VALUE INVESTING
(April, 1999)
"The ultimate
value of
a company is the
present value of its
future cash flows."
The ultimate value of a company is the present value of its future cash flows. However, this most basic concept sometimes gets overlooked by many investors, as they simply look for companies with recognizable names or that are in the current spotlight as places to invest without regard for the companies' future earning power and growth rate.
Most people say, "I just want the best stocks". However, this can be interpreted several ways. We find many people that invest refer to the "best stocks" to mean stocks of high investment quality. Other people use the words "best stocks" to mean having a good short-term outlook or that have gone up the most. When we use the term "best stocks", we mean simply the best values. That is to say, those stocks whose market prices are lowest in relation to their intrinsic or private market value.
The National Bureau
of Economic Research explains why value strategies work: "Value strategies
work because they are contrarian to other strategies followed by other
investors. These other strategies might range from extrapolating past
earnings growth too far into the future, to assuming a trend in stock
prices, to overreacting to good or bad news, or to simply equating a good
investment with a well-run company, irrespective of price. Regardless
of the reason, some investors tend to get overly excited about stocks
that have done very well in the past, buy them up, and these "glamour"
stocks become overpriced. Similarly, they overreact to stocks that have
done very badly, oversell them and these out-of-favor "value"
stocks become underpriced. Contrarian investors bet against such investors.
Because contrarian strategies invest disproportionately in stocks that
are under-priced, and under-invest in stocks that are overpriced, they
outperform the market." This type of investor psychology provides
us with great investment opportunities.
Now, let's review some basic ratios that we use in our fundamental evaluation
of companies. As a benchmark for large companies, let's examine the ratios
of the S&P 400 index.
The average price to sales ratio from 1960 through 1998 has been .88 times sales. The historical low was .38 times sales in 1979. Previously, the highest the S&P had sold in relation to sales was 1.22 times in 1961. In 1997, the S&P surpassed this record and is currently selling at an all-time high of 1.75 times sales. This is 98.86% above the historical average and 43.44% higher than the 1961 record.
The next ratio we'll examine is the price to cash flow ratio.
The average price to cash flow ratio, from 1960 through 1998, has been
9.1 times. The historical low was in 1979 at 4.59 times. Previously, the
highest the S&P had sold relative to its cash flow was 12.72 times
in 1961. In 1997 the S&P surpassed this record and is currently selling
at an all-time high of 15.75 times cash flow. This is 73% higher than
the historical average and 23.82% higher than the previous record set
in 1961.
The last ratio we will review is the price to earnings ratio ("P/E").
The average price to earnings ratio of the S&P 400, from 1960 to 1998, was 18. The historical low was 8 times earnings in 1974. Previously, the highest price to earnings ratio ("P/E") for the S&P 400 was 22 times earnings in 1961. In 1997, the S&P surpassed this record and is currently selling at an all-time high of 30 times earnings. This is 66.67% higher than the historical average and 36.36% higher than the previous record set in 1961.
This leads us to the next point of examination. When looking at both small and large capitalized companies, we currently have the widest disparity since 1963.
The way that analysts measure this is by comparing the T. Rowe Price New Horizon Fund versus the S&P. The T. Rowe Price New Horizon Fund is a mutual fund of small companies similar to those found in the Russell 2000.
A look at the above chart shows that at the extreme highs, the smaller companies sell at twice the multiple to those of the S&P. At the extreme lows, they sell at 1 times the S&P. Today, the chart below shows small-cap stocks are selling at the lowest level in 36 years, when compared to large-cap stocks. This chart shows the small-cap to large-cap relationship was 1.04 in June of 1998. As of March 9, 1999, it is lower still at 0.84. This is the lowest level in 36 years.
When we compare the S&P 400 (the index of large-cap stocks) to the Russell 2000 (the index of small-cap stocks), it is apparent that there are tremendous opportunities to invest in smaller companies because these stocks have become more under-valued than large stocks and are approaching their level of maximum pessimism.
It is because of these various disparities in values between a handful of companies and the rest of the market that we have structured our portfolios to reflect this. While the general market is not cheap, on an absolute basis, we believe that the small to medium-sized companies represent the greatest value as we look out 5 to 10 years.
"In 1998,
small stocks underperformed large stocks by the
widest margin in any year since 1929."
-Mark Melzer,
Chief Investment Officer
for Prudential Investments