Subject: OT: big companies
Sort of following on from the bearish slant to Mr Klarman's recent comments--
I don't claim to know what the market will do, nor the few gigantic firms that dominate it.
But you don't have to be the sort of person who tries to time the market to be interested in valuation levels.
If you care about what your portfolio returns will be in future, you should care about how much you're paying for what you're getting.
It's quite reasonable to consider valuation levels when you estimate what it would take to arrive at a decent forward return.
If you care about the forward returns of the broad US market, or the potentially over-optimistic valuations of the giants within it, here's one simple back of the envelope exercise which I think is worthwhile considering.
I assume that nothing experiences super-high growth rates for more than a decade (it does happen, but not predictably).
Since high valuation multiples come from high anticipated growth, I assume that terminal multiples for anything will be in the teens after a few years when middle age sets in.
So, I pencil in a multiple of 19 time cyclically adjusted earnings, tops.
My usual investment horizon for predictions is 5-10 years, being the longest any person can reasonably have an opinion about the prospects of a business.
Whatever good thing you think is going to happen, most of it had better happen by then, since the rest is peering through a glass very darkly : )
The middle of that range is 7.5 years into the future.
If you combine those assumptions with the current price and current earning power, you can estimate the rate of earnings growth that will be required to hit any given desired rate of return from the stock.
A representative "monkey with a dartboard" hurdle rate is inflation + 6.5%/year, what you'd historically have managed with a random US stock bought in a random year.
So I wouldn't invest in something that doesn't give me a better-than-even chance of achieving that result.
The top 7 popular firms in the US market by market cap are currently trading at a collective weighted-average earnings multiple of 36.96.
That's the aggregate market cap divided by the aggregate earnings. (AAPL MSFT GOOG AMZN NVDA TSLA META)
For earnings, I'm using the average of trailing and forward numbers--a plausible estimate of what's going on right now.
If they were all merged and those 7 together were one stock treading at $100 per share, it would have current-run-rate earnings per share of about $2.71.
Here's a possible future table, with the multiples gradually falling at a slowing rate, but earnings rising at a constant rate.
Real Real
Year P/E EPS Price
1 36.96 $2.71 $100
2 31.9 3.22 103
3 28.0 3.83 107
4 24.9 4.55 113
5 22.5 5.41 122
6 20.6 6.43 133
7 19.2 7.64 147
8 18.0 9.09 164
9 17.1 10.81 185
10 16.5 12.85 211
The average multiple in years 5-10 is 19.0, my chosen upper bound for the medium/long term.
The average price in years 5-10 is $160.20, giving a rate of return of inflation + 6.49%/year for ~7.5 years, my "monkey with a dartboard" rate.
In order for that table to work out, earnings for the group as a whole have to rise at a rate of inflation + 18.9%/year.
In a word, yikes!
I'm not saying it won't happen. I can't see the future.
But that does seem like a very ambitious hurdle for the minimum earnings growth needed to get a historically average real return.
Any slower growth rate, still with a sane terminal multiple (which is all the more likely with a slower growth rate), will give a lower or possibly negative return.
This exercise is of course going to be wrong as a forecast of the returns for those firms, but I think it's still an important one to try out.
You can mess with the assumptions to taste, but whatever rate of return you anticipate has to be consistent with the assumptions you're making.
Those 7 firms make up about 27.5% of SPY these days, so their outlook matters to anyone holding the broad cap-weight US market.
Jim