By Haddon Libby
When times are good, stocks are valued at higher multiples of earnings. When times are slow or the economy is weakening, that multiple goes down. To understand what this could mean to your 401k or investment portfolio, let’s consider a hypothetical example.
MegaUber Company (MUC) had earnings of $1 billion last year. Because growth is strong and earnings are expanding, MUC ended the year with a 24x Price-to-Earnings (P/E) multiple. This tells us that MUC is worth $24 billion. If we assume that MUC has 240 million shares of stock outstanding, the value per share is $100.
In the current year, MUC has been surprised by higher raw material, labor, and shipping costs. Inflation is running at 10% causing sales to decline. Between lower sales and higher expenses, earnings are expected to be 20% lower this year than last year. Because sales are slowing and earnings are contracting, MUC no longer warrants a 24x P/E multiple. As MUC declines are roughly on par with other stocks in its business sector, MUC has a current value of 17x the P/E multiple. With current earnings of $800 million and a 17x P/E multiple, the company is now valued at $13.6 billion – quite a bit less than $24 billion last year. With 240 million shares outstanding, the share price is now $56.67 or 43% lower than last year.
Now that the stock has fallen by 43%, you would think that it should be a good buying opportunity for MUC, right?
Maybe not! In addition to lower earnings, interest rates are going up which increases the cost of borrowing. Economic conditions are causing consumers to spend more on things like food, gas and shelter. This leaves less money to buy products like those sold by MUC.
We also must consider the wealth effect. When 401k and home values are strong, people tend to spend more. When those assets go down in value, even a financially well-to-do consumer will cut back.
Higher borrowing costs and slower demand cause MUC earnings to fall by another $100 million to $700 million. This lowered earnings level causes the P/E multiple to fall to 15x – a historic norm for MUC’s P/E multiple. This means that the company is worth $10.5 billion. Divide that by the 240 million shares outstanding and you get a new price of $43.75. The stock has now fallen by 56% over two years.
This should be the floor as earnings will begin going up next year…unless we have a deeper decline in economic activity than forecasted.
The important thing to remember is that the market overvalues assets during strong economic times and undervalues during weak economic periods. Over time, a valuation somewhere between the highs and the lows will be found.
The trick to being able to weather a down economic period with investments is to build a strategy that works for the long-term. This doesn’t mean that you hold an investment no matter its performance. You need to regularly review any investment you hold to assess whether the original idea behind the investments still applies.
When times are good, take a little money and put it to the side. During rough periods in the market, keep some cash around so that you can buy stocks as prices decline. Down periods are a good time to trade up in to higher quality investments. This means that you would sell a struggling stock and buy another that should recover more quickly when the economy turns around.
During rough periods in the stock market, focus on quality companies with strong cashflows, defensible market positions and best-in-class management teams. If you do these things, you will still see your stock portfolio go up and down with the market – the hope is that your positions go down less than the market as a whole and recover more quickly when better economic conditions return.
If the analysis and research that it takes to stay on top of your investments is more than you have time for, find a qualified investment professional who can help guide you.
Haddon Libby is the Founder and Chief Investment Officer of Winslow Drake Investment Management. For more information on our award-winning services, please visit www.WinslowDrake.com. As a reminder, nothing in this article is a buy or sell recommendation.