| Value Trap Voyeurism |
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| mercoledì 30 agosto 2006 | |
Equity Strategy
OPINION The investment community is always on the lookout for attractively valued stocks and indeed one can often hear pundits refer to the market as being cheap under certain circumstances. However, one needs to be careful with the notion of stocks being inexpensive since there may be good reason for the valuation/perception discrepancy. For example, as can be seen in Figure 1, homebuilder stocks traded at very low P/E multiples for the last couple of years, but many investors were deeply worried that a housing slump was in the making and that the earnings being reported were peak-like. The low multiple reflected what has now become very apparent and investors did not make money buying these low P/E names. Thus, the investment community constantly has to be on the lookout for possible value traps. Figure 1. (Figures avaiable in PDF format) Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy When we think about the broad market, it must be acknowledged that margins and multiples have a distinct inverse relationship. Figure 2 illustrates that P/Es have generally slipped as margins climbed to cyclical peak levels and looked to be at their highest when operating margins were depressed. This should not be that shocking since P/E multiples arguably should be high when earnings are depressed, leading investors to look at other valuation metrics such as price/sales or price/book to gauge true value. Indeed, this same relationship is visible when one looks at national income account margins and the market's P/E over the course of the past 50 years. Figure 2. S&P 500: Operating Margin Vs. Trailing P/E Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy There also is the tendency to look at a P/E multiple and define its benefit rather quickly. That is why we reviewed trailing 12 months' P/E multiples going back 65 years and then tracked the forward performance over the subsequent 12 months and found that the "sweet spot" for valuation and one-year appreciation was 14x-16x (see Figure 3), outperforming valuations of less than 8x or less than 10x (although three- and five-year performance data supported the lower valuation starting points) -- hence, the creation of the Valuation Bulls-eye found in our weekly PULSE report. Figure 3. Source: Global Financial Data and Citigroup Investment Research -- U.S. Equity Strategy Furthermore, one has to consider the level of interest rates. P/Es are typically higher when rates are low. Thus, we study earnings yield gaps and deviations off of their five-year rolling averages (see Figure 4). On this basis, the most important valuation call of the past five years was to grin and bear it during 2002 given that the gap had collapsed to a low of 2.8 standard deviations below the average, indicating a better than 98% chance that stocks were cheap back then. Current levels are just moderately attractive utilizing this approach. Figure 4. Source: Federal Reserve Board and Haver Analytics Balance sheets also may account for a whole lot of the valuation problems at times. Highly leveraged entities typically trade at discounts to companies with far lower debt to capitalization levels, which led us to develop our exclusive debt-adjusted valuation metric a few years ago, which is still calling for more upside in equity markets (see Figure 5) Figure 5. Source: Citigroup Investment Research - U.S. Equity Strategy In fact, when we look at data provided by quantitative analyst Keith Miller, we find that buying low P/E stocks over high P/E stocks has not historically generated powerful outperformance benefits (see Figure 6), again diffusing the argument that attractively valued stocks should win out. There may be very good reason for the valuation drag. For example, tobacco stocks traditionally trade at low multiples due to litigation concerns and pharma stocks have fallen into the same legal rut of late. However, we believe that the valuation levels of the big pharma companies currently argue for outperformance in the future based on correlative valuation/performance relationships of the past 20 years. Figure 6. Source: Citigroup Investment Research -- Global Quantitative Research We would note that investors have been telling us that bank stocks look expensive relative to history and thus they are less than intrigued by them. Yet, we have found bank stocks to be closely tied to the direction of bond yields in terms of stock price performance (see Figure 7). Fascinatingly, there seems to be little relationship between bank stocks' performance and P/E ratios (see Figure 8) despite a slew of publicly-traded bank management teams decrying their allegedly attractive P/E ratios. The problem tends to be their leverage - - on an enterprise value basis, the tech sector looks far cheaper than do highly indebted banks. Yet, we invariably listen to investors focus on valuations, sometimes to the exclusion of fundamentals. Figure 7. Source: Haver Analytics and Citigroup Investment Research -- U.S. Equity Strategy Figure 8. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy In the Capital Goods and Materials industry groups, investors seem mesmerized by the growth potential of developing economies such as China and India with seemingly never-ending needs for industrial commodities. Thus, commodity producers and the suppliers of the machines that dig out those raw materials must be owned as a proxy of investing in emerging economic growth. We are told that valuations are compelling, trading at 8x-10x earnings, but as Figures 9 and 10 suggest, those valuation perceptions seem to be inaccurate, and valuations have not determined stock price trends, for the most part. Figure 9. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy Figure 10. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy Yet, we can more clearly see how earnings estimate revisions move stock prices (see Figures 11 and 12), while valuation appears to play the equivalent of second fiddle. Hence, we continue to be wary of the industrial complex names despite a general affinity for them amongst investors we talk to. Figure 11. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy Figure 12. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy Utilities stocks also continue to look rather expensive and this P/E and performance track is actually quite revealing (see Figure 13), supporting our underweight stance on this sector. In contrast, the Pharmaceuticals and Biotech industry group's valuation looks rather appealing given past performance outcomes (as depicted in Figure 14). Figure 13. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy Figure 14. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy In the same vein, the Food & Drug Retail industry group is looking inviting as well based on historical relationships between P/E ratios and subsequent stock price performance (as illustrated in Figure 15). Hence, we feel encouraged in our overweight stance on this group as well. Figure 15. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy We should point out that the jury is out on the Energy sector's valuation. Many observers see Energy as the opportunity of the current decade given limited cheap supply and growing global demand. Yet, valuation is a very poor indicator of stock price trends (see Figure 16) even as we hear commentary about 8x P/E multiples looking very tempting. We remain market weight on the sector and continue to prefer integrated energy names rather than the E&P or oil equipment and service stocks given the intergrated's powerful cash flows that would stay very robust even if oil prices slipped. On the other hand, the service and drilling names tend to have a greater beta to oil prices and thus are riskier in nature. Figure 16. Source: FactSet and Citigroup Investment Research -- U.S. Equity Strategy In summary, we consider value trap voyeurism to be a critical investment thought process that investors often ignore. Unfortunately, in many instances, valuations are thrown in almost after the fact, once the investment thesis has been determined and now one has to rationalize the valuation. The high multiple must reflect the superior growth rate or the deep discount must mean that the Street just doesn't get it. More often than not, the valuation discrepancy is a function of having gotten the earnings estimate wrong and not the stock price appreciating, thereby closing the gap. Our experience suggests that one needs to be watchful of the stock price impact related to certain catalysts or fundamentals and not the business impact which often captures the imaginations of many investors, often to their myopic detriment. 25-Aug-06 Citigroup Citigroup Investment Research |
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