I’ve wrote many times about certain areas of the market being expensive, such as utilities and consumer staples. The biggest reason for the disconnect between price and value in my estimation is that the Federal Reserve’s zero-interest rate policy has forced investors and savers into high-yield stocks to generate income. Because many utilities and consumer staples companies are slow to no-growth companies, they tend to pay out larger percentages of their earnings as dividends.
For example a company that makes $100MM and has a market cap of $2.5 billion, trades at 25 times earnings. If it pays out 90% of its earnings as a dividend, the yield would be 3.6%. 25 times earnings is a very high multiple to pay for a slow-growth business and most of these companies trade at significant premiums to their historical mean valuations. A 3.6% dividend yield might look attractive in world with a 10-year U.S. Treasury bond that yields 1.8%, but any increase in interest rates or sell-off in the equity markets would leave the investor that pays 25 times earnings for this business at a serious risk of taking a permanent loss of capital, which is what we try to avoid at T&T Capital Management (TTCM).
Because of today’s market stigmas for industries such as financials; most market participants feel a lot better owning a company such as a Pepsi or a Kellogg, than owning a controversial company such as AIG or Citigroup. The reality is that all four of these companies have similar growth prospects but the valuation disconnect is absurd. AIG and Citi trade at discounts to liquidation value, while Pepsi and Kellogg trade at 20-25% higher than their historical mean valuations. Pepsi and Kellogg are better businesses, as defined by returns on equity and capital but that has always been the case and is why they trade at many multiples of book value as opposed to most financials. Therefore the recent disconnect in relation to historical mean valuations, is where you can see the skewed psychology in today’s market. I know that this can be complicated but bubbles generally form when the consensus view becomes too prevalent, which in my opinion has occurred in many of these stocks that most would refer to as “blue chips.” It isn’t much different to what occurred with the Nifty Fifty in the 1960’s or technology stocks in the late 1990’s.
Below is a helpful little article that shows what I’m talking about with Altria (MO). Remember, the most important part of the investment process is the price paid versus the underlying intrinsic value. Over the long-term, popularity and fads serve to lead most market participants astray. This is why short-term mark to market fluctuations should not be weighed too heavily because they have very little meaning to the long-term success of any given investment and pandering to these unpredictable fluctuations, generally leads to lackluster long-term investment returns.
Altria Shareholders – Should Consider Quitting