Understanding the Real...Squirrel!

12/07/2012 9:15 am EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Sometimes information overload and too much info on the wrong things can obscure our understanding of what's important and what's not, notes Kelley Wright of Investment Quality Trends.

I recently had the good fortune to spend some time in the waiting room of my children’s pediatrician. While setting up the tent and waiting for our provisions to be delivered, I was treated to an encore presentation of Disney’s 2009 hit movie Up.

For those unfortunate to have missed this cinematic masterpiece, retired balloon salesman Carl Fredricksen ties thousands of balloons to his house and travels to Paradise Falls, an adventure destination of his childhood dreams.

Among the inhabitants of this lost world are a highly trained group of dogs equipped with a special collar that allows them to speak. Despite their training and vocal abilities, the dogs retain some of their primal instincts, one of which is the inability to remain on task when distracted by the presence of a squirrel.

The comic factor comes into play when an action sequence or moment of drama is interrupted by the dogs stopping on a dime, pointing in the direction of the furry creature and loudly yelling “squirrel,” before resuming their prior activity.

The above vignette captures my view of how the financial and geopolitical events of the day are being covered and reported. To be sure, there is plenty of attention paid to the approaching fiscal cliff and the day-to-day drama that is the European sovereign and banking debacle.

The angle of the reporting though is as if these are competitions, and who are the winners and losers. In short, the media is distracted by the squirrels instead of the long-term ramifications of the possible outcomes of these issues. Furthermore, in my humble opinion, the media may actually be missing the bigger story: fourth-quarter earnings.

On the earnings score, I would point you to the weekly commentary of John Hussman, Ph.D. titled Overlooking Valuation. Although a little too academic for some, the entire piece is well worth the read.

For those who prefer the Cliffs Notes, Dr. H notes that: "On the valuation front, Wall Street has been lulled into complacency by record profit margins born of extreme fiscal deficits and depressed savings rates. Profits as a share of GDP are presently about 70% of their historical norm.”

Hussman further writes, "Presently, on the basis of smooth fundamentals such as revenues, book values, dividends, and
cyclically-adjusted earnings, the S&P 500 is somewhere between 40% to 70% above pre-bubble valuation norms, depending on the measure. That’s about the same point they reached at the beginning of the 1965-1982 secular bear period, as well as the 1987 peak.

"Stocks are far less overvalued than they were in the late-1990s, but it is worth noting that nearly 14 years of poor market returns have resulted simply from the retreat from those bubble valuations to the current rich valuations. If presently rich valuations were to retreat again to undervalued levels that have accompanied the start of secular bull markets (see 1982 for example), stocks would produce yet another extended period of dismal returns.”

So, if profits have been propelled by “extreme fiscal deficits,” which ostensibly are coming to an end as part of a reduction in government spending and deficit reduction, would it be illogical to presume that profits could decline from their current, highly elevated levels? Well, that depends in large part on GDP growth.

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GDP growth will be determined to a great degree by jobs, income, and consumer spending. In looking at these variables, we know that the “tax holiday,” the 2% of the Social Security withholding that was removed to stimulate the economy, is coming back. This will impact GDP anywhere from 0.75% to 2%, depending on how you factor the tax multiplier effect.

Now we have to add in the other tax increases and/or spending cuts that will most surely be part and parcel of any agreement between the White House and Congress on addressing the fiscal cliff. Additionally, there are the new taxes associated with the Affordable Healthcare Act.

If one is intellectually honest and able to set aside any political and economic biases, a reduction in government spending, deficit reduction, and tax increases will detract from GDP. For an economy that is already muddling along at best, the math isn’t very encouraging for GDP growth, let alone jobs, income, and consumer spending.

As disconcerting as the above is, we still haven’t factored in the possibility of something bad happening in Europe, which would no doubt have some effect on the US economy. Taken in their totality, all these variables could spell recession, which is not good for earnings or for GDP.

As long-time readers to our service know, however, earnings are a moving target no matter the macroeconomic conditions. For this reason, we focus on metrics that are less affected by cyclicality—most specifically the cash dividend and the dividend trend.

For the long-term health and viability of a company’s dividend, it is important that the company builds flexibility into the structure of their business to be able to withstand the inevitable downturns that occur within the normal course of the business cycle. Two examples of a flexible structure are a manageable level of debt and a payout ratio (the percentage of earnings that are paid to the shareholders as dividends) that will not endanger the dividend in the event earnings are impacted by poor macroeconomic conditions.

There is a legitimate debate about whether the payout ratio should be calculated using earnings or free cash flow. Free cash flow is the cash that remains at the end of the year, or quarter, after a company pays all its bills and pays for any new capital expenditures. This cash can be used for expansion, dividends, reducing debt, or other purposes.

Time and space limit the discussion about the myriad variables that must be considered before we make such a substantive change about the metrics we report in our data tables. However, we are deliberating whether such a change can add value to your investment considerations.

Whatever the outcome of those deliberations, we would suggest that our tried and true screens of identifying high quality and good current value, such as limiting considerations to Undervalued companies with a “G” ranking, an S&P Quality Ranking of A- or higher, and a modest level of long-term-debt-to-equity, will continue to provide long-term real total returns, which is the sole reason for investing in stocks in the first place. Squirrel!

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