1. SGAM/Act/Ana/Alfred Park 11/08/99
Special Report – SGAM Europe Top 20
SYNOPSIS
In light of strong equity performances across Atlantics over the past 4 weeks, I have briefly revisited
valuation level and market backdrops for the US equities, bellwethers for European equities, by looking
at each sub-component that is supposed to drive values. The result is very alarming, especially when
viewed together with studies of some academicians. This should certainly raise the level of caution for
equities in the US, and to a lesser extent, in Europe.
I have taken a widely accepted theory that the value-driving factors upon which a fair price of an asset
must be based are return on capital, cost of capital, and growth. The wild card that pushed up equity
prices to contradiction of a number of academicians and pundits has been a productivity growth, which
essentially affects the above three variables of value matrix. This report summarises our findings with
respect to the three value drivers, with an extra emphasis placed on productivity growth and its likely
impacts on these value drivers.
CONCLUSIONS
While we are fundamentally bullish for European equities, we have found several things that may be a
little different from otherwise implied by the market:
1. US’ government’s preliminary ruling against Microsoft: This government intervention is a clear
sign of the government not wanting concentration of wealth. I do not think that this is to be
taken lightly because today’s valuation is pricing in a continuing generation of EVA by S&P
companies for more than 30 years, which can only be justified by permission of oligopoly. In
light of this, we should adjust today’s valuation framework by removing a large part or all of
excess residual value contributing to today’s secondary stock price. According to my growth
fade model, a mid-cycle growth in earnings is arrived at 10.2% in base scenario and at 12.3% on
the most optimistic front over the next 10 years. Today’s valuation is discounting an annual
growth of 15-19% over the next 10 years. The US economy is having a banner year in 1999, for
which growth in earnings is expected to peak at only about 15-16%. In addition, the market is
also pre-emptively pricing in dramatic changes in investment/return composition in line with
new business model paradigm. What the market implies, however, is inconsistent with what it
is and unrealistically far from what it can be. Granted M&A effects and sustained productivity
growth, equity valuation still looks very bubbly.
2. Today’s growth mode through M&A has been largely that of globalization, which is heavily
dependent upon cost-cutting. My studies show that corporate buyers may have generally paid
too much for growth, which would likely weigh on return to shareholders in the near-term.
This, when combined with rising interest rates and high equity valuation, will reverse the
market psychology, and thus flow of funds into equities.
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3. Robert Gordon of Northwestern University, one of the leading experts on US growth
performance, has argued that productivity growth has been slower than people think. He
further points out that technology’s contribution to productivity growth has been negligible to
minimal at best. The recent figures on 09/02 showed that productivity growth had slowed and
labor market had been getting increasingly tighter, a combined recipe for inflation pressure.
4. The US private sector is witnessing a double dosage of current account deficit and falling
personal savings, both at unprecedented levels. The US economy is on a thin ice, which can be
easily broken if stepped on too hard. And it is not the Americans, but the foreigners that are
walking on the ice. It is their prerogative.
In the European market, the telecom sector, which is the very important sector I have been most bullish
for, as had been stated on my report on 09/17/99, seems fully valued. At current prices, Telefonica de
Espana, France Telecom, Deutsche Telecom, and British Telecom, all have upsides of less than 10%
(benchmark target price: British Telecom at GBP13) on the most optimistic front unless there are major
upside surprises in the year-end earnings, which I believe, are unlikely. If the telecom sector fizzles, the
whole market would be shaken up because the sector had been responsible for more than 22% (while
accounting for only 12% of economy) of all future growth needed for the market to sustain the current
valuation level.
Debt crisis in emerging markets just a couple of years ago showed how whimsical markets can be in a
transition to normalization from aberration, of which the latter had been caused by what I would call
‘motivated selling.’ Can this be applied to explain today’s equities in the US and Europe? I think yes. I
argue that the market has been largely driven by ‘motivated buying’ associated with institutional
indexing. For the market to sustain the current valuation, we need absolutely to see an unmistakable
combination of strong dollar, high corporate earnings growth, and continued wealth accumulation in
private sector. Respectively, let us ask ourselves the following questions:
1. Can the US dollar remain strong in spite of record-high current account deficit?
2. Can corporate buying of equities continue with shareholder returns maintained?
3. Can we continue having a magic balance of low unemployment and low inflation?
4. Now that the private savings are record low, are markets free of any possibilities of private
investors being forced into ‘motivated selling’?
