One good thing about that comes from trying to find value in an expensive market on a regular and ongoing basis is that eventually it dawns on you that among other things, there are an awful lot of stocks which offer very poor value to investors in the sense of any potential increase/decrease to their Fair Market Value (the dotted FMV line on our charts), and yet which the stock market persists in pricing at extremely high valuations (in the SVA price/book sense). When we find a stock that trades at 8 times book value or higher, and whose fair market value is only half of the current price, we have to expect that sooner or later some – or all – of that excess pricing will be taken away. Certainly, based on our experience with our FMV measure, it has had a powerful tendency to attract prices so that when we find that the downside risk of any given stock is 50-70% or more, we can say with confidence that the resulting hole that will be left in ones’ portfolio will be substantial.
When we ran the data for the S&P 500, we discovered, for instance, that 241 stocks in the S&P Index are currently trading with zero to negative Fair Market Value. Now, this is not the bottom of the stock market in a nasty recession that we are referring to, where earnings may have disappeared for the time being and which are likely to bounce back when the economy turns stronger, but eight years into a bull market expansion during which time investor confidence in a number of stocks has vastly outrun the ability of the underlying companies to generate supporting value. Worse, the overall earnings for the S&P 500 have been weakening for 5 quarters running. Of course, the analysts are claiming that 2017 will be a strong rebound year. It will have to be – and in some cases, several more – in order to justify paying some of the prices/valuations that we are seeing. But there is scant evidence that anything like that is remotely possible, save in the imaginations of those forecasting what may well turn out to be impossible earnings.
We have been here before. Only the names of the stocks have been changed to protect the innocently naïve. In 2000, it was high technology with their “for sure” big earnings gains needed to justify their outrageous market price/book valuations. Today, it is Tesla and Netflix among others where big sales and earnings growth are coming – for sure – to justify their massive valuations. Maybe yes, and maybe no – but when the stock market begins to pay for results too many years in advance of their appearance, then it is time for a little prudence to prevail.
When we ran the data for the TSX, of the 230 stocks that we have data for, 130 have zero to negative FMV Potential, with 96 showing actual downside FMV risk potential. We have to underline the reality that nothing is for certain, and just because there is negative FMV potential, it does not mean that a given stock will crater, or even go down. However, in our experience with this measure, when markets do fall, the stocks with very poor FMV potential often do very badly by outperforming other stocks on the downside. The issue is that the same psychology that drove the stocks up way in excess of any semblance of reasonable value, gets turned around against those same winners. We have only to consider the recent experience of Valeant Pharmaceuticals (VRX). When things were going well, management were geniuses, and industry consolidation was the miracle answer to creating value. In the crash, the leverage generated and the questionable goodwill that resulted from high-priced acquisitions saw investors panic when they realized that perhaps there was no, or very little, value at all. Back in 2000, Nortel Networks management created what investors thought was a powerhouse of a company – until investors suddenly realized that they were paying 100 times earnings for a company that was only growing at 15-20% per annum at best (and with a balance sheet equity had virtually all been replaced by goodwill). For the companies that we highlight below, we suggest that you take their bullish “story” and twist it back around and see what you think then. Think about Netflix (NFLX) one of our choices below. Netflix is going to entertain the entire world and is expanding everywhere. Now consider that every telco they are up against is trying to generate content for their own service. Positive earnings are hard to come by and competition is brutal. What is this stock really worth? Time will tell, but at 15 times book value, and an FMV potential of -85%, we for one do not intend to find out by personal experience.
In alphabetical order by company name but not by stock symbol, here are the stocks of two dozen major North American companies whose businesses look unassailable and therefore whose stock prices equally ‘safe and secure’ but who history tells us all too clearly, are vulnerable to massive price declines even if not a lot happens to their future earnings.