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Sunday, August 06, 2006
August 4th, 2006 - Financial Times By Vitaliy Katsenelson
Published: August 4 2006 19:42 Last updated: August 4 2006 19:42
Love was in the air, birds were singing, price/earnings ratios were growing and the stock prices of large-cap, bellwether companies such as Microsoft, Wal-Mart and Johnson & Johnson were rising as if dotcom had become their middle name. Investors could not get enough of these great companies that had created substantial wealth for shareholders in the preceding decades. But they were in for a surprise.
Late 1999 and early 2000 marked the end of the renaissance era for large-cap growth stocks. Most of them either have gone down or drifted sideways since. And this should not have been surprising. In the ecstasy of market excitement, investors had confused great companies with great stocks. And those great companies stopped being great stocks once their p/es reached unprecedented highs.
The birds stopped singing. Seeing their money going nowhere during the past six years, investors’ excitement has gradually turned into indifference and then disappointment. The cold reality of miserable stock performance leaves no room for argument: these stocks were grossly overpriced.
But time is the great healer, especially when earnings are growing. These companies have more than doubled their earnings since the late 1990s. Those higher earnings have combined with lacklustre stock performance to create very attractive valuations.
Microsoft stock has declined substantially from its 1999 highs when it traded at more than 50 times earnings. Since then its profits have doubled. Adjusting its price for a cash pile (that is soon to make its way back to shareholders’ pockets through a $20bn share buyback and constantly rising dividends) it trades at an unbelievable 13 times earnings. Yes, this is not a typo. One of the few legal monopolies – which has a return on capital of 28 per cent, scores profit margins of 30 per cent and is increasing revenues at a double-digit rate – is trading at a below-market p/e. To top all of that, this downward valuation has taken place when it is about to come out with two huge new product releases, Windows Vista and Office 2007.
Wal-Mart in 1999 sported a p/e of 39 and earned $1.28 a share. Six years later it is expected to earn $2.95 for 2006. Yet its stock price is at the same level as it was in 1999. Its p/e is at a level that has not been seen in more than 20 years: 15 times forward earnings. That is very cheap for a company that is likely consistently to increase earnings in the low teens for years to come, and has a moat the size of Lake Michigan around its business.
Johnson & Johnson is trading several dollars above its 1999 level in spite of its large size. Its earnings have grown at a very impressive 15 per cent a year at the same time as its p/e has been cut in half from 32 times in 1999 to 16 times 2006 earnings today. How often do we get an opportunity to buy one of the best and most diversified pharmaceutical and consumer companies that pays a 2.5 per cent dividend yield at this valuation? It happened a couple of times in the early 1990s, and Johnson & Johnson’s stock has more than quadrupled since then (although I am not saying I expect it to do that this time around). Did I mention it has $15bn of net cash (cash less debt) in the bank?
Six years of subpar stock performance for large-cap growth stocks has led many to believe there is something wrong with the underlying companies. That assumption could not be more wrong. The stocks have disappointed investors’ linear expectations because they were overpriced in the late 1990s and it took six long and dreadful years for the valuations – the p/es – to catch up with fundamentals. They have finally done so. What these companies usually share is that they have strong moats around their business, a long track record of success, above average dividend yields, strong brands, great return on capital, a bright future of growth ahead and very attractive valuations. They are considered to be bellwethers for a reason. Their defensive qualities make them less risky stocks, performing better than the rest of the market at times of uncertainty – and we have plenty of uncertainty to go round.
The laundry list of the large-cap growth stocks that have not gone anywhere in a long time and are hitting attractive valuations is very long. Also look at McDonald’s, Abbot Labs, Berkshire Hathaway and General Electric. They have not been this cheap in a very long time. When quality, defensive growth becomes value who can say no to that?
Vitaliy Katsenelson is a portfolio manager at Investment Management Associates and teaches at the University of Colorado in DenverVitaliy N. Katsenelson, CFA