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*ALERT* Scribbles and More Newsletter Portfolio Changes

publication date: Jun 12, 2020
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author/source: Brian Nelson, CFA
*ALERT* Scribbles and More Newsletter Portfolio Changes
Image: Why are stock prices increasing while the near-term economy and near-term earnings outlook isn't as bright as before...How unlimited quantitative easing, runaway government spending, increased inflation expectations impact equity values...Why this year's earnings expectations or next year's earnings expectations don't matter much...Why Valuentum thinks equity values are rising today, even as the near-term outlook remains unclear. Scribbles on page 76 of Value Trap.
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"I know it sounds crazy to say so during a global pandemic and during a recession, but the right multiple and the right earnings to use to value this market is an 18-20x multiple on $196 earnings, putting a fair value range on the S&P 500 today of 3,530-3,920. The S&P 500 is trading at about 3,000 today." 
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By Brian Nelson, CFA
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We've been keeping a running feed/stream of our emails, so new members can evaluate our track record during this crisis and existing members can check in to see if they miss anything. With all the market turbulence during the past few months, we think the feed has worked well as readers can catch up on prior work as they wish. 
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Typically, below each title and before the text of the article, you'll find the date that a piece was written. For example in the note below this one on this feed, you'll see "This note was emailed to members June 11." Not this note silly, the one below this one in this feed here. The most recent article will always be the one in the title of the email. We think this is rather self-explanatory, but if you're scrolling quickly, you may miss the time element to this dynamic.
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I say this because as the market ebbs and flows, our opinion is going to change. For example, in February, we were expecting a market crash. At the bottom in March, we thought dollar cost averaging made a lot of sense. Through yesterday from the end of April, the newsletter portfolios have been riding the strong bull market wave, something we think will continue. With that said, so where are we today? 
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For starters, we think we're still in the early innings of a "blow off top" scenario. The sell-off June 11 didn't have much substance to it. Not much was happening technically across the market, and while there may be a second wave of new COVID-19 infections, we know a lot more about the virus than we did in February. This is certainly not February. We're well on our way to knowing that at some point in the future, we *will* get past this thing. There is no longer any doubt in my mind, as there might have been in February/March. 
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The Right Multiple
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Many of you use multiples in your work, and that's fine, but I want you to understand the multiple that you are using. Every multiple expands into enterprise valuation, or a discounted cash flow model. So, for example, if you say you want to use 15x or 20x P/E to value the markets, there's a DCF model (and thousands of forward-looking assumptions) that back it up--you know, one of the themes of Value Trap. Where investors get into trouble is when they start throwing multiples on the market (and companies) and don't realize it is the DCF that drives the multiple and price. 
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There are bears on Wall Street, for example, that are merely throwing a 15x multiple on next year's expected earnings to come up with a ridiculously low S&P 500 price target. This approach makes absolutely no sense. For starters, stock prices are based on expectations long into the future, and Fed and Treasury policy have all but created an environment where higher multiples should be applied. In the image above (at the very top of this article with red scribbles), I show what is happening to DCF models (values and prices) today as it relates to both the impact of COVID-19 and aggressive Fed/Treasury policy stimulus. 
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As shown by the red scribbles, the near-term composition of the value of companies is declining (COVID-19 is depressing near-term earnings), but this reduction is more than offset by expansion in the intermediate and long-term values, which are driven more by normalized expectations, not the least of which is a lower discount rate (lower interest rates) and higher inflation (pricing power, growth) driven by Fed/Treasury actions. This means that the net overall value and price of equities is actually rising during this pandemic and recession. 
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Prior to COVID-19, for example, a 15-16x multiple on long-run normalized earnings (not next year's or the year after that) may have made sense, but today, perhaps an 18-20x multiple on long-run normalized earnings may be most appropriate. The multiple on this year or next year's earnings should then be astronomical. Don't worry about the talking heads on TV talking about lofty multiples on this year's earnings. Multiples on this year's earnings expectations should be enormous. With that out of the way, what are normalized earnings and how should we think about them?
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The Right Earnings
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Let's first throw out historical earnings numbers. Markets are forward-looking. You're not investing for last decade's dividend, are you? Good. That's why markets are forward-looking because you're investing for next quarter or next year's dividend (or dividend growth in the long run). Next, we know using this year's earnings or the year's after that doesn't make much sense. Just because a company has negative earnings doesn't mean it's worthless, for example. Therefore, we know there's a time element to valuation (as well as the balance sheet, etc) that we must embrace. So if not historical and if not next year's earnings, or the year's after that, what earnings should be put on that 18-20x multiple?
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You guessed it: long-run normalized earnings (not peak, not trough, but normalized). We know the U.S. has managed to prevail through just about everything that has been thrown at it, and we expect COVID-19 to be no different. We already survived a prior pandemic early last century, which was far worse than COVID-19. We also know that pre-COVID-19 2021 earnings numbers (~$196) were within reach and achievable, prior to the pandemic. It's reasonable to assume we're going to get back to those levels eventually, and as history has shown (even from the Great Recession), those pre-COVID-19 numbers might turn out to be low toward the middle of this decade, much like 2018 earnings numbers doubled from those in 2010 (see below). Therefore, on a conservative basis, we think the right normalized earnings number to use for a higher multiple is ~$196.  
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Image: Consensus earnings estimates for S&P 500 companies, as of February 28, 2020, prior to business shutdowns and the worst of the COVID-19 pandemic.
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The Right Value for the Market
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Even though we are talking in terms of price and earnings, using the P/E ratio to explain our valuation of the markets, our thoughts are soaked in DCF interpretation. For example, the DCF explains why a higher multiple is appropriate, and the DCF explains why the near term doesn't matter much, and why normalized numbers should be used in the valuation context. I know it sounds crazy to say so during a global pandemic and during a recession, but the right multiple and the right earnings to use to value this market is an 18-20x multiple on $196 earnings, putting a fair value range on the S&P 500 today of 3,530-3,920. The S&P 500 is trading at about 3,000 today.
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Yesterday, we made a few portfolio tweaks, which raised some "cash" in the newsletter portfolios, and today, we're putting that "back to work." We're putting the proceeds from the removals yesterday, less the new put option "partial hedge," back into Microsoft (MSFT) and Apple (AAPL), allocating the remaining proceeds equally to both in both newsletter portfolios to go back to "fully invested" (both Microsoft and Apple will now be in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio). 
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Our thoughts on re-adding Apple and Microsoft to the newsletter portfolios are rather simple. Aside from our liking them on a firm-specific basis, if the economy heads south, they've shown an ability to hold up better than most. If we see interest rates lower for longer, their dividend growth potential is enormous, which is a big catalyst for income/yield seekers, and if we do see a strong economy and market, they will participate, and perhaps even lead. One can say we should have never removed them, but we now know much more about COVID-19 than we did many months ago.
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We'll have the updated newsletter portfolios ready to view this weekend. We remain bullish on the markets. We remain bullish on big-cap tech, and we remain bullish on large cap growth. We're available for any questions. Have a great weekend!
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Brian Nelson owns shares in SPY and SCHG. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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Joshua Wojnilower (Washington)
 

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