Did You Hear the News?
When the stock market is acting crazy like it has been recently, it is easy to overlook news that is not nearly as eye catching. For example, last week Xerox and Fujifilm announced that they will merge the two companies into a single entity later this year called Fuji Xerox.
As far as I can tell, not many people are jumping out of their chairs over that development. They can be forgiven, since neither company has given them much to shout about lately.
I’m not saying this is the deal of the century, but I think it is worth taking a closer look at. That’s because it may turn out to be the type of company that leads the stock market higher as interest rates edge higher.
For the past several years, growth stocks have been on a tear thanks to very low interest rates. Many of them are valued based on earnings project many years into the future. But as rates rise, the present value of those future earnings are worth less today.
Consider Amazon.com (NasdaqGS: AMZN), the poster child for overvalued momentum stocks in my opinion. While the overall stock market lost nearly 10% of its value during the past week, its share price barely budged.
It is currently trading at 95 times next year’s earnings, with a profit margin of 1.7%. Not to worry, say its legion of zealous defenders. One day Amazon will become more profitable and when that happens, LOOK OUT!
Look out for what, exactly? Already, Walmart (NYSE: WMT) and Target (NYSE: TGT) are proving that they can compete in the online space with Amazon, and their profit margins are higher.
But Amazon grew revenue at an astounding 148% clip during the most recent quarter, they say. Of course, the most recent quarter includes Christmas, so that may be a bit misleading.
During the past year, Amazon has grown sales by 38%, which is still impressive. But at the same time, it only produced a profit of $6.15 per share.
I’ll save you the trouble of doing the math. At a recent share price of $1,430 Amazon is trading at a trailing P/E multiple of 231 times earnings.
To justify its current share price, either Amazon is going to figure out a way to improve its profit margins by about 500% or reduce the number of shares outstanding by a similar amount.
I don’t think either one of those things is likely to happen.
Instead, I believe rising interest rates will force analysts to recalculate both the likelihood and present value of Amazon’s future profits. When that happens, don’t be surprised if they come up with a share price value below $1,000.
At the same time, those analysts may discover that companies like Fuji Xerox are worth more than there low valuations suggest. You can buy Xerox today for less than nine times next year’s earnings.
By the way, Fuji Xerox promise that it will share at least 50% of its free cash flow with shareholders via dividends and share repurchases. That’s actual money you can put in your pocket.
Do you want to guess how much of its profits Amazon paid out to its shareholders in the form of dividends and stock repurchase during the past twelve months?
If you guessed any number other than zero, you are wrong.
Point being, very low interest rates created a class of stocks heretofore never seen. Namely, companies with absolutely no accountability to their shareholders trading at very high multiples.
Their days may not yet be over, but they are numbered. Specifically, that number is the yield on the 10-year Treasury-note, currently sitting at 2.8%. That’s DOUBLE where it was less than two years ago, and as high as its been in four years.
When that number crosses above 3%, then it will really be time to LOOK OUT!
Overvalued momentum stocks will be out and high-yielding value stocks will be in, like Fuji Xerox. There will many others, some of which can be had at bargain basement prices right now.
The trick to finding them is being able to sift through all the noise that the mainstream media puts out to identify the few stories that really matter.