Is the Dow Jones Industrial Average Over-Valued?
In last month’s newsletter I calculated that the S&P 500 index appeared to be about 41% over-valued. That is, by a wide margin, the highest over-valuation that I have calculated since I began doing this calculation in 2004. Whether or not the current level of the S&P 500 can be maintained is likely to depend more on interest rates staying extremely low than on earnings growth.
This month I have calculated that the Dow Jones Industrial Average appears to be about 6% over-valued. Interestingly, the DOW always seems to look like better value than the S&P 500 based on my analysis. It rarely looks over-valued based on my analysis and in fact this 6% over-valuation is the highest I have calculated going back to 2002. The S&P 500 tends to look more richly valued because it typically trades at a higher price/earnings multiple.
First Quarter Earnings on the S&P 500
This month we will be hearing that the S&P 500 companies have increased their first quarter earnings significantly compared to last year. The current forecast is that the earnings will be 22% higher on a weighted average basis. That is impressive earnings growth indeed. However, the final figure usually comes in somewhat lower than the estimate. More importantly, the Q1 2017 earnings are being compared to a weak Q1 2016 level.
In Q1 2016, earnings had been about equal to the 2015 level which in turn had been 12% lower than the 2014 level. If the Q1 2017 earnings do in fact grow 22% over the 2016 level that will actually only be 9% higher than the 2013 level for a meager growth of 2.2% per year compounded over the past four years. On that basis, we should not get too excited about this 22% earnings growth in Q1 2017. Nevertheless, if earnings do grow as projected for the full year 2017 then the trailing P/E ratio of the S&P 500 will begin to decline from its current lofty level of close to 25. The S&P 500 P/E ratio is just under 20 based on forecast 2017 GAAP earnings. However, it is has been my experience that projected earnings tend to quite optimistic.
Is Competition Working for Consumers?
Almost every company claims that they “operate in a highly competitive environment”. In many cases, this is patently false. Some companies have monopolistic positions in the market. Our report on VISA Inc. notes that it operates as a duopoly with MasterCard when it comes to consumers. But it operates as more of a monopoly from the point of view of merchants. Almost every merchant is virtually forced to accept VISA as well as MasterCard. This monopoly position is the reason that some governments have stepped in to regulate the charges to merchants.
At the end of the day, the high returns on equity that many companies make are proof that they do not in fact operate in a highly competitive market. To be sure, some companies do face stiff competition in regards to the prices they can charge. But many do not.
When the market for a product is truly highly competitive in terms of the prices that can be charged then the profit or return on equity gets competed down to about the lowest level acceptable. In a world where investors can earn only about 2% on a ten year government bond, the lowest acceptable return on equity is surely in the single digits. Any company facing a highly price competitive market would be unlikely to earn more than about an 8% return on equity in this low interest rate environment. And there are entire industries where companies have historically struggled to make any return at all. Airlines and most commodity producers come to mind.
Yet, it turns out that the average ROE of the DOW 30 companies is about 17.5% and has been in that range for at least a decade. I have an article that explores the surprisingly high ROEs of large companies in more detail.
Unless a company has the lowest costs in an industry, it will usually avoid getting into a situation of competing primarily on price. Companies do this in many ways. Companies attempt to differentiate their products in the minds of their customers through branding. Starbucks can charge a higher price for its coffee partly because it has succeeded in convincing customers that its coffee is different than and superior to competing coffee offerings. Consumers have a great deal of loyalty to their favorite brands and this allows suppliers to avoid competing too aggressively on price.
Companies also attempt to eliminate competition by buying up their competitors.
The high ROEs achieved by most large companies is proof positive that they have succeeded in avoiding having to compete aggressively on price.
This has been to the advantage of investors and to the disadvantage of consumers.
The risk to investors is that governments will turn their attention to the lack of aggressive competition and take measures to increase competition. To date, various competition regulators seem to approve most corporate acquisition proposals even when they have clearly lowered competition. And when companies have managed to monopolize an industry governments have largely not interfered.
As an investor, I try to focus on companies that do not operate in a highly price-competitive environment. There are many to choose from. In cases where the industry is highly price-competitive then it is best to look for companies that have the lowest costs. Costco is a case in point.
The Canadian Economy
Our reference article that looks at the makeup of the Canadian economy has been updated. It’s interesting to see which industries are the larger contributors to Canada’s GDP. And it is frightening to see how very little of Canada’s exports go to countries other than the United States.
Start Your Youngsters Investing Early
If there are young people in your family that are interested in investing in individual companies, they can get started with very little money. The trading fee to buy stocks in a self-directed account is $10 or less. For small accounts there is also usually an annual fee of about $100. But this fee usually does not apply if other members of the household have self-directed investment accounts that total about $50,000.
An 18 year old could open a Tax Free Savings Account with as little as $500 or $1000 if they wanted to gain some experience in owning individual stocks. They could pick a few companies or even just one company and buy as little as one share. A $10 fee on buying say $250 worth of some stock is a bit hefty at 4%. But it is also only $10 which is a small price to pay for the education that getting started investing in individual companies could provide.
From the perspective of maximizing return and diversification it would make much more sense to stick with mutual funds and ETFs when first starting out. But from the perspective of making the process interesting and educational going with individual companies would be more beneficial in many cases.
For young people under the age of 18, the account would have to be set up in an adult’s name but can be in-trust for the child.
END
Shawn Allen, CFA, CMA, MBA, P.Eng.
InvestorsFriend Inc.
April 23, 2017