5. Will hedge funds stay dormant? If they decide to be active, would they be for or against
equities?
Because I cannot say ‘yes’ to any of the above with strong confidence, we would remain tactically
underinvested in equities. I continue to believe that it is a bit more prudent approach to have stocks at
values that can be rationalized in arithmetic framework as shown below. At the current level of 1,377,
we think that S&P may continue rising on momentum, but likely be capped at 1,450 (5% upside). To the
downside, we would find our first support at 1,250 (-10%) level.
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1. Pn=SUM{(Di)/(1+R)^i}
2. Pn=Bn+SUM{(ROEi-R)*B(i-1))/(1+R)^i}
3. B(n+1)=Bn + (1-K(n+1)*E(n+1) = Bn*(1+(1-K(n+1)*ROE(n+1))
4. Pn=Bn*(1+SUM{(ROE-R)/(1+R)^I*(1+(1-K)*ROE^(i-1)}
5. Pn/Bn=K*ROE/R-(1-R)*ROE
6. R=(1-K)*ROE+K*ROE*(Bn/Pn)=(1-K)*ROE+K*(E(n+1)/Pn)
7. R=(1-K)*ROE+(D(n+1)/Pn)
8. E=(1-K)ROE=GRNGDP
9. R=Bn/Pn*(ROE-GRNGDP)+GRNGDP
10. Pn/Bn=(ROE-GRNGDP)/(ROE-GRNGDP-PG)
11. Pn/E(n+1)=1/ROE*((ROE-GRNGDP)/(ROE-GRNGDP-PG))
P=Share Price: D=Dividend: R=Cost of Equity: B=Book Value: ROE=Return on Equity:
E=Earnings: K=Dividend Payout: GRNGDP= Growth in Nominal GDP: PG=Productivity Growth
WHAT THE MARKET IS TELLING NOW?
We start with establishing a valid barometer for cost of capital. I have used a mid-cycle post-tax cost of
capital of 8% (=10%*51%+5.9%*49%) over the next 10 years. This reflects an equity risk premiums of 3-
4%, exactly as the history suggests. Should division of labour and capital, be attained, an equally-
weighted median return on invested capital must oscillate around 8%. As Adam Smith remarked, the
division of labour is limited by the size of the market. But the biggest of all markets is the world. If
people are able to access world markets and know-how, the size of their own economies becomes
irrelevant. This theory by A.S. has not held its own in a full-fledged fashion due to structural problems
in other parts of the world from the U.S, enabling a number of companies in the U.S. to enjoy excess
gains somewhat on the rebound. This is changing, thanks to reshaping of economy in Europe and
Japan.
Second, I have looked at today’s valuation in a Modiglianni/Miller framework. The assumptions are:
organic growth in sales at 6%, representing a sum of real economy growth, inflation and productivity
growth; and annual investment as a percentage of sales at 9% (vs. 10-year average of 7.3%), for which I
have given benefit of the doubt to the companies’ rising confidence in growth opportunities. Based
upon these assumptions, organic growth in capital, thus in earnings, (=(1+sales
gr)*(investment/sales)*capital turnover), which ultimately must converge with sales growth in long term,
is 10.2% over the next 10 years (*Incidentally the consensus 5-year forecast is 7.5% according to Zach’s).
This is quite an impressive number, but is still unrealistically far from the growth level that can explain
today’s valuation. Then how come the large-cap stocks in the US are trading at over 27X free cash flow
though the multiplier suggested by the bond yield is 12.5X?
The answer is 2 folds. First of all, the investors are betting that the large-cap stocks would continue
enjoying excess returns over the cost of capital for very long term, to be exact for 34-35 years.
