Analyzing Stock Valuations During Recessions

Now that third quarter earnings reports have largely been released, I thought I would write a bit about valuing stocks during a recession. Having seen all of the numbers and listened to all of the conference calls, I am beginning the process of going through my client accounts and making adjustments, if necessary, based on what information has come out during earnings season.

Drastic business model shifts are rare, so this analysis largely involves looking at management’s execution of a company’s particular strategy (are they doing what an investor would expect) coupled with valuation analysis (what price is the market assigning to the business and what assumptions are embedded in those assumptions).

Valuation analysis is a bit trickier during a recession because earnings are at depressed levels. The key is to understand that a stock price is supposed to equate to the present value of expected future cash flows in perpetuity. As a result, corporate profits for any given single year are not always indicative of value, meaning that valuations using earnings during a recession will likely underestimate a company’s fair market value and vice versa during boom times.

A lot of people these days remain negative on stocks, despite the recent crash in prices, because they are assigning a low multiple to depressed earnings and are concluding that stocks aren’t very cheap, when in fact, they have not been this cheap since the early 1980’s. For instance, many expect earnings for the S&P 500 to dip to $60 in 2009. Market bears will assign a “bear market” P/E of 10 to those earnings and insist the S&P 500 should be at 600 (versus 865 today). More aggressive projections might use a P/E of 15 (the historical average) and conclude that the market is about fairly valued right now (15 x 60 = 900).

The problem with this analysis, of course, is that it assumes the economy is normally in a recession and a $60 earnings target for the S&P 500 is a reasonable and sustainable estimate for the future. In fact, it represents a trough level of earnings, which is not very helpful in determining the present value of all future cash flows a firm will generate, unless of course the economy never expands again.

Consider an entrepreneur who sells winter coats, gloves, and hats in an area that has normal seasonal weather patterns. If this person wanted to sell their business and a potential buyer offered a price based on the company’s profits during the month of June (rather than the entire year as a whole), the offer price would be absurdly low.

Because of that, you will often hear the term “normalized” earnings power. In other words, when valuing a stock investors should focus on what the company might earn in normal times, rather than at the extremes.

Take Goldman Sachs (GS) for example. Wall Street expects GS to earn $0.28 per share in the current quarter, whereas in the same quarter last year they earned $7.01 per share. Just as one should not use a $7 per quarter run rate to determine fair value for GS (the stars were aligned perfectly for them last year), one should also not use a $0.28 per share run rate either, because today represents close to the worst of times for the company’s business.

Investors need to value stocks using a reasonable estimate of normalized earnings power and apply a reasonable multiple to those earnings. With cyclical stocks, oftentimes you will see share prices trading at elevated P/E multiples during the down leg of the cycle because earnings are temporarily depressed. Investors are willing to pay a higher price for each dollar of earnings (as shown by high P/E’s) because they don’t expect earnings to remain at trough levels longer term.

One of the reasons stocks are so cheap today in historical terms is because many firms are trading at single digit P/E multiples based on recessionary profit levels. Buying trough earnings streams for trough valuations has always been a winning investment strategy throughout history, which is why so many long time bears are finally stepping up and starting to buy stocks again.

Take a very recent purchase of mine, Abercrombie & Fitch (ANF), as an example. The stock is trading at $16, down from $84. ANF typically trades for between 10 and 15 times earnings. They earned $5.20 per share last year but profits are expected to drop to $3.30 this year and to below $3 in 2009. The 2007 level of profitability is not what I would consider a “normalized” number, but earnings could drop 50% from the peak by 2009 (to $2.60) and that would not be normalized either.

The great thing about today’s market for long term value investors is that we can buy a company like ANF for only 6 times earnings, even after taking their 2007 profits and slicing that number by 50% to account for the recession! When the economy recovers, isn’t ANF going to earn more than $2.60 per share and trade at more than 6 times earnings? If one believes that, then ANF is a steal (as is any other stock that is trading at a similar price) as long as one is willing to be a long term investor and wait out the full economic cycle.

Full Disclosure: Peridot was long shares of ANF at the time of writing, but positions may change any time

Enjoy this post? Subscribe and never miss another one: RSS | Email | Twitter

4 Thoughts on “Analyzing Stock Valuations During Recessions

  1. While I agree that retailers and Abercrombie in particular are being priced at tremendous discounts currently, I’m a little bit curious as to your choice of Abercrombie over a host of other very strong candidates.

    In retail alone, The Buckle and Urban Outfitters, two best in class retailers who have had SSS hold up even in the early throes of this recession are trading at PEs which would allow you essentially “buy growth for free.”

    J. Crew, which courts a similar price point as Abercrombie, is trading at nearly equivalent valuations to ANF despite the fact that ANF is considerably more saturated on a square footage basis and likely later on its SSS Tenement Curve.

    In a market where value seemingly abounds, why retail and why ANF in particular? With retail sales likely to decline in coming quarters and maybe throughout 2009, would an investment today necessarily offer better risk-adjusted returns versus other retailers or another pick altogether?

    (P.S. Don’t take this as criticism, but rather an attempt at intellectual discourse. I hold J. Crew stock myself and am considering purchasing more as I like the business and think the valuation is likely too good to pass up and because I’m nursing paper losses and probably should average down…)

  2. Chad Brand on November 17, 2008 at 4:48 PM said:

    First off, even if your comment was not a criticism, don’t worry about criticizing something I write. If it warrants it, go right ahead. Unless it’s not in good taste (some people can go over the top), you don’t have to worry about disagreeing with me on this blog.

    I agree that there are some very good candidates other than ANF. The reasons I picked that one was because of their strong brand (a loyal customer base will likely stick with them long term), high margins (plenty of room for contraction without bleeding red ink), a great balance sheet ($5 per share net cash), and the dividend yield (4%), just to name a few. I do not doubt that other retailers fit many, if not all, of those criteria (there are tons of great long time buys in the consumer discretionary sector right now if one is willing to be patient).

    As for the timing, I agree that 2009 is going to be ugly for retailers. I don’t try to pick bottoms though. Some people like to wait to see signs of a turn, but since stocks are leading indicators, they’ll turn before the business does. If I feel like the price is cheap and has quite a large margin of safety, I’d rather pounce too early and average down than avoid the situation completely. It really depends on one’s overall strategy though.

  3. on November 24, 2008 at 10:51 AM said:

    The nature of analyzing stock values is changing and becoming more technologically based. Although computer models have greatly assisted investors in making wise decisions, it has also caused problems for many. For instance, unregulated modelng often causes undisciplined, high-risk investments, which is the opposite of the technology’s purpose. Technology is very useful and of great assistance to many, but we must be careful to not let it overrule our rationale.

  4. Pingback: Abercrombie Chooses Fewer, More Profitable Sales Over Lower Margin Bargain Bins | The Peridot Capitalist

Post Navigation