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Sales Insight - July, 2008

Equity Valuation: Back to the Basics by Rich White   Return to Prospecting & Sales Insight See the new columns by Klein and Lovas.

Small-cap U.S. stocks are significantly overvalued.

This assertion isn’t meant to imply that all small-caps will decline in price. It doesn’t necessarily mean your clients should dump small-cap stocks or funds. Certainly, there are some great small-cap companies in the U.S. that will make investors rich in the future.

But it does mean – there is a lot of distracting “noise” in the air about equity valuations.

Part of this noise is a by-product of increasingly complex market analysis, and another part is hype designed to confuse investors and lure them into over-valued equities.

The purpose of this column is to help you see and correct biases the industry has developed in discussing P/E ratios and other valuation measures. Using simple ideas, I will show why small-cap U.S. stocks may be as over-valued today as the whole U.S. stock market was in early 2000. The goal is to help you communicate accurate information to clients and continue to build credibility and trust.

A Starting Point – Real Numbers

Let’s begin with a table published by The Wall Street Journal, quoting an authoritative analytical source, Birinyi Associates, and updated weekly here:

http://online.wsj.com/mdc/public/page/2_3021-peyield.html

For the week of 6/20/08, the table showed that the trailing twelve month (TTM) P/E ratio of the Russell 2000 Index of small-cap stocks was 76.50. For frame of reference, the index has a market cap equal to about 10% of the total U.S. stock market, or about $1.5 trillion. That’s about three times the market cap of Exxon Mobil and six times the market cap of Microsoft.

All 2000 companies in the index combined generated about $20 billion of earnings over the last four quarters ($1.5 trillion divided by 76.50). Over the same period, Exxon Mobil generated $37 billion of earnings and Microsoft generated $16 billion. The table below summarizes.

The Russell 2000 Index Vs. Exxon Mobil and Microsoft

Source: Yahoo! Finance

In today’s market, few private equity investors would pay 76.5 times trailing 12-month earnings to buy even the best public small-cap companies outright. Yet, investors are willing to pay that much to buy all 2,000 Russell 2000 components lumped together!

The strangest part of the Alice-in-Wonderland valuation numbers is this: You could search dozens of small-cap research reports and not see a 70+ P/E quoted anywhere.

Although TTM P/E ratios are based on reported performance (not forward estimates), their accuracy has been drowned out by the noise of exaggerated statistics including P/E ratios that exclude negative earnings, P/E ratios based on nonsense projections, and valuations that fail to account for significant changes in small-company realities – especially the rising cost of capital.

Here’s a caveat that small-cap investors should understand. At its peak in March of 2000, the S&P 500 Index had a TTM P/E ratio of 45. It then lost half its value (peak to trough, on a price basis) over the next 31 months. The S&P 500 includes many large, financially strong companies that maintained solid earnings through the last recession.

If history is a guide, it is possible that small-cap U.S. stocks are as overvalued now as the S&P 500 was in early 2000.

The Fiction of ex-Negative P/Es

Many investors assume that because Frank Russell publishes the leading style-based U.S. equity indexes, its P/E ratios are authoritative. As of 5/31/08, Russell quoted a P/E ratio for the Russell 2000 of 18.84 on an “ex-neg.” earnings basis and using forward earnings estimates. The difference between Birinyi’s P/E of 76.50 (including negative earnings) and Russell’s 18.84 shows the wide gap in valuation that different P/E calculations can produce. It also shows how many small-cap public companies have turned unprofitable over the past year.

Quoting the P/E ratio of an index without including negative earnings will always produce distorted results – and the distortion is magnified during periods when earnings are turning negative. To understand why, imagine two Russell 2000 components, both of which earned $50 million last year. This year, one company produced a positive $1 of earnings and the other produced a negative $1. Both companies experienced basically the same earnings decline. Yet, only one will now be counted in the ex-neg. P/E ratio. Effectively, the negative impact of two weakening companies has been cut in half. As hundreds of companies turn from positive to negative earnings, the distortion can produce a large valuation exaggeration.

A useful tool for monitoring U.S. corporate earnings from quarter to quarter is located here:

    http://online.wsj.com/mdc/public/page/2_3024-companyearn.html

This data base arrays earnings for more than 4,000 U.S. public companies by sector and industry for the most recent quarter and the comparable quarter a year ago. For example, Consumer Goods and Consumer Services are bellwether sectors that reflect conditions across a wide swath of the U.S. economy and approximately 850 public companies. The table below summarizes negative earnings in these two sectors for the first quarter of 2008 compared to the same quarter of 2007.