According to my calculation of top 200 companies in the US, the average return on invested capital
comes out to be about 12% as of 1998. The investors are expecting these excess returns of 4% of
invested capital would remain intact, which subsequently results in re-rating of terminal value by as
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much as additional 50% of invested capital. This essentially raises the required multiple from 12.5X to
25X, which then can be validated by a nominal earning growth of 11% per annum over the 10 years and
prevalence of the same level of confidence for forward excess EVA until 2031 or 2032. Secondly,
investors are expecting a continuing improvement in both productivity and efficiency leading to
unanswered increases in capital turnover while maintaining a currently high ROIC and accelerating the
earning growth over the next 10 years. The dominant factors behind this proposition are further
application of technology in every aspect of every industry and sustaining reduction in costs in light of
the future’s industry profile on the basis of record-breaking M&A transactions.
In short, the scenario implied by the market is a combination of stable increase in real demands of at
least 4% p.a., stable inflation at 1.5% p.a., very low-level of competition in which companies can pass
expense burdens onto consumers by more what inflation indicates as well as maintain a stable
oligopoly pricing, continuing improvement in productivity efficiency by at least 3% p.a. and the same
level of enthusiasm for equities lasting for, at least, the next 20 years.
In many ways, I share with the above propositions. No one can easily undercut the proposition that the
US is close to an acceleration point in the benefits from its technology investments and technology
adoption normally follows an exponentially rising ‘S-curve.’ The market is rightfully discounting this
acceleration point in US productivity as its full benefits have yet to be seen in today’s cash flows. But in
order to justify lofty valuations, I believe there must be concrete answers to the following questions
that are related with rationales behind today’s valuation for equities:
1. Is it fair to assume that excess returns currently enjoyed by large companies would indeed last
for at least 30 years?
2. Would a further consolidation through M&A indeed result in increased shareholder values?
3. Would we indeed see an accelerating pace of productivity growth?
4. Would an inflation-free consumer demand be sustained?
EXCESS RETURNS
As stated earlier, the average return on invested capital of top 200 companies in the US, which I believe
are close surrogates for S&P 500 composites, was about 12% as of 1998. This is, in itself, a misleading
representation in a context of capital market theory because the market-wide return on capital should
equal the market’s cost of capital as investors and corporate finance bankers neutralize each other by
serving the best interests of their own through a well-calculated plans and strategies for optimisation of
excess returns.
The explanation for this discrepancy between return on capital and cost of capital is an increasingly
opportunistic division of capital by quality. Investors appear to be fully convinced that quoted markets
in the US are now comprised of only two animals: global enterprises that continue adding EVA on the
basis of their low cost leadership and sustained productivity growth, and hyper-growth tech enterprises
that would realize supernormal returns on capital.
But at the same time, investors have not fully taken into account competitive profiles in which further
competition in a form of price destruction would be constantly invited and the level of uncertainties,
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therefore risks, should rise for the incumbent players as some would undoubtedly fail. This essentially
comes down to a question of whether today’s global competition is a ‘zero-sum’ or ‘positive sum.’
While I cannot disagree on the point that technology creates value-added via its low-marginal-cost
intellectual capital, global economy is currently too imbalanced for this effect to go into a virtuous cycle
in a way the market envisions. I simply think that it may be a bit premature to be overly optimistic as to
take excess earnings as ‘given’ in today’s valuation because the two numbers representing return and
risk eventually have to converge. Otherwise, the US (and the world) will be comprised of 150-200
mammoth enterprises with oligopoly pricing and thousands of small enterprises that subsist on
residual demands. This does not exactly fit well with the kind of economic landscape that policymakers
are envisioning, especially in context of division of labour. To policymakers, it is creation of jobs that
serves the most principle purpose in economic welfare. Supportive evidence can be found in the US’
government’s preliminary antitrust ruling against Microsoft on Nov. 5, 1999.
