Category Archives: Facebook

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Minimize Risk Without Sacrificing Returns? Sven Tells You How


  • By dissecting the S&P 500 per valuation quintiles we see that only parts of the market are overvalued.
  • Historically, buying the lowest PE quintile stocks has increased annual returns by 360 basis points.
  • High PE stocks have large market capitalizations which force you to own more of them through index funds, increasing your risks and lowering your returns.

Introduction 

Beyond the top news stories about central banks increasing stimulus to fight the BREXIT or sluggish economic data with high hopes for the future, there is one recurrent theme that still flies under the radar. The recurring theme is that financial markets are overvalued.

As we all know, bull markets climb a wall of worry. Investors who sold everything in 2011 believing markets were overvalued were happy for a while, but are probably still crying now as, if they had not gotten back in the market, they missed a huge upside. We might be in a similar situation where selling now would mean losing much upside, but there is another option.

Figure 1 S&P 500 last 10 years
Figure 1: S&P 500 chart for the last 10 years. Source: 5yearcharts.com.

Today we are going to discuss the alleged market overvaluation and dissect it into overvalued and undervalued segments. This is possible as the market is currently all over the place. We are going to end with an example of potential irrational exuberance, social network stocks, and show how such investments can be avoided even when allowing for a high level of diversification.

Dissecting Market Overvaluation

The PE ratio of the S&P 500 is 25.24 if you calculate it by using S&P 500 earnings. By changing methodology, you can get to other averages, but we believe this one to be the most accurate as it looks at aggregate earnings and not stock PE ratios with a lot of negative inputs that skew the result. The average PE ratio for all S&P 500 stocks with negative ratios included ends up at around 19, so don’t get confused by the difference.

In any case, the expected returns with a PE ratio of 25.24 are below 4% per annum, and as corporate earnings are not growing we cannot expect much more. If you hold a diversified ETF or mutual fund that tracks the market, you can’t expect more than 4% returns in the long run, but you should be able to lower your risks and even increase your long term returns if you choose not to include irrationally overvalued companies in your portfolio.

Of course, complete S&P 500 diversification is then out of the question, but here is why. When buying an index, the most expensive stocks have the largest weights because as they get more and more expensive, their market capitalization increases and the fund manager is forced to buy more, which further increases the price and forces the asset manager to buy even more creating a vicious circle that leads into irrational exuberance.

But by looking at quartile valuations of expected forward PE ratios, we see that the market is overvalued only within the highest PE quintile.

figure 2 quintile expected forward PE
Figure 2: S&P 500 PE ratios by quintile. Source: Smead Capital Management.

As historically stocks with the lowest PE ratios have outperformed all other groups, we can limit the risks of a market downturn by shifting our portfolios towards low PE ratio stocks. Those who did that in the last 40 years achieved above market returns of 360 basis points (market average 11.7%, lowest quintile PE stocks 15.3%).

figure 2 PE ratio returns
Figure 3: Returns by valuation quintile. Source: Smead Capital Management.

To give some research aid, here are the 25 S&P 500 stocks with the lowest PE ratios. Be careful because low PE ratios don’t always mean high earnings. Special events like divestitures or future imminent costs can skew PE ratios.

CompanyTickerPE Ratio
Delta Air Lines Inc.DAL3.87
Noble Corp.NE6.44
Yahoo! Inc.YHOO6.64
Valero Energy Corp.VLO7.03
American International Group Inc.AIG8.91
AFLAC Inc.AFL9.26
Assurant Inc.AIZ9.42
Danbury Resources, Inc.DNR9.50
Unumprovident Corp.UNM9.59
Deere & Co.DE9.69
Travelers Companies Inc.TRV9.94
CF Industries HoldingsCF9.94
Lincoln National Corp.LNC10.04
Ford Motor Co.F10.23
Hess Corp.HES10.36
International Business Machines Corp.IBM10.39
Verizon Communications Inc.VZ10.48
Lyondellbasell IndustriesLYB10.52
Masco Corp.MAS10.55
Murphy Oil Corp.MUR10.69
Chevron Corp.CVX10.72
AT&T Inc.T10.88
Capital One Financial Corp.COF10.91
Allstate Corp.ALL10.92
Goldman Sachs GroupGS10.95
Figure 4: S&P 500 lowest PE stocks. Source: The Online Investor.

Digging into such a list can give you companies that have stable businesses and low valuations despite any market whim.

