Sunday, January 24, 1999

Now it seems unlikely.

But there was a time, before 1982, that Business Week adorned its cover with a somber question, cast in big type:

"Are Equities Dead?"

The question seems ridiculous today, but it drew serious attention then. Stocks had gone nowhere for years. Many were selling below book value per share. Most were selling far below the actual replacement value of their underlying hard assets. A typical stock was valued at about 8 times trailing earnings. That's less than one-third of the current market multiple.

At such prices, corporate management was reluctant to issue new shares because it would dilute shareholder equity. And, not surprisingly, executive compensation was in cash, thank you. No one talked about stock options.

Now I am waiting for a new cover on Business Week. This one will ask an equally cosmic question:

"Are Equities Immortal?"

The prices certainly are supernatural.

Skeptics should consider some recent comments from Jim Grant, editor of Grant's Interest Rate Observer. In his December 18 issue he pointed out that it was now possible to bring an Internet company public and the cost of the underwriting could be as high as the companies revenues for the preceding year.

AboveNet Communications, for instance, went public on December 10th, raising $65 million on sale of five million shares at $13. Of that sum, $4,550,000 was "gross spread", a broad measure for the cost of the underwriting.

What kind of sales did AboveNet Communications have? Try $4.8 million in the preceding 12 months.

Similarly,, underwritten by Hambrecht and Quist, Nationsbanc Montgomery, and Dain Rauscher on December 15, raised $75 million. The underwriting cost $5.25 million which was 85.7 percent of the companies $6,127,000 in sales revenue in the preceding 12 months.

In the same issue Mr. Grant wondered what it was that made eBay, with less than $28 million in revenue and $1 million in profits, worth $7.8 billion while Sotheby's, with nearly $400 million in revenue and $31 million in profits, was worth less than $1 billion.

The problem here isn't just frothie Internet stocks. They are only symbolic of how completely we have embraced the idea that stocks are the only possible good investment.

In fact, any investment, whatever its quality, won't be good for us if we pay too much for it. Many investors are counting on having a "Goldilocks" economy forever— low inflation, low interest rates, and rapid growth. It has been argued, for instance, that while the historical P/E multiple on stocks is only 14, the current serenity and vitality of our nation and the world may justify a multiple of 25 or more for the indefinite future. It has also been argued that we are in an era of rapid growth. In this era, many companies will be able to grow much faster than the historical 7 percent growth rate of corporate earnings.

So let's do some imaginary testing of the future.

If a stock has no dividends (and most are miniscule to non-existent these days), its entire value to us is what investors will pay for it in the future. Suppose, for example, that you buy a stock earning $1 a share for $25. That's 25 times earnings. If the earnings double in 7 years (reflecting a 10 percent growth rate in earnings) the price of the stock should double as well, provided only that investors are still willing to pay 25 times earnings.

Your return will increase if investors are willing to pay more for a dollar of earnings. Over the last 15 years, nearly 8 percent of the annual compound return of the Standard and Poors 500 index came from investors being willing to pay more for earnings. That's what an expansion of P/E multiples can do for you. More than dividends. More than the historic rate of earnings growth.

It can work the other way, however, if future investors are willing to pay less for a dollar of earnings.

But lets not worry about that. All other things being equal and unchanged, your future return will be equal to the growth rate of earnings.

Query: What does Wall Street expect for earnings?

To examine this I used Morningstar Principia Pro for stocks, data from December 31, and checked the range of analyst earnings expectations over the next five years. Nearly 4,000 companies had long term earnings estimates, with a median expected growth of 16 percent a year. A whopping 90 percent of the companies were expected to grow at 9 percent or better. The table below shows the expected growth range by decile.

Forecast: Boffo Earnings Growth

Decile Expected 5 Year Annualized EPS Growth
Top 10% 31-80%
2nd 25-31
3rd 21-25
4th 19-21
5th 16-19
6th 14-16
7th 12-14
8th 11-12
9th 9-11
10th 0- 8

In this ideal world, more than 90 percent of all stocks would provide returns better than bonds and the most common return would be about 16 percent, a slowdown from recent years but still way over historical averages.

The message: invest away Mr. and Ms. J. Q. Public!

The caveat?

Analysts, as a group, are compulsive optimists. What they project and what happens is seldom the same thing.