LBW Commentary Q2 2019
How LBW Seens It
2019 has been widely successful for most asset prices. For example, year-to-date the S&P 500 TR is up 18.39%, the Russell 3000® 18.70%, and the MSCI ACWI ex USA GR 13.99%. Furthermore, on June 28th, 2019, the S&P 500 closed at 2,941.76; only 58.24 points away from 3,000, a number never reached before. The continued rise in prices wiped out the market decline we experienced in the back half of 2018, and some of the culprits of these wild swings include trade wars as well as both the Federal Reserve (“Fed’s”) and European Central Banks’ (“ECB’s”) policy execution.
If we were to rewind time to Q3 2018, the conversation around the markets would have consisted of the Fed and their potential to continue increasing the federal funds rate, and the current administration’s trade spats with most countries around the world. These factors lead to fears of both U.S. and global economic slowdown pushing the markets downward. Fast forward roughly a year later and the tone around the markets have changed, but the outlook on the slowdown of the U.S. and global economic landscape has not. For example, Fed Chair Jerome Powell recently stated:
“Along with this favorable picture, we have been mindful of some ongoing crosscurrents, including trade developments and concerns about global growth. At the time of our last FOMC meeting, which ended on May 1, there was tentative evidence that these crosscurrents were moderating. The latest data from China and Europe were encouraging, and there were reports of progress in trade negotiations with China. Our continued patient stance seemed appropriate, and the Committee saw no strong case for adjusting our policy rate.
In the weeks since our last meeting, the crosscurrents have reemerged. Growth indicators from around the world have disappointed, on net, raising concerns about the strength of the global economy. Apparent progress on trade turned to greater uncertainty, and our contacts in business and agriculture report heightened concerns over trade developments. These concerns may have contributed to the drop in business confidence in some recent surveys and may be starting to show through to incoming data. Risk sentiment in financial markets has deteriorated as well. Against this backdrop, inflation remains muted.”
The uncertainty of trade negotiations and their impact on the U.S. and the rest of the globe has led the Fed to prepare for rate cuts in the hopes of achieving their two objectives: full employment and two percent inflation.
Furthermore, in recent weeks the ECB has indicated further rate cuts to help mitigate the effects of trade negotiations, deflation, and slowing growth. For example, the ECB stated:
“…while the most recent hard data for first quarter economic activity were better than expected, in part due to temporary factors, weak global trade and the prolonged presence of uncertainties continued to be a drag on euro area growth developments. This was reflected in another downward revision of the growth outlook in the June 2019 Eurosystem staff projections.”
Both the Fed and ECB feel the trade negotiations occurring across the globe are contributing to slower global economic growth. Each institution is prepared and projected to cut interest rates to help assist their respective monetary goals. Similar to Q3 2018, the fears of global slowdown has not changed; however, the willingness to step in and implement a policy to help support their respective economies has changed the markets’ outlook. As we have discussed before, markets are forward-looking. The notion that both the Fed’s and ECB’s willingness to step in and help curtail further slowdown provides tailwinds for the market. For example, if trade negotiations begin to stabilize, and if both the Fed and ECB cut rates, the outlook for the market could be positive. Easing trade tensions will help with global economic growth moving forward, and decreasing interest rates will allow for easy lending across the market from business investment to individual spending. Theses factors are tailwinds and could drive assets’ prices higher, even though we may be in the late innings of a historic bull market.
Even though markets may continue to run, that does not mean asset values will be on the rise as well. Furthermore, the artificial drive in asset prices could push market indexes higher, bolstering their already astonishing return in the past decade. The returns experienced in the past decade, we feel, will not persist. This could lead to recency bias, just like investors experienced after the Great Recession, further driving irrationality into the markets as investors continue to seek unsustainably high returns.
The macro and global economic pictures are diverse and complicated. The number of factors and overall uncertainty is a ball game LBW does not look to play in. As one can see from the statements of both the Fed and ECB, it only took months for them to completely reverse their prior projections and policies. These changes could impact trade, markets, and potentially, generations to come. The uncertainty and unpredictability, however, is a game in which we try to avoid. Instead, we attempt to understand what we own; we consider macroeconomic data but do not allow it to dictate how we invest. We feel market prices have the potential to continue their rise, depending on the developments discussed. If the markets do, we will most likely take a sideline pass as we feel the opportunity set is beginning to shrink and we are happy to sit, be patient, and wait for the next pitch.
Nathaniel's Beautiful Mind
What is a Multiple?
The most common multiple that investors have heard of is the oft-quoted P/E multiple. P/E stands for Price/Earnings - you simply take the price per share divided by the Earnings Per Share (EPS). For this writeup’s purposes, we will use Coca Cola’s (KO) stock to use in our examples below. As of 7/17/19, KO’s price is ~$52/share and their trailing-twelve-months EPS equals $1.57/share. Hence, their P/E is $52 / $1.57 = 33.1.
