The Magic of Multiples
Eric Coffin and David Coffin
Everyone loves a bull market. There's nothing like it to make stock pickers look smart and gloss over the odd miscue. Bull markets are about sentiment and the reason they tend to work so well is that they are driven by results and sentiment. Sometimes sentiment is the overriding factor, as in the tech bull of the late 1990's where companies commonly traded at three digit multiples.
That sort of P/E regime is, of course, a sign that something is very wrong in the market. When 100 P/E multiples become the norm while risk free returns of 6-7% can be had in the T-bill market there's only one way the market can go-down.
Multiples can be your friend though, if you pick your spots wisely. One thing that makes a sector an out performer is the arrival of the masses. Good news, plenty of press coverage and plethora of generalist market analysts and strategists "discovering " a sector draws more and more investment dollars. The graph of the S&P500 P/E ratio over the last 30 years shows the effects of those broad capital flows.
Through the first half of the graph (up to 1990) the P/E ratio rarely exceeded 15, which was considered a pretty healthy number in the "old days". As the 1990's wore on, things started to change dramatically. The CNBC generation discovered the market and the buying that ensued dragged the P/E for the S&P as a whole to the 35 level. Some of the expansion was due to lower debt costs and risk-free rate of return which is negatively correlated to P/E multiples (i.e. lower interest rates = higher P/Es) but much of it, especially in the late 1990s was purely sentiment driven. It was buying based not on past or current profits for the companies in the index but on expectations of future profits.
The second peak in 2002 is less relevant, since it's created by a profit contraction rather than a sentiment expansion. Profits dropped much faster than share prices when the bubble burst and a few quarters of corporate mea culpas and accounting "corrections" ensued. That drove the P/E ratio up in a short sharp and unhealthy spike.
Since that time the markets have based and the P/E ratio as returned to a level of 20-22. This is high by historical standards and one reason many analysts view current market conditions as a bear market rally rather than a new bull market. Historically, P/E ratios drop below 10 before the market bottoms after a major top like 1999-2001.
The important point to note is that rising sentiment lead to investors paying more and more for each dollar of earnings as the 1990's wore on. This is where expectations come into the picture. As investors get more bullish about a sector they begin to assume higher and higher profit growth going forward and are willing to pay more for each dollar of current earnings. In other words, as the 1990s wore on a company with flat earnings could have seen its share price double purely because investors were willing to pay twice as much for each dollar of earnings.
Price earnings ratios tend to be "sticky". Even when conditions change they are often slow to respond. That's part of the reason the S&P saw the large increase in P/E in 2002. Even though conditions worsening markedly the companies in the index had enough support to keep their ratio from collapsing.
Why is this talk about P/E ratios important to resource sectors, particularly metals and energy? Because the metals and energy sectors have always been "valuation challenged" compared to the rest of the market.
The stickiness referred to above is working against energy and metals mining issues, keeping them from moving up sharply. (Note that we are not talking about gold miners here. Gold is a special case. Gold producers tend to get valued on reserves, not on income or cash flow streams)
A major determinant of a sector's P/E ratio is earnings quality. When analysts talk about this they are referring to an industry's capability to generate both earnings growth and earnings consistency. To use the TSX (Toronto) as an example, the P/E ratios for individual sectors within the S&P/TSX Composite index vary from 14.8 for the Metals/Mining sector to 46.7 for Info Tech. Metals have the lowest ratio, with Energy faring little better with a P/E of 16.5.
What accounts for the difference? Techs a viewed as high profit growth sectors, though few companies have actually lived up to that assumption and many have profit histories with plenty of cyclicality and loss making years. Because of the growth reputation and growth expectation, tech companies tend to attract much higher P/E ratios, even though they rarely live up to their billing.
"Commodity stocks" on the other hand, attract low P/Es because it is assumed they will be subject to short cycles with large profit swings. In short, they are viewed as having low earnings quality. Admittedly, there is more than a little truth to these charges. If you look back though history at the metals sectors you'll find 3-4 profitable years followed by 2-3 loss making years. The picture is even worse over the short term since the period from 1997-2002 is one that many miners just want to forget.
Metals and Energy stocks do display big profit swings, but do they deserve the valuations they are attracting? If you believe, as we do, that we are still in the early stages of a secular bull market for commodities then the answer is a resounding NO.
We expect commodity and energy prices to be strong and remain above trend for many years to come. As we move forward, companies in these sectors will be building longer and longer track records of superior earnings, not to mention fat bank accounts and strong balance sheets. Odds are those will be followed by either dividend streams or large share buyback programs. Share buybacks are much beloved by institutions, even when they get done with other people's money as is the case with many tech issues. Based on our analysis, we are expecting strong earnings for the sector for the next several years. We are not assuming that commodity prices will necessarily stay at current levels for the rest of the decade but they don't' have to justify our premise.. All they need to do is stay well above historical trend for the current valuations the metals and energy sectors receive to be proven grossly conservative.
We'll give you an example. Teck-Cominco (TEK.B-T) which we recommended as a core holding to Special Delivery subscribers when it was $12. TEK is trading at about $41 which is a nice gain but still a very conservative value. Last week Teck released its Q4 numbers, including stellar earnings of $285 million ($1.42/share). That was the 5th quarter of strong earnings growth and some of the main contributors (notably coal) will be fetching much higher prices through 2005.
Annualized, the Q4 profit would amount to $5.68/share, implying a forward P/E of just 8! The problem is that the market is clinging to the assumption that copper, zinc and coal prices will soon return to historical norms. We think they will have periods of weakness but it's very unlikely that we will see the base levels (copper below $1.00, zinc below $0.40, etc) that are built into prices for these companies for a very, very long time.
The TSX has a 14.8 P/E compared to 18.5 for the TSX Index as a whole. Even that makes the pricing look better than it is for metal miners since the index includes a number of pulp and lumber producers and gold miners that drag the index P/E upwards. The P/E for the metals miners alone is closer to 10. This means improving sentiment that lifts the sector just to the average for the entire index would generate a 100% gain. If metals become the overweight sector we assume they will as they generate quarter after quarter after quarter of strong earnings and earnings growth the gains should be larger. What goes for TEK goes for other producers on the list like FM, EZM and PVM. None of them are discounting earnings based on anything like price levels for metals and energy prices that should prevail in the next few years. In other words, most market players still don't "get" that this is a secular bull cycle and that earnings levels way above historical trend are here to stay for a long time. Based on that realization along, accumulating on weakness still makes sense. 
Eric Coffin and David Coffin
March 6, 2005
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