Why The Stock Market Is Irrational Right Now

November 21, 2008 at 10:14 am  ·  Category: Fundamental Analysis, Macro Economics, Market Commentary, Sentiment Analysis, Stocks

One of the things about Wall Street is that it is incredibly short term focused.  Investors, including (especially?!) professionals, tend to care about the here and now and possibly a year out.

If you do this, you might think that stocks are fairly valued right now.  Top down analysts are calling for $63 in earnings for the S&P 500 next year.  With the S&P trading around 750 this morning, that’s a 12 multiple on next year’s earnings.  That’s cheap but not real cheap, historically.  So it might seem reasonable to think that stocks are actually rationally discounting what’s ahead.

The mistake here is to only consider 2009.  The value of a business shouldn’t just be based on what it will earn in 2009.  It should also include what it will earn in 2010, 2011, 2012, etc…  That is, any reasonable valuation should take into consideration a fairly long term horizon.  If you can look past next year, which will be terrible, the incredible value now available in stocks becomes apparent.

Let me give you some examples.

Take a look at Target (TGT).  Shares are currently trading around $27 – down from $70 last July.  That gives Target a market capitalization around $20 billion.  That is, you could buy the entire company for $20 billion. 

Target is getting killed right now.  Same store sales were down -3.3% in the quarter ended November 1.  Net income was off 24%.  Bad debt expense in their $9 billion credit card portfolio almost tripled to $314 million from $130 million last year.  They wrote off credit card receivables at an almost 10% annualized rate.  2009 promises to be even worse as they cope with one of the worst retail environments ever.

It wouldn’t be surprising for earnings to drop 25% next year to around $2.50 a share – even though analysts are still calling for $3.03.  At $27 a share that’s an 11 multiple on next year’s earnings.  Cheap but not ridiculously so, you might think. 

But next year’s earnings are going to be highly depressed.  That is, they will be significantly below Target’s normalized earnings power.  At some point, a year or two down the line, the economy will rebound, Target’s shoppers will come back, their same store sales will flip positive and earnings will be higher. 

It would take 11 years of next year’s earnings to get your money back on Target – still not a bad 9.1% return on your money.  But, in all likelihood, it will really only take 7 or 8 years because earnings in 2011, 2012, 2013 and beyond will rally back above $3 a share and higher.  That means the real forward earnings multiple is only around 7 or 8 – for the best middle market retailer in the USA.  That’s a steal.  I love owning Target right here.  I’d buy the whole company if I could.

As another example, take giant copper producer Freeport McMoran (FCX).  Freeport has taken one heck of a beating over the last 5 months as copper prices have dropped from around $4 a pound in July to around $1.60 today.  Freeport’s average cost of production for a pound of copper has been $1.21 (see pg. 4) in 2008 so this sort of drop in the price of copper crushes its margins.  Shares have dropped from $127 back in May to around $19 today – down 85%!

2009 will be a really tough year for Freeport.  It’s even possible that Freeport will only break even for the year.  But if you can look beyond next year, to a time when the global economy recovers and the demand for commodities returns as the emerging world industrializes, Freeport’s long term prospects and earnings power are enormous. 

Freeport’s peak earnings for the last cycle were close to $8 a share.  I see no reason why they won’t return to those levels and even exceed them in the years ahead: 2012, 2013 and beyond.  I’d expect Freeport to earn it’s entire share price within the next 5 to 6 years.  That’s a steal for one of the largest copper producers in a world of increasing population and industiralization and fixed and scarce material resources.  Again: I’d buy the whole company if I could.

As a last example let’s look at internet infrastructure giant Cisco Systems (CSCO).  Fears, and the reality, of a slowdown in corporate capital IT investment have cratered Cisco’s shares from $34 last November to around $15 today.

A couple weeks ago Cisco said orders fell off precipitously in October and forecast a 5-10% drop in revenues in the current quarter (CSCO FY 1Q Earnings Release).  Cisco isn’t immune from the worldwide economic slowdown as companies cut back on their immediate IT spending.  2009 will be a tough year.  I wouldn’t be surprised to see earnings drop 25% in their fiscal ending in July to $1.10 a share – even though analysts are still calling for $1.39.  That results in a 13 forward multiple on next year’s earnings.  Cheap – but not ridiculously so.

Again, however, Cisco’s earnings will rebound with the global economy.  The real forward P/E is probably much more like 9 or 10 than 13 once you take that into account.  That’s cheap.  I’d buy the whole company if I could.

It’s hard right now not to focus on the devastation being wreaked on our portfolios and the tough year or more ahead.  Fear is rampant and analogies to The Great Depression are all over the media.  But if you can step back and take a longer term focus, it’s clear that the opportunities of a lifetime are available right now to investors with a time horizon longer than an insect.

Heed the timeless wisdom of Rudyard Kipling in his great poem “If”:

If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you
But make allowance for their doubting too,
If you can wait and not be tired by waiting,

You will be handsomely rewarded my friends!

Disclosure: Top Gun is long shares of Target (TGT) and Freeport McMoran (FCX) and has no position in Cisco (CSCO) shares.

Posted by Greg Feirman  ·  Trackback URL  ·  Link
 

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