Grated Expectations
Cover Story, by Mark Robertson, Managing Partner June 1st, 2009
If a Rhino falls in the forest, does he or she bounce? How should we think about strategic selling? What role does quality continue to hold.
If a Rhino falls in the forest, does he or she bounce? In this month’s issue, we explore some compelling opinions about changes and disruptions in the Bigger Picture. Should our growth expectations be muted or conditioned? We’ll launch an exploration (continued on our Forum) of the voices and thoughts of investing giants Jack Bogle, Jeremy Grantham and Bill Gross about the hazy crystal ball and roads ahead. Is it different this time? I don’t know. But along with the rest of you, I cherish an opportunity to explore how our methods position us very well for whatever destiny lies ahead. How should we think about strategic selling? What role does high-quality (once again) hold for us?
Fun⋅da⋅men⋅tal adjective
- serving as, or being an essential part of, a foundation or basis; basic; underlying: fundamental principles; the fundamental structure.
- of, pertaining to, or affecting the foundation or basis: a fundamental revision.
- being an original or primary source: a fundamental idea.
The building blocks of our forecasts reside in three basic fundamentals:
- Growth expectations
- Profitability forecasts
- Valuation estimates [P/E and P/CF]
All of these are the underlying components in our projected annual return (PAR) forecasts. How these pieces play out when embedded in our constant 5-year time horizons is what our stock studies are essentially all about. When these characteristics exhibit evidence of a material shift or change, we’re compelled to take a closer look. Understanding the drivers and impact is a path to opportunities and/or capital preservation.
Where Do We Go From Here? Aggregate analyst expectations have been cascading for several months. As shown here, the median EPS growth forecast for stocks in the MANIFEST universe have experienced substantial reductions in projected average P/E ratios (bars) and EPS growth rate estimates (depicted as a line.) I’ve mentioned before that EPS growth forecasts have been 13-15% in “bulk” for as long as I can remember - at least since we started keeping track nearly 20 years ago. Analyst forecasts for 2009 missed badly. Are they overdoing it now?
It’s pretty hard to top the rapid cascade in our median PAR that we’ve dubbed MIPAR. (See Sweet 16, page 6) From levels of 20-25% just a few months ago, we now see levels of 11-12%. One of the factors, of course, is the rapid price recovery for stocks in general. That recovery has been led by the smaller companies. We expected this. It’s at the heart of the reason that we maintain the overall sales growth forecast for our portfolios at sufficiently high levels. It puts us in position to realize the rewards of investing in the “nimble.”
The price recovery has been dominated by companies with the lowest financial strength ratings, weakest balance sheets and “sub-prime” credit ratings. To me, that doesn’t sound like much of a foundation. While prices have soared, the Rhinos have been collectively reducing expectations. Some community members believe the Rhinos are — once again — reliably overdoing it and their forecasts are now way too dismal.
Anatomy of a Recession, Redux. This chart displays actual year-over-year changes in median EPS results from 2000-2008 and forecasts for 2009 and 2010. The 2001 (and now, 2009) recessions show up pretty clearly.
Thud? Bouncing Rhinos?
When a Rhino goes off the high board, how much of a splash does he or she make? I’ll wait and let that image take shape. Go ahead. Smile. The conjured image is at least as funny as the rhino in this year’s Super Bowl ad.
The recession of 2008-TBD was a surprise to many Rhinos with some notable exceptions like Roubini, Schiller, Ritholz and a flock of Black Swans — and perhaps most notably, John Paulson, the hedge fund leader who extracted a few BILLION in personal compensation (for 2008) by betting against the financial sector and homebuilders.
The proof is staring at you in the accompanying chart. In October 2008, a mere two months before wrapping up the final score, Rhinos (in general) were still calling for 10% year/year EPS growth. For 2009, a 15% surge in EPS for the average company burst from the haze of their crystal ball for the “average” company. Confessions being good for the soul, I have to admit that I ingested some of that “recession, what recession” Kool-Aid despite residing at Ground Zero in the Detroit area.
