Equity Market Strategy - Partying Like It's 1999?

Not long ago we were marveling at the strength of the bull market in 1999. Led by high price-to-earnings ratio (P/E), and low- or no dividend-yielding technology and Internet stocks, the late 1990’s bull market seemed unstoppable. Most of us are young enough to remember the lyric “I’m gonna party like it’s 1999” from the song “1999” written by Prince. The recent market rally boosted the S&P 500 Index over 21% since its March 2003 low. In some respects, it feels like the market has been partying like it’s 1999. To put the market’s recent performance in perspective, we looked at the characteristics of the top 20% of the stocks in the S&P 500 in terms of three-month price performance. We found that these top performing stocks have some unsettling characteristics when compared with the broader market.

The table below shows that this top 20% has tended to have dividend yields that are less than one-half to one-third of the market. The P/E ratios are almost double the market’s P/E ratio. The consensus 2003 earnings growth rates for these stocks are more than two to three times that of the market, but end up collapsing to more reasonable levels when looking at 5-year forecasts. The returns on equity are substantially lower than the market. The beta coefficients, which measure volatility risk relative to the market, are substantially higher than the market. Free cash flow yields are significantly negative compared to fairly positive free cash flow yields for the market.

Representative companies of this group are largely companies that, at this time, we feel are either poor long-term investment choices or are excessively risky and are not appropriate for our clients, including:

• Passenger airline companies, still reeling from the impact of higher energy prices, declining passenger volumes, negative cash flows and bordering on bankruptcy;
  
  
• Technology companies still experiencing weak end markets and excess capacity including firms in the communications semi-conductor and telecom equipment industries; and
  
  
• Energy trading companies still recovering from the collapse of the energy trading markets in the wake of the Enron debacle.

What many of these companies have in common is that their stocks have been subjected to short selling during the last year. Short sellers borrow stocks from their brokers and sell them hoping to make a profit when the stock goes down. The short sellers “cover” their positions by buying the stock back at hopefully lower prices, returning it to the broker and pocketing the difference. During the last three months the combination of a relief rally that began with the outbreak of the war in Iraq and short sellers covering their positions to avoid losses has resulted in a significant run up in stock prices. While this recovery in the market is a welcome change for most investors battered by the three year bear market in stocks, it has been lead by expensively priced, low return on capital, negative free cash flow companies bouncing off oversold levels and benefiting from short covering.

A research article recently published in the Journal of Finance entitled “The Level and Persistence of Growth Rates” makes the argument that since high earnings growth rates are hard to sustain over long periods, high P/E multiples based on these expectations are hard to justify. The research article also points out that given the difficulty in predicting long term earnings growth rates and the risk of those forecasts not being met, high P/E multiples in general are probably unjustified. In the table above, it is interesting to note how high the ratio of P/E to 5-year forecasted earnings growth is for the top performing group of stocks when compared with the index. The P/E to 5-year earnings growth ratio for the top performing S&P 500 stocks in the last three months is 2.6 versus 1.5 for the full index, quite a substantial difference. When looking at the P/E ratios, 2003 earnings growth rates and 5-year earnings growth rates for this group of stocks, one can only wonder when the P/E ratios for this group will start to collapse.

Certainly, there is cause for some optimism on the part of investors in equities. The Federal government has embarked on a course of massive fiscal and monetary policy stimulus that includes, along with the aforementioned reduction in interest rates and personal tax cuts, a huge injection of liquidity by increasing the growth in money supply, as measured by M2, at an almost 8% annual rate, far beyond the long term sustainable growth rate of about 3% for the economy.

The cheaper dollar against most foreign currencies will not only help export industries but will result in higher earnings via foreign currency translation gains for U.S. multinationals. Inflation remains low despite huge monetary stimulus and higher energy and commodity prices. Consumer confidence has improved and the uncertainty surrounding the outcome of the war in Iraq has been reduced. A great deal of excess capacity has been removed from many industries as witnessed in the large number of factory closures and layoffs over the last two years resulting in improved operating margins. The bull market in bonds is viewed as largely having run its course and, most importantly, corporate earnings continue to recover. Earnings on the S&P 500 companies are estimated to be up by 7% to 9% this year and 9% to 11% in 2004.

