Bill Nygren 2010Q2 commentary

AGA7d

Kinda old - but still valid. -AGA
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The S&P 500 fell 11% in the quarter, despite the continuing recovery in corporate earnings. The S&P now stands at about 11 times next year’s $93 consensus estimate of net income from operations, and it yields 2.2%. At the Morningstar conference last month, I kept telling skeptical attendees that I was bullish because it is so rare to be able to buy the S&P at three-quarters of its long-term average P/E and with a yield that is more than a five-year government bond. Their responses were always the same, “But what if the pessimists are right, and we enter a long period of no real growth in GDP?”

I don’t for a minute concede that we are condemned to that future, but for kicks let’s run the math. If annual inflation is 1.5% and real growth is zero, then corporate sales and profits probably average that same 1.5% growth rate. In a no-real growth mode, companies won’t need to spend much more than depreciation, which leaves them with an after-dividend free cash flow yield of about 6%. With corporate balance sheets already cash heavy, let’s assume excess cash is simply used to reduce shares outstanding.

Where does that put us in five years? Corporate earnings would be up 8%, common shares outstanding would be down 27%, and EPS would be 47% higher. If the P/E rose to its long-term average of 15 times, the S&P would just about double in five years and would have provided more dividend income over that time than the interest income from a five-year Treasury. That’s not too shabby for an economic backdrop that I believe is much too pessimistic. Of course, things could always get worse, but with stock prices appearing so depressed, the bears need to come up with more imagination than that.

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