Stocks Cheapest in 26 Years Amid Rising Profits

This Bloomberg article points out valuations are getting rather low.

Bloomberg: Stocks Cheapest in 26 Years Amid Rising Profits

As an example of these low valuations, check out the consensus 2011 price to earnings for the large cap stocks among the Dow Industrials:

Company 2011 P/E
3M (MMM) 14.5
AT & T (T) 12.9
Alcoa (AA) 11.1
American Express (AXP) 12.6
Bank of America (BAC) 10.0
Boeing Co (BA) 18.1
Caterpillar Inc (CAT) 13.9
Chevron Corp (CVX) 7.7
Cisco Systems (CSCO) 9.3
Coca-Cola (KO) 17.0
Disney (DIS) 14.5
Du Pont (DD) 12.8
Exxon Mobil (XOM) 9.1
General Electric (GE) 13.5
Hewlett-Packard (HPQ) 7.1
Home Depot Inc (HD) 14.9
IBM (IBM) 12.3
Intel (INTC) 9.3
Johnson & Johnson (JNJ) 13.4
Kraft Food Inc (KFT) 15.4
McDonalds (MCD) 16.0
Merck (MRK) 9.4
Microsoft (MSFT) 9.0
J.P. Morgan (JPM) 8.2
Pfizer (PFE) 9.0
Procter & Gamble (PG) 15.6
Travelers (TRV) 12.2
United Technologies (UTX) 15.6
Verizon (VZ) 15.9
Wal-Mart Stores (WMT) 11.8

Obviously, that consensus could turn out to be optimistic. We could be heading into a soft patch (or worse) that makes those earnings look a bit inflated.

Still, look at the earnings yield (inverse pricing to earnings) of some of the above businesses.  Many comfortably have an earnings yield in the 8% to 12% range. As long as those earnings are truly free to benefit shareholders (i.e. not needed for business competitiveness), that's a solid return even without the long run growth in earnings.

The key thing is that those earnings are 1) free to be distributed to shareholders and/or 2) can be used for incremental investments that ultimately produce high returns for shareholders. Some businesses need to use just about all earnings (or what seems like earnings) to remain competitive. Airlines and automakers come to mind. Those companies only have earnings in an accounting sense but less so in an economic sense.

Speculators can try to jump in and out of these if they want.

Investors would seem to have better things to do with their money.

There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there's never any cash. It reminds me of the guy who looks at all of his equipment and says, "There's all of my profit." We hate that kind of business. - Charlie Munger at the 2003 Berkshire Hathaway Shareholder Meeting

For some of these franchises (not all), zero future growth in earnings over the long haul is no doubt conservative. Many produce lots of excess cash available for distribution to shareholders. What does get reinvested can produce high returns that also ultimately benefit shareholders. Just a little bit of growth on top of that 8% to 12% explicit earnings yield (again, as long as it is of the high quality variety...i.e. earnings not required just to maintain competitiveness) quickly becomes above market returns.

So market prices should -- though hardly a certain -- provide some cushion* for, at least, some of these stocks. The risk of poor near term performance from buying too early is real, but missing the chance to benefit from potential favorable long run economic effects of a franchise can be just as costly (errors of omission).

Buffett has pointed out how costly errors of omission can be:

During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in. - Warren Buffett in the 2008 Berkshire Hathaway Shareholder Letter

The key question is the sustainability of each franchise. If it's long run economics are likely to remain in tact, the short run earnings noise is a distraction with the stock market price dropping a side benefit. The focus should always be on price paid relative to a conservative estimate of probable long run economics produced by the business.

Lending money in the form of something like 10-year Treasuries yielding less than 3% seems, by comparison, very unattractive.

Those 10-year Treasuries probably feel safer to some investors in the short run but that doesn't mean they are actually safer when all risks are considered.

Adam

Long positions in MSFT, INTC, CSCO, HPQ, KO, PG, JNJ, AXP, and JPM. Many of these positions were established at much lower prices.

* Some of the above stocks look even cheaper when you back out the net cash (in the case of tech stocks like  INTC, MSFT, and CSCO) and consider that earnings are still normalizing for the large banks (JPM and BAC).
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Stocks Cheapest in 26 Years Amid Rising Profits
Stocks Cheapest in 26 Years Amid Rising Profits
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