Wall Street’s Other Nostradamus

by StockJockey

Thursday, October 23, 2008 - 10:39 pm

I have given value investors a hard time around here, mostly because 6-7 years of outperformance against their growth counterparts had swollen their heads to the point that they could not see balance sheets. Half of the new Ackman fans had never heard of Bill's adventure investing in golf courses, and worshipping Bill Miller was a December ritual.

But not all value investors have fallen hard...and some have just nailed this market, almost to the day of the highs.

I can vouch for Tom Au after working with him for a stint, albeit not very closely. We don't have much in common, although I pulled the plug two weeks after him.

But he is the next best thing to Nouriel Roubini, and picks stocks and price targets to boot. Props to him:

October 24, 2007
Could the market go down another 10% from here? Or 20%? I think it could be more like 50% (although I'm not sure when, having cried "wolf" before).

Bill Gross, the bond king at Pimco, spooked the market in 2002 when he opined that the Dow was worth only 5000. For analogous reasons, I've updated that metric to about 6600.

To get there, I use a measure called investment value, which is book value plus 10 times dividends. This follows the spirit, if not the letter, of Graham and Dodd investing. While there were naturally variations between individual securities, stock indices such as the Dow traded close to investment value until the successful Persian Gulf War. TheStreet.com

But valuations since 1991 (like during the 1920s) have reflected a “new world order” of American political dominance that is now being eroded by troubles in the Middle East and elsewhere, and a highly leveraged “new economy” that is looking flimsier by the day. By calling for stocks to return to prewar valuations, I’m stating my belief that the elevated profit margins, returns on equity and earnings growth of the past 15 years that supported recent valuations are an historical aberration, and that a decade (or more) of U.S. stock market progress is about to be wiped out.

The 30 individual Dow stocks are as illustrative as any. Friday’s closing prices (P) and investment values (IV) are in parentheses in the format (P, IV). Also see the table on the last page for complete valuations.

AIG (AIG - commentary - Cramer’s Take) ($63.27, $50): Given its skimpy dividend and legacy issues from the Greenberg era, it is not worth its premium to fellow financials Citigroup and JPMorgan Chase.

Alcoa (AA - commentary - Cramer’s Take) ($37.44, $26): This stock is trading somewhat above investment value. Its cyclicality and the collapse of takeover speculation mean that it could go below this value, however.

Altria (MO - commentary - Cramer’s Take) ($70.50, $35): This stock is now a pure play on tobacco. There is downside until the stock is trading to yield at least 6%. But after the 1920s Prohibition, tobacco was one of the few items to grow in the hard times of the 1930s, and is likely to do so again.

American Express (AXP - commentary - Cramer’s Take) ($57.11, $15): This is the “pick” in the credit space. But collapsing credit is the fundamental economic issue of our time, and American Express will not be spared.

AT&T (T - commentary - Cramer’s Take) ($41.95, $32): The stock of the original “Ma Bell” was one of the few to hold up during the 1930s, and her successor, trading not much above investment value, may be one of the few to hold up during the modern 1930s. Bear in mind, though, that she has gotten older between then and now.

Boeing (BA - commentary - Cramer’s Take) ($93.90, $21.75): This stock is way overvalued on today’s metrics, because it has commanded a “war premium” since 1991.

Caterpillar (CAT - commentary - Cramer’s Take) ($73.57, $26): Another cyclical, this one recently traded over three times investment value. There’s downside all the way to $25-$30.

Citigroup (C - commentary - Cramer’s Take) ($42.36, $46.75): This company is trading below its investment value. Downside is limited if earnings are solid and book value and the dividend are secure, but that’s a big “if.”

Coca-Cola (KO - commentary - Cramer’s Take) ($58.76, $22): Coke is a steady producer of a variation of a necessity (flavored water) that deserves a premium to investment value, but not as large as the current one.

Disney (DIS - commentary - Cramer’s Take) ($34.27, $19.50): How much is a mouse worth? Given its brand, it probably deserves only a small premium to investment value.

Du Pont (DD - commentary - Cramer’s Take) ($47.16, $26): There are a lot of moving, cyclical parts here. It does not deserve much of a premium to investment value.

ExxonMobil (XOM - commentary - Cramer’s Take) ($92.14, $35.50): It often traded at a discount to investment value in the 20th century, and that’s a long way down.

General Electric (GE - commentary - Cramer’s Take) ($40.04, $22.50): The whole is less than the sum of its parts (GE Capital in particular, ought to be spun off): After peaking at about five times investment value in 1929 (and again in 2000), it sold at only a small premium in the 1930s. That makes it a $20-something stock, not a $30-something.

General Motors (GM - commentary - Cramer’s Take) ($37.60, $2.25): Takeover or bankruptcy candidate? The negative book value and shaky dividend say it all.

Hewlett Packard (HPQ - commentary - Cramer’s Take) ($51.40, $18.20): The net present value of the company’s skimpy dividends and back-ended earnings will decline toward investment value as ongoing credit tightening leads to rising discount rates.

Home Depot (HD - commentary - Cramer’s Take) ($30.76, $22.75): Home may be where the heart is, but it’s no longer an ATM, nor is the company that serves it.

Honeywell (HON - commentary - Cramer’s Take) ($58.42, $21): See the note to Boeing.

IBM (IBM - commentary - Cramer’s Take) ($112.28, $28.50): See the note to Hewlett Packard.

Intel (INTC - commentary - Cramer’s Take) ($26.30, $11): “Yesterday’s tech is tomorrow’s cyclical.” It doesn’t deserve much more than investment value. Yikes!

Johnson & Johnson (JNJ - commentary - Cramer’s Take) ($64.23, $32): This is an intermediate case between fellow pharmaceuticals Merck and Pfizer (see below): Safer than Merck, more of both upside and downside than Pfizer.

JPMorgan Chase (JPM - commentary - Cramer’s Take) ($45.02, $51.50): See the note to Citigroup.

McDonald’s (MCD - commentary - Cramer’s Take) ($56.42, $25): The stock has been lifted by Pershing Capital’s highlighting of the value of its real estate. It is worth a premium to investment value based not on operations, but this real estate, which will soon decline with real estate values.

Merck (MRK - commentary - Cramer’s Take) ($53.11, $24.50): It was trading near investment value in 2004. It got out of that territory since then, but may return there.

Microsoft (MSFT - commentary - Cramer’s Take) ($30.17, $8.60): Bill Gates’ retirement says it all. Both man and company went from wunderkind to senescence in record time. It’s not worth much more than investment value until we get a better look at the “new” Microsoft.

Shame on me for not reading more of his work, but those comments are looking eerily prescient in many ways. Some of the outperformers were beneficiaries of rotation, and might struggle during the next phase, but Tom Au nailed it.