The Problem with Forward Earnings Estimates

Both Russell and Birinyi publish P/E ratio for the Russell 2000 based on forward earnings estimates, and the gap between them has not been great recently (18.84 and 22.40, respectively). But neither number bears resemblance to current reality. Forward P/E ratios usually are based on “bottom-up” estimates made by analysts, which tend to be heavily influenced by companies’ own forward earnings guidance. Two of the leading sources of bottom-up EPS estimates are the Institutional Brokers’ Estimate System (IBES) and Standard & Poor’s.

Let’s focus on two small-cap sectors that tend to be sensitive to the economic cycle – Consumer Discretionary and Information Technology (IT). Together, they account for 40% of the companies in the S&P SmallCap 600 Index. The table below summarizes the annual changes in earnings and forward P/E ratios for both small-cap sectors for the period 2006-07 (actual) and 2008-09 (estimated).

Source: S&P SmallCap 600 Operating Earnings by Ecoinomic Sector: Bottom-up estimates as of 6/16/08.

    http://www2.standardandpoors.com/spf/xls/index/iee600_gics.xls

Both sectors experienced weaker earnings growth from 2006 to 2007. Both also experienced quarter-over-quarter earnings declines in the fourth quarter of 2007 and first quarter of 2008. Yet, for all of 2008 and 2009, S&P estimates a strong upward turn in their earnings.

From the first quarter of 2008 through the fourth quarter of 2009, S&P estimates that Consumer Discretionary small-cap earnings will more than quadruple and IT earnings will double. On this basis, S&P estimates forward P/E ratios in the mid-teens by the end of 2009, making these sectors seem reasonably valued today.

This picture is based on the most optimistic view imaginable for the macro economic environment in which small companies operate. In general, small companies and their earnings are more sensitive to economic cycles than large companies, and it’s uncertain how long and deep the current slowdown will be. We do know that periods of earnings weakness often have lasted more than a year and have extended well into the next recovery. We also know that extraordinary, unsustainable conditions pumped up U.S. corporate earnings to record levels in 2005 and 2006.

There is no conservatism or caution built into these estimates – largely because most companies are loath to guide downward until they must, and most analysts are lambs.

Incrementally in recent years, bottom-up forward earnings projections have become more promotional hype than accurate financial science. During times when the economy is weak and the outlook is cloudy, the hype turns ridiculous. For this reason, responsible financial advisors should avoid quoting forward P/Es or making valuation judgments based on them.

The Law of Large Numbers

Based on Birinyi data, the Dow Jones Industrial Average recently had a TTM P/E ratio of 80.27, even higher than that quoted for the Russell 2000 (76.50). Does this mean the Dow is as overvalued as small-caps?

It does not. Among the Dow’s 30 components are two giant financial stocks (AIG and Citigroup) that have experienced massive write-downs and huge earnings losses over the past year. Without these losses, the TTM P/E ratio of the Dow would be far lower.

In a broadly diversified index like the Russell 2000, no single company accounts for more than .3% of total index market capitalization, and it’s not possible for a small group of under-performing companies to sway index valuation. When you see a TTM P/E ratio of 76.50 in such an index, consider it a valid sign of overvaluation across a broad swath of American small companies.

Don’t Forget DCF Valuation

The acid test of a company’s fair market value is discounted cash flow (DCF) analysis, a primary methodology for valuing closely-held small companies. DCF projects a company’s cash flow or earnings over a future period (typically 5-10 years) and then discounts future flows by the company’s weighted average cost of capital (WACC).

Given comparable future earnings growth assumptions, DCF values a small company at a lower P/E than a large company because the small company usually has a higher WACC. In addition, it is common to add to WACC a “size premium” of 2-4% for the smallest companies (under about $500 million market cap) to account for their extra risk. The table below compares DCF-generated P/E ratios for two companies, a large-company with a WACC of 8% and a small company with a WACC of 12% plus a size premium of 2%.

On a DCF basis, only the strongest and fastest growing small companies with access to cheap capital (low WACC) are valued at a P/E above about 15-20. The public stock market currently is valuing most small companies at a ridiculous valuation premium to the prices that DCF establishes for comparable private companies.

