When is "Cheap" Cheap Enough?
Everyone agrees that you should buy stocks when they’re cheap, but no one ever seems to agree about what “cheap” is…or least, what “cheap enough” is.
The definition of “cheap” is, in fact, the opposite of Supreme Court Justice Potter Stewart’s classic definition of hard-core pornography: “I know it when I see it.” Almost no one knows what “cheap” looks like, even when it is standing stark naked before their eyes.
When stocks were selling for seven times earnings in 1982, they didn’t seem cheap enough to most investors. Sure, someone was buying Boeing, Dupont and Exxon at less than seven times earnings in 1982. But someone was also selling them. And someone was also selling these stocks at nine times earnings in 1980.
With the benefit of hindsight, nine times earnings was “cheap enough” in 1980, even though these stocks would tumble 25% to 50% during the next two years. Boeing, for example, fell more than 50% from its highs of 1980 to its lows of 1982! But during the decade of the 1980s, as a whole, Boeing shares quintupled! The shares of DuPont and Exxon posted similarly spectacular results for the decade. Clearly, US Blue Chips were cheap enough in 1980.
By contrast, US Blue Chip stocks have seemed “cheap enough” to most investors during most of the last 10 years. But these appraisals were frequently off target. Anyone who purchased an S&P Index fund between April 1999 and January 2001 would still be nursing a loss…more than nine years later! Similarly, anyone who purchased an S&P 500 Index fund October 2005 and September 2008 would also be nursing a loss.
The good news is that this “lost decade” was not a total loss. The opportunistic buyer of US stocks at the market lows of September 2002 would have enjoyed a 60% return over the ensuing eight years – equal to about 6% per year. But guess what? Buying 10-year Treasury bonds in the fall of 2002 would have produced an even higher return…with much less volatility and risk. From this perspective, stocks were still not cheap enough, even at the lows of 2002.
Maybe US stocks were finally cheap enough in March 2009, when the S&P 500 touched a 12-year low of 666. But even at that diabolically depressed quote, the S&P was trading for 12 times estimated earnings. To be sure, that valuation was very cheap relative to recent history…but not so cheap relative to the history of important buying opportunities. During the Great Buying Opportunity of 1977 to 1982, the S&P 500 never traded above ten times earnings.
Nevertheless, the opportunistic buyer of stocks at the market lows of March 2009 would be sitting atop a plump 70% return…and would have amassed that gain in just 15 months. But even if stocks were cheap enough to buy in March 2009, are they cheap enough to hold (or to continue buying) in August 2010?
To answer this question, we must understand what cheap isn’t. Cheap is not, for example, a constant or an absolute. It dwells in a world of relativistic assessments. It is more Las Vegas than Mount Sinai. Cheap always resides in the context of competing investment opportunities.
Many investors did not buy stocks in 1980, even though they were selling for seven times earnings, because long-term Treasury bonds were yielding 15%. Stocks were statistically cheap. No doubt about it. But to justify taking the risk of buying stocks in 1980, an investor would have had to anticipate annualized returns above 15%. To many investors, that hurdle seemed too high to try to clear. When risk-free Treasurys provided a 15% return, buying stocks – even very cheap stocks – seemed not just imprudent, but ridiculous.
By contrast, the statistically not-cheap equities of today face negligible competition from most other asset classes. Short-term Treasury securities yield next to nothing, while long-term Treasury securities yield only slightly more than nothing.
Furthermore, we would remind our dear readers, equities represent interests in enterprises that produce capital, rather than obligations from a government that absorbs capital. Therefore, as James Grant argues in a recent issue of Grant’s Interest Rate Observer, many US Blue Chip stocks may be cheap enough…at least relative to Treasurys.
“We’ve come to favor the ‘risky’ equity of Johnson & Johnson…over any long dated ‘safe’ claim on the US Treasury,” says Grant. “What’s ‘risky’ and what’s ‘safe’ is a question that time alone will answer. Ten years from now, we hazard, somebody is going to be very surprised…
“Because Treasurys have been in a bull market since 1981,” Grant continues, “they tend to get the benefit of the doubt. No such free pass is accorded these days even to the sturdiest of American corporate oaks.”
Johnson & Johnson is one of the sturdiest oaks on the Wall Street chaparral, according to Grant. “J&J has been around since 1887,” he observes, “when Grover Cleveland, a gold-standard man, was in the White House. The company grew up in a monetary turmoil of the 1890s. It survived the dollar devaluation of 1933-34 and every subsequent monetary system including the interwar gold-exchange standard in the postwar Bretton Woods regime…J&J operates in 60 countries (slightly more than half of its sales come from abroad) and employs 115,500 people. In 2009, sales totaled $61.9 billion…”
What’s more, Grant notes, the company recently raised its quarterly dividend for the 48th consecutive year. And yet, this robust shade tree sells for a valuation that would embarrass a sapling.
“Since 1980,” Grant’s colleague, Dan Gertner, observes, “JNJ has traded an average price-earnings multiple of 20.8 times. It is currently trading at 12.6 times trailing net income at 12.1 times the 2010 estimate. It yields 3.7% and is one of the four AAA-rated industrial companies left in United States.”
Johnson & Johnson, Grant concludes, is one of a small handful of “immense, fast-growing, well-financed, world beating enterprises that [are] somehow regarded by the mass of investors as a little less desirable than the 10-year Treasury.”
Grant suggests taking the other side of this trade.
“Safety first, we say – and Treasurys last.”