But what does this multiple really mean? One method is to assume the following:
you purchase KO’s shares today,
the amount of EPS would never change,
KO would distribute 100% of its earnings to shareholders, and
you sell your shares after 33.1 years had passed at the same price you bought them for.
You would see your entire original investment returned to you in approximately 33.1 years. This is equal to a 2.1% annualized return.
One would be correct in saying that the likelihood of these assumptions happening in real life is slim to none. In reality:
the average investor won’t hold onto their shares for 33 years,
KO’s EPS will be different every year,
KO will most likely never distribute 100% of its earnings to its shareholders for the next 33 years (despite recent years coming pretty close), and
KO’s price will vacillate every business day until you sell your shares.
Our point-of-view on multiples
A multiple is a shorthand for a Discounted Cash Flow (DCF) calculation. There are several inputs involved in a DCF calculation, including normalized free cash flow (FCF), estimated 10-year growth rate, estimated terminal growth rate, and discount rate, and these are subjective to the investor’s biases and analysis. DCF’s are used by investors to determine how much the market is valuing a certain security and how much they are willing to pay for said security. Using KO again, we can reverse engineer what inputs investors are using today to arrive at a 33.1 multiple:
Table input explanations:
EPS: we prefer to use FCF because we view it as a cleaner interpretation of earnings. Management is less able to hide shenanigans in FCF vs earnings. For the purposes of this writeup, we’ll use EPS to keep things simple.
Shares Outstanding: since I use per share numbers in the calculation, there is no point in using KO’s 4.266B shares (as of 4/22/19). If, however, we were to use KO’s total earnings of 6.319B, then we would input its outstanding share count.
Estimated terminal growth rate: we typically use ~3% to account for the average inflationary rate (1913-2019 average) for companies whose business models allow for at least an increase in their prices equivalent to inflation like KO.
Discount rate: this rate encapsulates your views on what you think a dollar is worth in the future invested in KO stock vs. a comparable benchmark, such as the S&P 500 Index. Typically, we use 12% discount rates for all publicly-traded equity securities. The discount rate changes depending upon the type of investment. If you were to invest in a privately-held company, your discount rate will likely increase to compensate you for risk factors like illiquidity and key-operator risk.
KO would have to grow ~18.16% per year for the next 10 years for today’s valuation to make sense! Based on KO’s past 10-year growth in EPS of ~0.66%, I think it’s highly unlikely KO will grow as much as today’s price suggests.
If we use a more grounded 10-year growth rate of 3% into the DCF, we get the following:
According to above, an appropriate price for KO’s shares today is more like $18/share, or an 11.5 multiple ($17.97 / $1.57). Now, perhaps my inputs are too pessimistic. Some investors choose to use 9-10% discount rates for publicly-traded equity securities. Watch what happens if we use 9%:
The valuation jumps almost $9/share and is a 17.2 multiple ($26.95 / $1.57). With just one change, the valuation has increased by 50%!
Here’s my point: a multiple is just that – a multiple. What matters are the inputs you use to create your multiple. If you’re too optimistic with your estimated growth rate or use too low of a discount rate, you will get a high multiple estimate that could lead you to believe the security is a buy (provided it’s trading at a lower multiple). Conversely, if you’re too pessimistic with your estimated growth rate or use too high of a discount rate, your estimated multiple will suggest that you not buy, and you may miss out on a great deal. In our KO example, it’s not that the 33.1 multiple is too high for KO’s stock, it’s that the assumptions (specifically the assumed growth rate) underlying the multiple are too high. Assuming all other inputs are accurate and after of course applying our favorite filter, the Margin of Safety (MoS), if you honestly believe that KO will grow EPS at 18+% for the next 10 years, and KO is trading at a multiple less than your MoS-applied estimate, then, and only then, should you buy it. If not, you shouldn’t buy it. It’s as simple as that.
 Year-to-date = 1/1/2019 – 6/30/2019
 LBW Wealth Management, sourced from: http://us.spindices.com/indices/equity/sp-500
 LBW Wealth Management, sourced from: https://www.ftserussell.com/analytics/factsheets/Home/Search
 LBW Wealth Management, sourced from (gross return): https://www.msci.com/documents/10199/ca7b1b93-7bae-4fe2-928e-7340ff17c71c
 On the close of July, 12th, 2019 the S&P 500 closed at 3,013.77, a level never reached before.
 Transcript of Chair Powell’s Press Conference June 19, 2019: https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20190619.pdf
 Account of the monetary policy meeting of the Governing Council of the European Central Bak, held in Vilnius on Wednesday and Thursday, 5-6 June 2019 - https://www.ecb.europa.eu/press/accounts/2019/html/ecb.mg190711~16eb146254.en.html
 Ibid; to match the historical inflation rate.