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Looking Backward and Forward – Q4 2020 Review

In 2020, the SP500 has returned 18.40%, vs. 3.39% for Euro Stoxx 50, 16.01% for Nikkei 225, and 17.05% for the iShares MSCI Emerging Market. Those are stunning returns (with the exception of the European markets) for the world equity markets amid a once in a lifetime pandemic, from which the world is still looking for an exit. Those extraordinary returns are the result of enormous fiscal and monetary responses around the globe. In addition, many industries have benefited tremendously from the pandemic, unlike a typical economic recession when almost everyone gets hurt. The largest firms have also performed well or better than their smaller rivals, as they had better resources to adapt. Further, with the rapid development of therapeutics and vaccines for Covid19, the odds for a V shaped recovery are high and equity markets usually act ahead of the curve. All in, 2020 is a year when sectors and industries had very different fortunes and the bifurcation of the haves and have-nots has reached a new extreme.

When we assess a typical SP500 firm ending the 2020 roller coaster, its valuation has become quite unattractive since June of 2020. Granted, the SP500 could stay unattractively valued for an extended period, as was the case in the late 90s through early 2000s. The “stretchy” valuation then, resulted from a multi-year long bull market, followed by, a crash. Today, the SP500 valuation could also improve, if discount rates decline or cash flows improve relative to current expectations or both. Valuation for the S&P500 hit a low point in late 2009, for example, but improved in 2010 and 2011. In this case, the “stretchy” valuation was the result of pessimistic cashflow forecasts amid The Great Recession, while the market rallied back from a sharp sell off. Once long-term interest rates hovered around much lower levels and the economic recovery took hold, the index’s valuation level started to improve, reflecting improving fundamentals. The situation we are facing right now is interesting. The current rich valuation follows a multi-year bull market. However, risk free rates are already at historically low levels, which have very limited room for further downward movement. The latest Fed forecast called for US 2020 GDP to decline 2.4% from 2019, and for 2021 GDP to rise 4.2% from 2020, suggesting the 2021 GDP would surpass 2019 by 1.7%. For SP500, the current EPS estimate is $169.20 for 2021, nearly 4% higher from $163.02 in 2019. The SP500 right now is nearly 20% higher from the close of 2019. In comparison, the SP500 EPS grew 47.3% from 2009 to 2010 and 15.1% from 2010 to 2011. Forward P/E for the SP500 is 23 times right now, vs. 13 times at the end of 2009. For stocks’ valuation to improve, the economy will likely need to grow at a much faster rate than currently expected, or companies will need to deliver much better margins in this growth environment than currently projected.

Percent to Target – Current – Compares the intrinsic value estimate to the most recent closing price for each firm.

Intrinsic Value – The cash flows implied by fading Economic Margins and diminishing capital growth over each firm’s Competitive Advantage Period can then be discounted to a present value estimate of a firm’s enterprise value. Debt and other obligations with superiority to common equity holders can be subtracted to estimate the intrinsic value of a firm’s equity, and this can be divided by current shares outstanding to estimate the firm’s stock price.

*Applied Finance Research Data

Incorporating the latest 10 Yr US Treasury yield into our market derived discount rate calculation, the Equity Risk Premium (ERP) per our estimates, is currently at ~6.8% for nonfinancial US firms in nominal terms, significantly higher than the historical median and average of ~4.5%. With the risk free rate historically low, equity investors seem to be demanding a fair amount of protection, though the market appears overvalued despite the high ERP.
*Applied Finance Research Data

When we examine Financial firms, their Equity Risk Premium (ERP) per our estimates, is currently at ~8.9% in nominal terms, their highest point since 1980. Everything else equal, Financials appear to be more attractively priced than the industrial firms.

*Applied Finance Research Data

With 10-year US Treasury yields continuously rising, discount rates for equities could also rise. Once that happens, the market must either correct, investors need to lower their return expectations, or future cash flows would need to increase significantly, to justify the market levels. As Yogi Berra said, “It’s tough to make predictions, especially about the future”, but Wall Street seems to have become extremely flexible in justifying any situation: Right after the November election, the stock market rallied because, according to the pundits, investors liked the prospect of a split government, which would likely result in a better relationship with China and other countries, while at the same time policies such as increasing taxes would not pass. Now the Georgia senate runoff election resulted in a democratic majority in the Congress, which means no split government and high odds for upcoming personal and corporate tax increases. The stock market again rallied cheerfully because, according to the pundits, more stimulus spending will be passed ushering in a faster and stronger economic recovery. The question being ignored, is whether more borrowed stimulus spending will overcome reduced profitability and growth because of potentially higher corporate and personal income taxes? We are very wary of this “rally on anything” mentality.

Valuation can be stretched for a while, as history has shown, but as always, the Valuation 50 will seek to invest in the best names with attractive relative and absolute valuations in their respective sectors, commanding strong fundamentals, and sustainable competitive advantage. Intrinsic value calibration is a result of the dynamic interactions of companies’ economic profitability, investment strategy, risk, and competition. While the pandemic has had a dramatic impact on most companies regarding the four valuation components, it did increase our appreciation for competition and risk, for example:

It is amazing to see how Disney (DIS) boasts more than 90 million Disney + subscribers, a year after the service’s inception. Management now forecasts to have 230-260 million global subscribers by 2024, vs the prior 2024 target of 60-90 million. For a point of reference, Netflix (NFLX) currently has approximately 200 million subscribers worldwide, and it started its streaming services in 2007. While Netflix performed well during Covid, the pandemic enabled Disney to become a formidable competitor at an unprecedented pace, which neither company could have imagined.

Disney’s streaming success is a result of perfect timing –the worldwide lockdown happening just 6 months after the Disney + launch, but more importantly management’s strategic decision a couple of years ago to create streaming services as a platform to expand its portfolio and strengthen its competitiveness. Disney also had the balance sheet and financial prowess to invest, launch, and grow the new service, which demands an enormous amount of capital. Size and leverage are indeed the critical gauges for risk. The large and less leveraged tend to be in better position to navigate choppy waters.

The future path of the virus, the mass distribution of the vaccines, and the Biden administration’s implementation of the policies he campaigned on, especially regarding taxation and the green economy, may increase price volatility, especially to a valuation stretched US equity market. We expect to gain more clarity on companies’ mid to long term prospects in the year ahead. We will continue to focus on companies’ fundamentals and their valuation resilience.


  • Jun Wang, CFA – Applied Finance Partner Joined Applied Finance, 2003. Portfolio Manager and Fundamental Research Analyst. B.A. Southwest University China, MBA from California State University, Fresno.


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