If we only relate supernormal growth for 10 years with no EVA after the 10th year without reflecting
additional 400bp in terminal value, the implied nominal growth rate in earnings is 19% p.a. More
loosely, if we assume supernormal growth over the next 10 years and attribute 40% of today’s stock
price to terminal value in today’s valuation framework, for which, we do not care about validity or
justification, an annual growth rate to justify the current valuation is arrived at 14.5%. With organic
economy growth rate at 6%, this however can only come from combination of cost saving enough to
produce additional 4% growth annually in earning and mid-cycle capital turnover at 25% higher than the
current mid-cycle level that I had calculated to be about 1.19. This proposition is, needless to say,
inconsistent with what we have seen. Consider the following reality checks:
1. Since 1991, an US company’s operating margin has improved at an annual coefficient of only
1.28 in spite of much publicized efficiency improvement, implying an additional contribution to
earning growth by mere 30-40bp.
2. As for capital turnover, it has fallen for 4 consecutive years since 1994 and is now at 1.29.
Today’s equity valuation would have made sense if the market-wide capital turnover were 3.7
instead of 1.29.
3. According to my screening of 8,876 companies in the US, only 630 of them had a capital
turnover of 3.7 or higher in FY98. All, but only 34, were small-cap companies with
capitalization of less than USD3bn. that do not count in the index .
4. Out of 34 S&P 500 member companies, only 15 fulfilled the criteria with respect to ROIC (for 3
years) and capital turnover (in 1998) that deserve the rating that the market is currently
implying for the whole economy.
In any cases, whether today’s valuation assumes supernormal growth is to be realized for 10 years or
longer, a hurdle rate we need to witness is 14.5% while a current ROIC of 12% is maintained, below
which, today’s valuation would prove to be faulted.
EFFECTS OF M&A
My initial objection in this context is that the investors may have failed to interpret the effect of M&A in
a fair manner. A record number of M&A deals have bid up prices of quoted shares in the market, which
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were then justified by the premise of cost saving effects and growth factors. Investors often
overestimate the effect of M&A in a highly emotional and theoretical mindset. The starting point for a
rational analysis must be the fact that mergers and acquisitions have historically proven a success ratio
of only 46% though it had risen a bit higher in the recent years.
There are five types of growth direction, namely market penetration, vertical integration, horizontal
integration, diversification, and globalisation. These modes all have their own merits. Fir instance, a
type of growth that can truly multiply the synergy if successful is that of horizontal integration. An
illustrative example is Disney. As a result of its pursuit of horizontal integration strategy for years,
Disney was able to multiply its bottomline revenue base in a truly “blockbuster” way. The company, for
example, grossed over USD2bn. from the movie “Lion King” for which the budget was only USD50mn. by
leveraging synergies between the movie, video, theme parks and merchandise sales. This type of
“blockbuster” result is not a main objective of other types of growth. The mode of growth through M&A
that we are witnessing today is largely that of globalisation, which bases its merits on economies of
scale and transparency in pricing. This is consistent with both the larger changes in the world economy
and with the current emphasis on focused companies. For this type of growth, the key word is cost
saving.
Cost saving as a result of M&A is usually related with marketing expenses, intangible amortization,
advertising expenses, product promotion expenses, research and development expenses. The above
items together account for about 10% of sales. Suppose 30% of these costs were spared, operating
margin would rise by 3% (*In actuality, subsequent restructuring costs partly offset this increment). The
impact on shareholders is a consequential increment in returns on capital by 2.6-2.9% (=increase in
operating margin*(1-tax rate)*capital turnover) on a post-tax basis depending on a degree of variance of
effective tax rate. However this assumption has not taken into account increases in invested capital for
financing the transactions. In order for a shareholder to gain any benefit, magnitude of increase in
capital has to be less than 24% based on a current capital structure of corporate America. Therefore I
would look at a likelihood of cost cutting of this magnitude and the magnitude of capital addition in
digesting the deals in 1999.
Total M&A transaction volumes in the US are
on pace to amount to USD 1 595bn. in 1999.