It’s worth commenting on the reduction in the double taxation of dividends enacted with the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003. Companies have three different ways of returning cash to their shareholders. They can pay dividends, buyback stock or enter into cash based acquisition transactions. Of these three, the payment of dividends has historically been the most inefficient from a tax perspective. Dividends are paid out of retained earnings, taxed once at the corporate level, then taxed a second time as ordinary income at the individual’s tax rate. With the passage of the new tax provisions, individuals receiving dividend income will see their tax rate on this income reduced to 15%. The reduction in the double taxation of dividends increases the economic value of dividend-paying securities, and strengthens our long-held view of the importance of dividends to a stock’s total return.

Cash based acquisition transactions are the most advantageous from a tax standpoint for the purchasing company’s shareholders. The only potential downside is whether the acquisition ultimately adds shareholder value. Investors have almost always viewed stock buybacks very positively. Responsible corporate managers not able to invest surplus capital into new or existing business lines at rates of return greater than the firms’ cost of capital can return the capital to shareholders in the form of stock buybacks. Shareholders who want the cash and are willing to trigger a taxable event can sell their shares as the company buys back the stock. Shareholders who don’t want the cash can keep their shares and benefit from the increase in share value created by the buyback.

It is interesting to note that the volume of stock buybacks this year has dropped dramatically. Part of the reason for this might be the anticipated and now enacted reduction in the tax on dividends. Another explanation is that corporate managers are finding the opportunity cost of share buybacks to be too high. In other words, they are finding that share buybacks are too expensive either because their share prices are too high or, in the alternative, they are finding projects with attractive potential investment returns. However, given the lack of a rebound in investment spending in the economy, it is more likely that those corporate managers view their shares as highly priced in the current environment.

While there is some fair cause for optimism on the part of investors, there are also reasons for concern beyond the decline in the volume of share buybacks. The budget crisis faced by many states as a result of a lack of spending discipline during the economic expansion of the 1990’s will result in spending cuts and tax increases that will partially offset the massive fiscal and monetary stimulus provided by the Federal government. The unemployment rate remains stubbornly high, job growth is anemic and the retail and manufacturing sectors continue to be sluggish. Many businesses still lack pricing power and some need to continue to pare back capacity.

While the market may be partying like its 1999, we’re taking a more sober approach. We began the second quarter of 2003 positioned fairly defensively with higher than average cash balances in our portfolios. We judiciously invested some cash and in late June we sold some profitable positions into money market cash. This was the prudent thing to do given the uncertainties surrounding the war in Iraq and the mixed signals we are receiving on the prospects for the economic recovery.

Oakwood’s research effort continues to be geared toward identifying companies where the stock is priced at an attractive discount to the firm’s long-term intrinsic value. Our focus is on identifying companies with high returns on capital, positive free cash flows, promising earnings prospects and shareholder oriented management while managing the overall risk structure of the portfolio consistent with the objectives of the strategy. We pursue buying opportunities when the fundamentals of the company and the price of the stock dictate a buy and we view the stock as having the potential to add value to the overall portfolio, rather than chasing short-term rallies in the market. Determining the potential of a stock to add value entails assessing the contribution of the stock in terms of its return potential and its impact on the risk structure of the overall portfolio consistent with the strategy’s objectives.

A recent sale of our position in a retail bank highlights this decision making process. The appreciation in the bank’s stock price over the last several months had reduced the projected remaining return to the low end of our target range. This, coupled with the continued growth in the risk of the derivative holdings of the bank, made it an opportune time to take profits.

We view the stock market as being at or near the top of its current trading range as we continue with the second quarter’s earnings reporting season. While global markets and the geo-political situation have improved, the economy and earnings pre-announcements continue to provide us with mixed signals. While we do not believe we are necessarily at the beginning of a new sustained long-term bull market in stocks, we do believe that:

1. Firms will continue to rationalize capacity with demand, thus increasing their operating leverage, and;
   
   
2. The improvement in corporate profits started in the third quarter of last year will continue, thus providing some support for stock valuations and the capital necessary to fund investment spending when and where needed to support further growth.

In the months ahead we will continue to follow our discipline, look for opportunities to put cash to work and to improve the structure of our client’s portfolios. We enter the second half of 2003 with a constant focus on changes in the economic environment, confident that we will continue to add value to our client portfolios.