscription service. Disney will also be folding Fox’s content into this new subscription service making for a formidable competitor with exceptional quality of content. Combined, they will have produced about 40% of the entire 2018 US box office and own an incredible combination of elite brands.
Facebook is trading at 21 times expected 2019 EPS, down from its recent peak of 27. Facebook’s U.S. user base under the age of 25 declined by almost 3 million in 2017, a trend which appears to be continuing. How confident should we be that Facebook will be growing in 5 years or 10? Had Facebook not been fortunate enough to buy Instagram, its growth rate would have slowed even faster and we might already be looking at a company whose total traffic is already in decline. Facebook is also no longer cool. It has been main stream among adults for a while now and what’s cool to parents is never cool to their kids. When I wear my baseball hat now (which has a curved brim) younger kids call it a “dad hat.” Their brims are perfectly straight. A lot of Facebook’s recent revenue growth has come from earning more per page rather than increased traffic. This is an exceptionally difficult trend to keep up without continually adding more ads per page or coming up with ways of further exploiting the data of their users. But user data exploitation has likely peaked and increased content scrutiny by the government, and even Facebook itself, will also limit a lot of the bait click content that generated a lot of the pageviews on its website. Finally, and most simply, Facebook, and social media more generally, has been shown in multiple surveys to reduce people’s happiness. How much longer can Facebook’s revenue grow under these conditions? Even though Facebook’s multiple is no longer in the stratosphere, 22x still implies the market is expecting several years of above average growth.
If we exclude 4 names from the index—Facebook, Amazon, Netflix and Google—the S&P is trading at 13.3 times next year’s expected earnings. At 13.3x, the S&P is cheap. Value stocks have had a tough go during the 2010s. Indeed, this is only the second decade in the past 90 years in which value stocks have underperformed. In a rising interest rate environment, the tailwinds for value stocks are improving and I expect value to once again outperform growth as those tailwinds pick up strength.