A Fundamentals Question: Do They Still Apply?
In the days before stocks routinely moved 50% in six hours--i.e., before the dawn of Internet stocks and Internet-based trading--people used to think about, and even abide by, what were considered “fair” prices for individual shares.
What had the company earned, per share, recently, and what was a reasonable earnings expectation for the foreseeable future? What price, relative to earnings, were similar companies’ stocks trading for? How much of a cash dividend did the company pay?
After a little basic multiplication and division, you arrived at a fair price. If the stock was trading below that price, it was a bargain. Above that price, it was arguably overvalued.
This is an oversimplification of the way things were, of course. But anyone who has played in the market since at least 1980 would probably agree that investors used to be a lot more concerned, in determining what to pay for stocks, with the hard and fast fundamentals--the historical balance-sheet and income-statement information of companies.
Today, veteran Wall Streeters like David Dreman of Dreman Value Management in New York argue that many individual investors care very little, or not at all, about the fundamentals. “At this point there isn’t [that focus] for most investors,” Dreman says, with more than a touch of lament in his voice.
Even at the professional money management level, the fundamentals have taken a back seat to an investment discipline based more on pure momentum: If a stock is going up, and its earnings are growing (or just expected to grow) at a relatively fast pace, don’t worry about the price of the stock vis-a-vis those earnings--just buy it, before someone else does.
“I would agree that the majority of money managed today is managed on a momentum basis,” says Robert Bissell, president of Los Angeles-based Wells Capital Management, which runs about $44 billion for clients.
Now, discussing the apparent decline of investors’ focus on the fundamentals runs the risk of sounding like Grandpa and his tales of the old days: walking 5 miles to school, reading by kerosene lamp, listening to FDR on the radio, etc.
In other words, so what? That was then and this is now. Things have changed, generally for the better. Most kids don’t have to walk 5 miles to school. Who’s to say that the same fundamental rules that governed stock prices 20 or 40 years ago still make sense today?
And that’s really the issue--whether the U.S. stock market overall must eventually revert to price levels closer to historical averages relative to underlying earnings per share, dividends and expected growth of earnings and dividends.
If that were to happen, it’s an understatement to say that many stocks would be sharply below today’s levels.
The blue-chip Standard & Poor’s 500-stock index today is priced at 23 to 28 times the companies’ aggregate expected ’98 earnings, depending on whose estimates you use.
Since 1923, the S&P; index’s average price-to-earnings ratio, or P/E, has been 13.5.
Meanwhile, the average dividend yield (annual cash dividend divided by current share price) for those S&P; 500 stocks today is about 1.4%, versus the historical average of 4.5%.
Looking solely at those numbers, the stock market might appear egregiously overvalued. But even those Wall Street veterans who fear that investors have lost sight of the fundamentals admit that there are good reasons why people should be paying more for stocks today than, say, even 10 years ago.
Dividends, for example, were a lot more important to investors when the tax rate on capital gains was much closer to the rate on ordinary income (such as dividends).
But as capital gains rates have come down since 1980, it’s logical that investors would prefer gains to dividends. And so many companies have de-emphasized dividends, and dividend yields have plunged. “I don’t think we’ll ever go back” to historical average levels of dividend yields, Dreman concedes.
Far more important for stock prices, interest rates today are substantially lower than they were in the 1970s and ‘80s. That automatically makes stocks worth more because bonds and other interest-paying securities offer less competition for money.
It wasn’t that long ago that one of Wall Street’s favorite fundamental rules was that you shouldn’t buy a stock whose P/E was substantially above its expected annual earnings growth rate.
But in today’s low-inflation, low-interest-rate environment, it would only be surprising if P/Es hadn’t expanded significantly.
Still, how high is too high for stock prices? When, if ever, does some semblance of old-style fundamental analysis begin to govern share prices again?
Internet stocks are, of course, the easy target for people who believe the market has lost its collective mind. Many Net-related stocks are priced at levels that are unprecedented in market history, given the companies’ lack of earnings and short operating histories.
But such niche-centered market manias occur regularly. What continues to trouble more Wall Street veterans are the high valuations afforded many blue-chip stocks--the most-owned companies.
On Friday, Coca-Cola confirmed what some analysts had been warning about earlier in the week: Hampered by weakened sales growth overseas, the company said fourth-quarter earnings per share will be in the range of 24 to 25 cents--far below the 33 cents earned a year ago.
That will mean that Coke’s full-year 1998 earnings will be down about 13% from 1997. That will be the first annual earnings decline for Coke in the current bull market (dating back to 1982).
So Coke’s fundamentals are deteriorating. Do investors care? To some extent, they do: Coke’s stock fell $3.19 to $62.88 on Friday. And it’s 29% below its record high of $88.94 reached in July.
Yet the stock still is priced at 44 times Coke’s lowered 1998 earnings-per-share estimate--or about three times the 15% or so annual profit growth rate that many analysts think is possible in coming years.
Paying attention to fundamental analysis used to mean that “there’s a limit to what you should pay for growth,” says Bradlee Perry, a veteran market analyst at David L. Babson & Co. in Boston.
Should Coke, which investors judged worth one times its growth rate in 1990, be worth three times its growth rate today--especially with profits falling, at least near-term?
Maybe the fundamentals don’t matter anymore. Maybe the rules have simply changed, and permanently so. Maybe “scarcity value” is what makes certain companies worth much more today, no matter what their growth rates. (There’s only one Coke, after all.)
Perry offers another explanation: “I think this speaks to the declining age level and experience of investors” in the ‘90s market.
In other words, this generation will eventually learn the importance of investment fundamentals and the danger in overvalued stocks, just as every generation before has learned--usually the hard way.
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Weaker Profits, Higher P/E
Are stock valuations today significantly out of whack with history? Consider the case of Coca-Cola Co.: While its earnings growth has slowed in recent years, the stock’s price-to-earnings (P/E) ratio has surged--which means investors are paying more for ever-slower growth. Coke’s earnings per share (EPS) growth each year versus its annual average stock P/E:
1998 Average P/E: 44*
1998 Annual EPS: -13%
* estimate
** current P/E based on estimated 1998 EPS
Source: Value Line Investment Survey
*
Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.
