Saturday, March 11, 2017

What Bruce Greenwald Thinks of Current Market Valuation

Bruce Greenwald is one of the renowned professor of finance at the Columbia University and is personally one of my favorite personnel.

Back late in Dec 2014, I've read books about him and tried to understand and replicate his financial modeling of the Earnings Power Value (EPV) method in great detail. You can read my past articles here if you are interested in the EPV method for valuation. It is one of the important tools of valuation methodology that are being used by many fund houses and analysts today other than the DCF.

Greenwald went to an interview recently and he gave this take on the current market valuation of the US market hitting new high.

Here are the excerpts:

Michael Ricciardi: Bruce has also been recognized across all of Wall Street as the Guru to the Gurus, and so we are delighted that he’s here with us today. So Carl Icahn has said that what’s going on right now is in effect a replication of what took place in 2007-2008, and in fact the market is about to go off a cliff, and that people are going to find themselves and dramatically worse shape going forward than they did at that point in time. And I want to have you about that? 

Bruce Greenwald: Okay, so let’s talk about that in detail. The first thing is that the valuations are actually not as rich as they were in 2007. 

Michael Ricciardi: That’s based on PE? 

Bruce Greenwald: Yeah. Second thing is that the craziness where nobody thought there was any risk, so that for example in 2007 you could buy credit default swaps on Dubai sovereign debt, the riskiest region in the world dependent on the most unstable commodity in the world, which is oil, for four basis points. Which is 1 in 2,500 years they’re going to go completely under. So that craziness is not in the market. The real issue is the earnings power of these companies. So that if you look at people like Jeremy Grantham who has been now for 9 years doing the Carl Icahn story. Their view is that these earnings levels are not sustainable. And what you’ve seen is that as a share of total U.S. income, corporate profits which pre-1990 were about 8.5 percent are now around 13.5 to 14. So there’s been this huge increase in profits. If that increase in profits is sustainable, and it’s likely to continue, then we may have a flat market for a while, we may not have the kind of increase in prices that we’ve had, but we’re probably not gonna see the kind crash we saw in 2008-2009. Now, I think that profits are gonna stay where they are, and I think that’s the important thing to understand. And then I’ll talk about the downside is that people are gonna have to get used to. 

Michael Ricciardi: So, to the extent that profits do stay where they are. Is your expectations that the market will stay in a range? 

Bruce Greenwald: I think that’s right. I mean, I think it’s pretty fully valued at these profit levels. It’s not they’re screaming bargains out there. Things fluctuate, and I think for various reasons interest rates are gonna have to go up, and that’s gonna make the comparison to fixed income a much tougher comparison. So it’s not going to be so easy to buy equities on margin and leveraged equities, and you really will. But let’s talk about what’s really going on with profits. We are in the middle of a transition that’s comparable to what happened in the depression. In the depression what happened is that agriculture died. So, you know the third of the U.S. population that was on the farms had their income fall 80 percent. That what happened then in the depression is all the countries with big agricultural sectors tried to save those sectors by exporting. You had the kind of imbalances that you have now where everybody try to export, nobody wanna import, and the problem was that when you added up overall countries, the surpluses and the deficits have to be zero. So, it was a very long-term problem until the adjustment got made in the course of the Second World War and they got everybody off the farms. What’s happening today is that manufacturing is dying, and everything is going to services. 

Michael Ricciardi: U.S. manufacturing? 

Bruce Greenwald: Global manufacturing. That’s why the Chinese are going down the tubes, and that’s why the Japanese have gone down the tubes. I don’t know if you remember, but when you got out of business school the Japanese were all the rage. Everybody was studying the Japanese. 

Michael Ricciardi: One square foot of property in Tokyo cost, you know, million dollars. 

Bruce Greenwald: Million dollars. Everybody was going to be dressed up as Mickey Mouse entertaining Japanese kids at Disney Land. Didn’t happen. And that’s because they concentrated in the sector which is manufacturing, which is just going away. And it’s going away for the same reason that agriculture went away, which is productivity growth is 5-7 percent and demand growth is like 2-3 percent. And so employment is going away, value added is going away. And you see that going on. What that means is that everybody’s trying to save those sectors. Everybody’s trying to export. You have these huge imbalances where the Germans who can control the appreciation of the market now that they’re part of the Euro, where the Japanese who control their currency, where the Chinese who control their currencies. Where they all basically maintain their currencies to maintain exports are exerting extraordinary deflationary pressure on the world. That’s the bad news, and that’s not going away. Nobody is talking about getting rid of manufacturing sectors. On the other hand there’s a good news side to this; everything is going to services. Now, profits come from either fair returns on assets or barriers to entry, which is protected markets. What barriers to entry look like is guys dominating markets and keeping everybody else out, which is economies of scale of various sorts. Whether it’s network effects, whether it’s just fixed cost, or whatever, coupled with enough customer captivity so the guys who wanna enter can’t come in and steal their market share. Big global markets, which are the manufacturing markets, which are the commodity markets, are very difficult to dominate. The markets that you can dominate are local markets, either in product space, so that if you look at the people in the personal computer industry have made all the money. It’s not the IBM’s and the Apple’s who originally dominated it. It’s the Microsoft’s who did only operating systems. It’s the Intel’s that did only CPU chips. It’s the Oracle, it’s Google and so on. Or in geography, which is how Walmart made all that money. They dominated geographies, they kept other people out, and they made a ton of money. As you move to services you move to local markets. The other thing about these service markets is they’re incredible stable. It’s not like you have a replacement cycle the way you always had with capital goods. Or you have these huge price swings, the way you have with commodities. So you’ve got very stable and safe sources of income increasingly that are not dependent on investing a lot. So actually, the thing that’s going to keep your kids at home to til their 55 years old cause they can’t get jobs which is this transition out of manufacturing… 

Michael Ricciardi: This is supposed to be the good news? 

Bruce Greenwald: Is really good for companies. So I think in those terms that you’re not gonna see some big reversion to the mean to historical profit levels. So, and because of the stability, I think you’re not gonna see things like the housing market or any other markets that are overextended, and again as I say, you don’t see those levels of no fear in the options markets that you saw in 2007.


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