High Valuation Example

Not taking anything away from Facebook (FB) or giving any investment analysis, we are going to use it as an example of how a high PE ratio stock can influence our long term investment.

FB’s current weight in the S&P 500 is 1.53% which means that the average Joe that only invests in the S&P 500 has 1.53% of his portfolio in FB. This might be a good thing as FB has had an extraordinary performance since its IPO, but it also means you are paying $125 a share for something that has a book value of $17.54 and EPS of $2.09.

FB will probably continue on its growth path in the future, but investors must understand such a situation carries more risk and the risk can be explained with the huge fall other social networking stocks have witnessed.

figure 5 FB LNKD
Figure 5: Facebook’s, Twitter’s and LinkedIn’s performances in the last 4 years. Source: Yahoo Finance.

LinkedIn has fallen from a price of above $250 per share at the end of 2015 to a price near $100 earlier this year due to lower growth. It was saved by Microsoft which bought it for $26.2 billion, or $196 per share.

Twitter didn’t find any suitors, so its price is still 55% below IPO.

Any change in FB’s growth trajectory, which is bound to arrive sometime as no corporation can grow forever, can have a LinkedIn effect on Facebook which will mean that half of the 1.53% of one’s portfolio would be wiped out.

Another example of high PE ratios and low returns could be Microsoft which bought LinkedIn despite the company not being profitable. Microsoft’s PE ratio is currently around 28 which puts it into the higher valuation quartiles. Microsoft’s weight in the S&P 500 is 2.41%.

Conclusion

The main message of this article is that you can choose where to be invested and you can minimize long term risk and, from an historical perspective, you do not even have to sacrifice your returns. By buying the stocks that are suitable to your investing goals you can achieve better returns and avoid the market risks you don’t like. Those can be social networking stocks, money-losing car makers, or oil companies. Because in order to have a well-diversified portfolio, you only need about 20 stocks.

figure 6 portfolio risk
Figure 6: Number of stocks needed in order to eliminate market risks. Source: Investopedia.

As index funds are created for long-term investors that want to be well diversified, if you want something other than that, you can lower your risk and achieve better returns by buying stocks that have higher earnings as in the long term, stock returns and earnings are perfectly correlated.

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Corporate Earnings of the S&P 500’s Top 10: Why It Is Important for You


  • Corporate earnings and fundamentals are variable, pick the stocks that best suit you.
  • There are low PE ratio stocks, high growth stocks, and high dividend yielders – anything you might want.
  • But be aware: some companies engage in buybacks that are detrimental to shareholders’ value.

Introduction

When you add up the top ten companies by weight, they account for 17.7% of the total weight of the S&P 500. For investors who are heavily invested in the S&P 500, following the earnings of its top ten companies is essential in order to understand the risks and rewards of being invested in the index. In this article we are going to assess the current market situation by looking at what has been going on with the 10 biggest companies in the S&P 500 index.

Apple

Apple (Nasdaq: AAPL) reported earnings after hours on Tuesday. Q2 2016 revenue declined 14.4% year-over-year and earnings per share declined 27% to $1.42 from $1.85. Those results were better than expected, and AAPL jumped 7% in after-hours trading.

AAPL isn’t a standard company, its revenue is highly dependent on iPhone sales which fell due to customers awaiting a new generation iPhone to be announced in September. If the same trend holds true as it has in the past with new iPhone generation sales, AAPL’s sales will increase when it releases the new phone. In the meantime, perhaps the most important thing from this earnings report is the fact that AAPL returned $13 billion to investors through dividends and repurchases.

The dividend yield is 2.38% annually but when we add in the repurchases, it comes to a staggering 2.3% quarterly yield, making AAPL’s dividend yield quite a bit higher than the S&P 500 average of 2.05%.

In total, the S&P 500 buybacks were $161 billion in Q1 2016,—interestingly, Apple alone makes up about 8% of this total— second only to Q3 2007 when the buybacks reached $172 billion. The most important thing with buybacks is the question: is buying your own stock the best use of cash at that point in time? Yes, companies protect and increase their share prices, but at what cost? We all know what happened in the two years after Q3 2007 when repurchases reached record highs…

Another company that is strong in repurchases in Microsoft (Nasdaq: MSFT).

Microsoft

MSFT also saw its revenue decline, by 6%, and earnings per share declined 23% (GAAP results), but nevertheless returned $2.8 billion in dividends and $3.6 billion in repurchases, giving a dividend yield of 2.54% and a 3.1% indirect yearly repurchase yield.

