Saturday, 11 June 2011

Will markets crash without QE3?

Much has been said about the markets needing the liquidity provided by the US Federal Reserve in order to maintain current levels. Certain forecasts such as S&P at 400 without QE3 has caused me no end of confusion as there are so many conflicting views and palpable fear that it is hard to see the forest for the trees. In some ways, this has caused me to doubt my investment strategy by thinking that there could be a massive drain of liquidity from the market and thereby impact all investments in stocks, both good and bad. I haven't changed my strategy and am still focusing on profitable gold, oil and gas producers.

I've read commentary about PE ratios and overall fundamentals not being up to scratch to current prices. I'll address this issue as I've had a good look at the market valuation. I was surprised with my conclusion and it has provided me with significant insight as to the potential market movements over the next 12 months.

My view of investing and investment valuations includes the idea that PE ratios are a terrible indicator of value and they are a rule of thumb that does not indicate anything about the actual business itself. How does the current market price for a share provide you with any idea at all about the value of the underlying business? The share price is irrelevant in this context and is a derivative of the business itself - a derivative that can wildly fluctuate at any point in time without any price sensitive information being released. The share price, divided by the company earnings, does not provide any insight on the business value or inherent risks involved.

PE ratios and similar rules of thumb are a very poor tool in determining current business value. Therefore, given the fact that the market is an aggregate of many individual businesses, the current value of the total market is poorly represented by PE ratios. This is similar to the concept that a combination of toxic collateralised debt obligations is not less risky in aggregate compared to an individual break-down.

The approach that I take is to look at the intrinsic value of the business and then compare it with the current market price. By doing this we can determine that margin of safety of investing at a certain price. The intrinsic value is driven by the profitability of a business, measured as return on shareholder’s capital and the ability to sustain a high incremental return on equity versus the payout of earnings in the form of dividends.

Based on my analysis, stocks will generally move towards their intrinsic value over a 12 to 24 month period. There can be significant short term divergence between market price and value, but this is inevitably corrected. The largest component to future company value is future earnings and the ability to either grow, sustain or the inability to sustain an adequate rate of return on reinvested profits.

So what I’ve done is to create an aggregate value of the 30 companies in the Dow Jones as if they were one company and titled it a Dow Jones Industrial Value Index. The result is a rolling intrinsic value which can be compared with the price. It is the same process that I use to analyse an individual company. I can therefore determine whether the Dow is cheap, expensive or about even. I can also have a look at the Dow as a company and determine if it is something that I’d personally invest in or alternatively if it is an ugly beast that I’d hide from.

Price versus Value

Margin of safety: 30%

The current forward value of the index is $2,265 and it is current trading at $1,579. This is based on consensus earnings forecasts and is therefore dependent upon the accuracy of such forecasts. However it is based on current expectations and adjustments can be made based on the risk of earnings failing to meet the forecasts.

We can see that companies are currently very profitable and are expected to be able to maintain it at current levels. There has been a significant improvement since 2009, but earnings don’t look stretched. In the event that companies are able to maintain current profitability, there looks to be a significant margin of safety of 30% at current prices and therefore stocks don’t look like they are about to tip over without further injections of government liquidity in to the markets.

The downside risk from here is that current profitability is, to use the cliché, ‘transitory’ and will fall back from here. In the event that this were to happen (e.g. profitability becoming slightly worse than 2009 levels), the model shows that the underlying value would fall to around $1,344 over the next 12 months or so and therefore could be as much as 15% overpriced. Even if this were true, it provides me with an understanding of the downside risks and indicates a negative scenario that really isn’t too bad. This works out to be around 2:1 upside versus downside risk. Clearly the markets can fluctuate wildly based on sentiment in the short term, but they must respect value eventually.

The Dow index includes Bank of America and JP Morgan which can skew the picture and clearly have significant issues at hand. By excluding these two companies, the overall price versus value picture is very similar with a current forward margin of safety at 28%. 

Price versus Value - ExBanks

Margin of safety: 28%

The remainder of my analysis excludes the banks as they significantly skew the picture when it comes to company debt levels and reduces clarity in determining what companies have been doing with their finances. From what I can see, Bank of America and JP Morgan together account for around 61% of the total debt load out of all the Dow.