Rhino expectations continue to hover at 10-12% for 2010 vs. 2009. It may seem like they’ve not adjusted their 2010 forecasts, but keep in mind that it’s a year-over-year metric. The substantial reductions in the 2009 forecasts “carry through” to the 2010 forecasts. It’s like knocking down the bar in the high jump and resetting it a few feet lower for the next launch.
RESET: A Lasting Shift in Expectations? Profitability has generally returned to the trend following recessions and corrections. This was true in the aftermath of the 2001 recession, most recently. This figure depicts earnings for all U.S. companies, measured in TRILLIONS. The current recession is shown in the highlighted area. Current expectations for the post-recession period are subdued with lower EPS growth forecasts. 9% growth is nothing to sneeze at. But it’s not 13%.
Speaking of ‘Reset’
From the podium at last week’s Morningstar Investment Conference, PIMCO Bond King Bill Gross shared some concerns about “it just might be different this time.”
Gross characterized the road ahead as “A New Normal” complete with reduced return expectations. Quoting Barton Biggs, he urged all of us, as “children of the bull market” to carefully consider the drivers and potentially new conditions. Is it possible that we’ll morph from a secular bull market interrupted by periodic setbacks to a new, lower-return normal?
I don’t know. But it’s probably not prudent to ignore Bill Gross so it’s worth some serious head-scratching.
As the accompanying figure shows (in concert with the image on page 1) a legacy of mid-double digits could be replaced by “something else.” Recessions and bear markets of the past have more resembled speed bumps — with a return to trend that had been intact.
The expectations for the 2008-2009 recession may be different. In this case, in the period following the recession, is it possible that operating results will not approach previous levels with little or no delay? When they do, is it possible that growth will be “muted” relative to historical tendencies?
What company is shown in the figure?
(b) All of the above. It’s an aggregate of all companies used to form Value Line’s forecast for the U.S. economy.
Best Opportunities? In his arguments at the Morningstar Investment Conference, Jeremy Grantham of GMO made a compelling (and charming) case that it’s probably wise to be bullish about high-quality stocks right now. Source: GMO 7-Year Asset Class Forecasts (April 2009)
Reset Button Implications
Those of you who remember Hill Street Blues probably fondly remember the watch sergeant’s sage, “Be careful out there,” advice as the law enforcement personnel started their days and beats.
And I fully realize that our “beat” is not the total stock market. We seek leadership companies that ooze excellent management with high-quality characteristics. We expect them to be well-positioned in their own “beats”, capturing and optimizing opportunity as a routine vocation on behalf of their stakeholders.
For those of you in investment clubs, do you remember a frustrating moment when “everything” was on sale and you had no cash on hand to deploy? If we’re honest … most of us will admit that has been the case on too many occasions.
This is an opportunity to tackle and destroy the MYTH that we should ALWAYS be fully invested in stocks and funds. My interpretation is that George Nicholson never suggested this — and certainly not for experienced investors.
We’ll explore more about asset allocation according to Nicholson going forward, but for now — think about the last time you procrastinated on selling a clearly-overvalued stock because all potential replacements seemed to be overvalued also. I know that I have been there and done that.Be willing to hold strategic cash (or cash equivalents, more on this to follow) while you prudently shop … for as long as it takes to buy and hold the next stock — for as long as it makes sense to do so.
I was also bolstered by Morningstar conference conversations with Jeremy Grantham (a renowned bubble historian) and Jack Bogle. I think it was MANIFEST subscriber Stephen Phillips who brought Mr. Grantham and his firm, GMO, to our attention on the MANIFEST Forum. From where I sat, Grantham stole the show in Chicago. Nutshell version: Buy high-quality stocks as this “flaky” rally surges ahead. (Jeremy refers to those lower financial strength companies, mentioned earlier, as “flakes.”)
We’ll be exploring the wisdom of a few “Grumpy Old Men” on the MANIFEST Forum in days ahead.
I think Rhinos do bounce. (A little) And RESET buttons happen, enabling our pursuit of flakes and blue chips … when conditions merit. Patiently seek the best fit.
Mark Robertson
Mark Robertson is founder and managing partner of Manifest Investing, a source for research and portfolio management focusing on strategic long term investors.