This amount roughly represents 20% of the
aggregate invested capital of S&P 500
companies. A further improvement in working
capital management is very much limited after
rigorous measures taken about inventory
control and the companies’ rising willingness
to lower receivable turnover in the face of
fierce competition. Therefore we could assume
for the last year’s increases in capital to be
about 23-26% (~20% + 6% of organic growth - decrease in working capital), which incidentally matches
with the magic number mentioned in the preceding paragraph. This shows that the business
development managers in the US are not stupid at all, but will the cost saving be on track exactly as
they plan for?
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Because of high exposure to costs that are subject to be reduced, banking and pharmaceutical sectors
are two of the sectors for which the saving effect is greatest. I have taken two actual sample cases to
see the effect of cost cutting.
Bank One has been on M&A binge over the past several years. In March 1995, it successfully acquired
First Coppell Bank, which was very well received by the market and awarded with rapidly rising stock
price on the premise of cost cutting. This acquisition was actually a decisive factor to put a brake on a
2 year-long downgrading of the company’s stock price. The ensuing results have proved to be quite
disappointing as can be seen in the below table.
In the pharmaceutical sector, the most highlighted marriage over the last 5 years was probably that
between Glaxo and Wellcome, creating Glaxo Wellcome in May 1995. This deal was also highly
applauded for positive outlooks then and, more importantly, is today considered one of success stories
in M&A arena. It is equally difficult to conclusively trace the effect of cost cutting during 95-98.
Statically in 1995, operating margin did improve by 1.4% on a pre-tax basis (thus less post-tax), but the
company’s invested capital also increased by over 68%, resulting in a deterioration of 5% in return on
invested capital. Bottom-line earning measure, ROE, did and does continue to render a wrong picture of
the company’s profit generation capacity. Although the company’s shareholder value seemed to
recuperate in 1996, it was attributed to one-off decrease in capital base due to asset sales, for which
merger is only partially responsible. The evidence of falter is clearly shown by successively decreasing
ROIC in 1997 and 1998. After 4 years of what people dub as a “perfect marriage”, the company’s
operating margin and per-head efficiency are down and cash profit returns continue to deteriorate
following the merger.
In conclusion, execution of cost cutting seldom takes place as planned out on the drawing board prior
to the merger. The plan by the business development managers to raise a pre-tax operating margin by
3% to offset the impact on return on invested capital due to a 20%+ increase in invested capital, as
implied by the market valuation, is a truly ambitious one, which leaves a very little room for mistake.
PRODUCTIVITY GROWTH
What is driving the economy’s performance? There are two schools of thoughts today. The first is that
the economy’s result is largely the result of good luck. Plunging import and energy prices due to the
economic problems overseas should explain the booming economy. This school of thought would have
it that the good times will appear substantially less good a year from now.
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The other school of thought has it that the economy has undergone a structural formation. An
apparent acceleration in the pace of technological change and ongoing globalisation of the economy
have raised the economy’s underlying productivity growth and heightened competitive pressures so
that the economy can grow more quickly at lower unemployment with subsequently lower inflation. The
economy’s current performance, according to their view, will thus be long lasting.
Robert Gordon of Northwestern University, one of the leading experts on US growth performance, has
analysed the impact of productivity growth. According to Gordon, growth in output per head since the
last quarter of 1995 has recovered more than two-thirds of the productivity growth slowdown
registered between 1950-1972 and 1972-1995. Thus between the last quarter if 1995 and the first
quarter of 1999, non-farm output per hour rose at an annual rate of 2.2%, which is not far below 2.6% of
the period between 1950 and 1972, and far above the 1.1% of the period between 1972 and 1995.
However, Gordon also argues that all of
this productivity rebound can be explained
by thre factors: improved measurement of
inflation; the response of productivity to
the exceptionally rapid output growth over
the last few years; and the explosion of
output and productivity in the production
of computers. More specifically, of the 1
percentage point improvement in
productivity growth in non-farm private
business since 1995 compared to the
period of 1972-1995, Gordon concludes
that 0.3% are explained by the recent
cyclical acceleration and 0.4% by the
improvement in measurement of inflation.
This leaves a structural improvement in
productivity growth of only 0.3% a year, all of which can be explained by productivity improvement in
the manufacture of computers alone.