Components (excluding BOA and JPM)

On a per share basis, companies have been able to maintain debt levels relatively stable. Of course during the financial crisis companies had a significant increase in debt levels in order to protect them against liquidity risks; however they have now been able to scale it back.

Earnings are clearly strong at present and companies are profitable. They seem to have been retaining earnings in order to better manage their financing activities. This is a good thing as it reduces the risk of further liquidity shocks in the future.

Revenue is growing, dividends are stable but not growing as fast as they used to and cash profit is relatively stable. Short term assets have increased substantially versus short term liabilities, which is reassuring.

Cash balances are increasing at a very rapid pace and are approximately double the level held in 2007.

Cash flow is positive and clearly is being directed towards financing activities. Debt loads are being substantially reduced and companies are also managing to buy back some of the shares raised in recent years. In this respect, business health seems to be returning to trend and is a very positive outcome.

What will companies do with their cash?

I’ve listened to a lot commentary about companies currently sitting on large cash hoards and speculation on what they will do with it: ranging from mergers and acquisitions to buying back shares. I’m going to take a stab at this and say that companies, in aggregate, are not going to do anything substantially different to what they are already doing. What they seem to be doing, from my perspective, is significantly reducing debt burdens, buying back shares that were raised during 2009 and 2010 and improving overall liquidity by allowing cash to build up at a much faster pace compared to short term commitments.

Many companies seem to have been caught unaware when the financial crisis hit and therefore sold expensive capital when share prices were low and are now buying it back when prices are higher. This is not necessarily the most efficient form of capital management (buy high and sell low), but at least they are taking action and the debt is being dealt with.

As mentioned above, cash holdings seem to have doubled from 2007 at around $150 billion to around $300 billion in 2011/12. I think that companies will keep on doing what they are currently doing and perhaps if cash holdings continue to rise at current rates, businesses will increase the growth of their dividends which have been slightly held back during this period.


Credit market and sovereign debt issues aside, businesses are currently very profitable. Based on consensus forecasts there is a very decent margin of safety between prices and value. This provides substantial shelter in the event that earnings in the near future come in below expectations. I started out being concerned about market levels and whether or not QE3 would eventuate (I think it will), what shape it might take and the timing. I have now concluded that it doesn't matter too much for the market. I think that there are serious issues that the world faces, but the DOW companies are well positioned and are unlikely to fall substantially from current levels as some claim. 

Is the aggregate of the DOW a business that I would personally invest in? Probably not, but that's mainly because I seek individual companies with greater upside potential. Is it an ugly beast that I'd hide from? Definitely not.


  1. I like your logic . Thank you Fish

  2. Fantastic analysis. Well done. You must have a substantial data capture system.
    Have you done a similar analysis for say the ASX200?

  3. Steve

    Great Job. Can you please check the legends on your Graph. The Graph shows a big drop in IV around 2007, but the table shoes this in 2009. maybe the labelling needs a tweak.

    Overall, a very useful analysis.

  4. Fantastic analysis. Well done. You must have a substantial data capture system.
    Have you done a similar analysis for say the ASX200?

    I like my data :)
    I'm currently working on an analysis for the ASX200 - you have read my mind.

  5. "Great Job. Can you please check the legends on your Graph. The Graph shows a big drop in IV around 2007, but the table shoes this in 2009. maybe the labelling needs a tweak."

    Thanks for the feedback. I agree that this needs to be clearer, but it is intended. I build my valuations based on future expectations. Therefore in the graph there is a two year difference between IV and the date.

    It is my belief that current share prices are based on future expectations and they therefore must factor in to the current value. Whilst in some cases it can appear a little off (IV versus price), in most cases it works perfectly. Most importantly, it is the situations where the most attractive opportunities present themselves that it works the best.

  6. I'm currently working on an analysis for the ASX200 - you have read my mind.

    EDIT: ASX20 not ASX200

    I'd like to try at 200 at a future date, but given that my current data system sometimes brings up some issues that require manual adjustment it is too big a hurdle at this point.

  7. This whole QE thing is a bad joke. You cannot print your way out of a crisis. You must find real solutions to real problems.