A Huge Increase in Small Companies’ Cost of Capital

According to an article in The New York Times (6/13/08), secured hedge fund lending to small-cap public company has become a booming industry: “While some (hedge) funds have been offering loans for a few years, more are moving in because the credit squeeze has hobbled many banks and left hard-pressed companies hungry for cash.” The article can be accessed here:

    http://www.nytimes.com/2008/06/13/business/13hedge.html

Industry sources say that a typical “secured loan” made by a hedge fund to a small public company carries a 12-15% interest coupon plus an equity or warrant kicker, bringing the total cost of capital to perhaps 14-18%. Sources also say that in today’s market hedge funds can be very selective and drive hard bargains because the smallest public companies have a desperate thirst for capital.

Two types of small companies seek loans at such high cost: 1) sick companies that need capital to survive; and 2) healthy companies that need capital to expand. Most of the sick companies probably are not worth double-digit P/Es, and the healthy companies may have their earnings hobbled for several years by today’s high cost of debt capital.

Typically, secured hedge fund loans to small-cap public companies are for terms of one to two years, which means borrowers will soon need other sources of cash to retire loan principal. Industry sources say many small companies hope to return to the public stock market to raise cash in a year or two. The pressure to pay off high-cost loans and the potential common stock dilution produced by warrants, convertible debt, and new equity offerings may put a lid on small-cap earnings for some time. The prime market for secured hedge fund loans consists of the smallest 1,000 companies in the Russell 2000, those below about $500 million in market cap.

Circular Logic

In an article entitled Are Small-Cap Stocks Signaling a Recovery? (6/22/08), The New York Times pointed to a 12.7% increase in the Russell 2000 Index from March through June. The article suggested that this could be a leading indicator of an economic recovery because small-cap strength historically has led other recoveries. However, it’s also true that: 1) small-cap stock performance has become a barometer for stock market leverage and speculation, both of which were on an upswing during this period; and 2) in most extended bear markets, there are strong interim rallies like the one from March through June.

In communicating with clients, here’s the type of circular logic to avoid: “If a period of small-cap strength signals an economic recovery, then the stronger economy will be good for small companies, boost their earnings, and make today’s high valuations seem more realistic.”

Excessive P/Es speak for themselves, regardless of the economic environment. As 2000-02 showed, they can be devastating to investors’ portfolios during (and even after) economic slumps.

Not Your Father’s Inflation

The same New York Times article quoted the Chief Investment Strategist at Wells Capital Management, James W. Paulson, as arguing that “small stocks have typically have outpaced large stocks during periods of accelerating inflation. In the 1970s, for example, as inflation was running at an average annual rate of 7.4%, small stocks gained 11.5% a year, on average, versus 5.9% for large stocks.”

The full article is here:

    http://www.nytimes.com/2008/06/22/business/yourmoney/22fund.html

But today’s inflation is not like that of the 1970s. Producer prices are rising faster than consumer prices, and that means companies’ costs are increasing faster than their ability to pass costs through to consumers. Large companies generally have more pricing power than smaller companies, and small public companies tend to be especially vulnerable when producer prices are soaring in times of general economic weakness.

In Summary – Use Common Sense

At times, common sense is worth more than fictional financial numbers such as ex-neg. P/E ratios based on forward estimates. When you talk to small business owners in your market today, you may often hear that conditions have turned tougher over the last two or three quarters. Business is weaker, growth if more iffy, capital is harder to find, and costs are up. In addition, business owners are worried about future uncertainties such as health care expenses, increased taxes, and energy or environmental costs or surtaxes.

Small public companies face the same pressures as local private businesses. Because so many public companies took advantage of easy credit during the economic expansion, they tend to be more highly leveraged than small private businesses, which makes them even more vulnerable in a credit crunch.

You still have many great small companies and high-quality small-cap mutual funds to choose among. But a P/E ratio of 76.50 is a lot to pay for 2,000 small companies in today’s environment.

Trust the stories that straight numbers and common sense tell – and you will help your clients invest more successfully.

P.S. Here’s an idea for your clients who own (and are happy holding) high-quality small-cap stocks or funds. To hedge against the systematic risk of a decline in the Russell 2000, suggest adding to their portfolios some ProShares Short Russell2000 (RWM) or UltraShort Russell 2000 (TWM). These ETFs are designed to track, respectively, 1X and 2X the inverse of the index on a daily basis.

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