The decline in revenues and earnings further exacerbates the above mentioned buyback issue, but even more alarming is the fact that MSFT is buying its stock despite their PE ratio of 27.7, while AAPL’s is at 11. This is where alpha kicks in because good stock picking can make you avoid such bad cash investments.

Exxon Mobil

The consensus earnings per share for Exxon Mobil (NYSE: XOM) is $0.64 for Q2 2016 which is 34% below the earnings per share in the same quarter last year.

XOM’s share repurchase program is another crazy example of ill-timed purchases. In February, XOM stopped its buyback program after spending $210 billion over the last decade. The craziness lies in the fact that the company has stopped buying back stocks despite the price being at multiyear lows.

figure 1 xom buybacks
Figure 1: XOM’s stock price movement in the last 2 years. Source: Yahoo Finance.

This falls perfectly in line with what usually happens as managers time buybacks poorly. When stocks are cheap, management doesn’t buy them. When they are expensive, buybacks explode, eroding shareholders’ value.

figure 2 total buybacks
Figure 2: Quarterly share repurchases and number of companies repurchasing shares. Source: FACTSET.

Johnson & Johnson

Johnson & Johnson (NYSE: JNJ) is continuing on its wonderful ascent despite revenues and earnings per share not growing since 2014. JNJ has a $10 billion share repurchase program that is being financed by debt. The current enthusiasm is of course backed by global monetary easing which pushes future expectations higher.

General Electric

General Electric (NYSE: GE) has survived terrible times in the last 7 years. GE’s revenue is currently just 64% of its 2008 revenue, but the company finally managed to increase earnings and revenue in the last quarter. The PE ratio is still high at 24, and J.P. Morgan warns that GE will face bad times again due to the volatility in the economy and other internal issues.

Amazon and Facebook

Amazon (NASDAQ: AMZN) and Facebook (NASDAQ: FB) have the growth that the companies discussed above are missing, but it comes at crazy valuations.

AMZN’s PE ratio is 303, while FB’s PE ratio is 74.5. We cannot know if AMZN will manage to grow its earnings by more than tenfold in order to reach a more normal valuation or if it will forever stay the mega growth company.

Holding the S&P 500 gives you diversification, the unfortunately you gain exposure to companies after their initial growth cycle has passed. AMZN’s weight in the S&P 500 was only 0.46% in 2009 when its price was about a tenth of its current price.

Berkshire Hathaway

Berkshire Hathaway (NYSE: BRK.A, BRK.B) hasn’t yet release its earnings but what is significant and different from the above companies is that buybacks are limited. BRK will buy back its own stocks only if the price falls below 1.2 times book value. Warren Buffett believes that buying back the company’s own shares above book value is a disservice to shareholders. This might be one of the reasons why BRK has by far outperformed the S&P 500 in the last 30 years.

figure 3 brk vs sandp
Figure 3: BRK vs the S&P 500. Source: Yahoo Finance.

AT&T

AT&T (NYSE: T) doesn’t have comparable earnings as it recently acquired DirectTV, however it is a company that keeps on growing, has a high dividend yield of 4.53%, and has had minimal share repurchases when compared to other companies in the last 4 quarters.

JPMorgan Chase & Co

The last company on our list is JPMorgan Chase & Co (NYSE: JPM). JPM reported revenues up by 4% and net income up by 5%, and has a PE ratio of 10.87 with a price to book ratio of 1.0, making it the company with the best fundamentals on our list and a great introduction to our conclusion.

Conclusion

Most great investors would advise the average investor to hold the S&P 500 for the long term, but the analysis of the 10 companies we’ve discussed and the variety of their revenue growths, earnings, and management buyback policies suggest something different.

Being long the S&P 500 just because that’s what everyone else does means also having managers destroy shareholder value by excessive and poorly timed buybacks, or it means paying high valuations for companies with no growth or exorbitant valuations for growth companies. On top of that, the risks of just owning the S&P 500 are increasing as its valuation is higher and is at levels only seen twice historically, in the dotcom bubble and just before the 2009 crisis.

figure 4 s&P 500 pe ratio
Figure 4: S&P 500 PE ratio. Source: Quandl.

Investors should assess their own needs and financial requirements. There are plenty of relatively safe high dividend yielders on the market, value companies, growth companies and declining companies from which to build your portfolio.