Gordon’s conclusion is that underlying productivity growth may be a little better than in the past two
decades after the first oil shock but this performance remains far from that of the pre-1973 golden era
and the technical progress in the production of computers has not really spilled over to the other 99%
of the economy. Based on these facts, I am subsequently more convinced of the first school of thought
while the optimists have failed to rationally quantify exactly how and why this ‘productivity thing’ has
meant so much for equities thought it is not really a new thing.
Perhaps the most prudent presumption should be to acknowledge both sides of schools of thoughts.
However as there must be an answer or logical explanation to everything, I am leaning more towards
the assumption that the economy’s current rate of growth (and more markedly, equities’ rate of return)
is not sustainable.
Productivity growth in the second quarter was just 0.6% on a seasonally adjusted annualized basis. This
is the slowest growth since the second quarter of the last year. The downward revision was the result of
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downward revisions to output and upward revisions in hours of all persons. This slowdown was not
unexpected. At this late stage in the business cycle, the exceptional productivity gains of the recent
past were not expected to be maintained. Furthermore, strong business investment growth over the
past three years, which was the primary influence behind the improved productivity growth, slowed in
the first quarter. Productivity growth is expected to slow over the next several quarters though the 3Q
figure to be released on 11/12 may come out a bit high on the rebound.
What is more problematic about the latest
revisions was the increase in unit labor costs. Unit
labor costs, which are the amount of money
employers pay in wages and benefits for each item
produced, was revised upward to 4.5% on a
seasonally adjusted annualized basis. This is the
largest increase in unit labor costs since the first
quarter of 1994. Wage pressures are unlikely to
stabilize in the near term as jobless claims remain
near a record-low level (picture).
The increase in labor costs and decline in
productivity is largely due to acutely tight labor
markets. With markets so tight, expanding firms
are increasingly forced to hire less-qualified
individuals. As such, firms are facing training
costs and paying higher wages to less qualified
workers. This results in increased costs and lower
productivity.
While one or two quarters do not make a trend, should labor compensation continue to rise at such a
rapid pace, and if lower productivity growth is sustained, it will eventually give rise to growing
inflationary pressures. On net, the latest report raises concerns that inflation pressures are mounting.
Business can delay the time at which they will have to either raise prices or experience falling profits by
eking out productivity growth that is already reaching its upper bounds by almost any standard. The
jobless rate will have soon fallen below 4% (refer to the above chart) and labour costs will be
accelerating. Moreover, profits are at best growing only marginally, far from a level that can otherwise
explain today’s valuation.
THE HIDDEN TRAP: CURRENT ACCOUNT DEFICIT
An increasingly popular scenario of sustained growth upon which the stock markets has strongly rallied
from the end of Oct. into the beginning of Nov., actually poses a great threat because a large part of
the growth had been financed by external monies, which no one has really argued against. Since stocks
are highly vulnerable in an environment characterized by weak (relatively) profitability, rising interest
rates, and record-breaking valuations, even a little crack in a stock market could be enough to reverse
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the market liquidity, which in a severe case can even push what should be an already slowing economy
into an outright recession.
A critical assessment hinges on whether growing foreign indebtedness, which is now equivalent to 20%
of gross domestic product, is used to increase the level of US productive investment or to boost
immediate consumption. There is no available analysis that shows clearly whether investment or
consumption is stimulated by such forces. However, although it does not provide an arithmetic
explanation because of different base (consumer spending is about 5 times gross investment), the
above table shows that current account deficit and consumer spending have moved hand in hand
during 1990s. Growth in private investments has been more sporadic and seems to be slowing since
1997. Therefore I do not think that it is out of line to assume that 80% of current account deficit has
gone into boosting immediate consumption.
Along with sharp pick-up in consumer credit and consumer spending in the 3rd quarter on YoY basis,
household savings as a percentage of disposable incomes dropped to 1.6% in Sep. for only the second
time since 1970. The only other time this number had been seen was in April of 1997, several months
before the equity market crash.
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