Do Not Fear the CAPE Ratio; Buy Skyworks and Sell Campbell's
There is a lot of concern right now about the value of the US stock market, and not without reason. Robert Shiller’s CAPE ratio is at 25x, which implies real returns in the stock market of 1.1% per year for the next ten years. If you’re not familiar with the CAPE ratio there are better places to learn about it, but just know that it historically has been pretty good at predicting future returns in the US stock market and a lot of people pay attention to it.
I started managing my own IRA about a year ago after dabbling very successfully in the stock market for about ten years and have had a hard time reconciling the gloom of the CAPE ratio with what I’m actually finding in the market. It’s certainly harder to find good buys now then it was two years ago, but they’re still out there, and especially it seems in the growth part of the market. I’ve been trying to figure out what it means and now I’ve got a theory: one segment of the market is massively overvalued and is driving up the CAPE ratio leading to irrational fears of the market overall.
To illustrate my point, consider two companies: Skyworks Solutions (SWKS), which I’ve recently added to my portfolio, and Campbell’s Soup (CPB) which I wouldn’t buy on a dare.
Skyworks makes analog semiconductors and components for wireless devices including smartphones, tablets, GPS devices and smart utility meters. They are perfectly positioned to benefit from several massive trends including increased adoption of smartphones in developing economies and the ‘internet of things’ that will lead to 50 billion things and machines being connected to the internet by 2020 (think, for instance, of cars and utility meters now being connected to the internet.)
Campbell’s makes soup, or as they call it, ‘branded convenience food products.’
Let’s consider the numbers for SWKS: Over the last five years revenue has grown at a rate of 18% per year and net income has grown at 24% per year. They do not pay a dividend, but they did repurchase $185M worth of stock last year, which represents about 3% of current equity market value. Analysts are projecting EPS growth of 16% per year over the next five years and the forward PE ratio is 12x.
Now the same numbers for CPB: Over the last five years revenue has grown at a rate of 3% per year and net income is essentially flat. They do pay a dividend which at the current stock price yields 3%, but they do not have a material stock buyback program. Analysts are projecting EPS growth of 3% per year over the next five years and the forward PE ratio is 16x.
Yes, the forward PE ratio on CPB is 16x. I did not accidentally type a ‘one’ in front of that ‘six.’
But the valuation of CPB is not irrational, it’s just that for investors seeking income, there is no better alternative. With 3% expected EPS growth and a 3% dividend yield, the expected return on CPB is about 6% per year. The average yield on high quality corporate debt for a 5-year maturity is about 2% per year according to the US Treasury. Getting paid 400 basis points per year to hold the equity of Campbell’s as opposed to the debt is fair, and I would guess in line with historical averages.
The problem is that when interest rates really start rising, stocks like CPB are going to get crushed. The interest rate on debt of 2% referenced above is about 400 basis points lower than its historical average. If debt interest rates were to rise 400 basis points, CPB would then need an expected return of 10% to maintain historical parity with the debt. Since EPS growth of 3% per year isn’t going to change, that would require a 7% dividend yield. In order to get to a 7% dividend yield, the stock price would need to decrease by 60% and the resulting forward PE ratio would be 6.5x.
I don’t have the database to prove this point, but that same effect across the entire universe of high-dividend stocks would almost certainly correct the CAPE ratio back to non-scary levels.
Which brings us back to Skyworks. If interest rates rise 400 basis points the company will actually benefit, at least directly. Skyworks has no debt and $500M in cash on its balance sheet. An increase in interest rates of 400 basis points would increase their net interest income by $20M per year. That’s it. And EPS otherwise keeps growing at 16% per year.
The takeaway for individual investors is clear: do not fear the CAPE ratio. Instead buy stocks that are fairly valued or undervalued and not sensitive to interest rate increases. Those stocks are out there and I am reaping the benefits (up 38% since I started the IRA in May 2013 and 13% YTD in 2014). Happy hunting everyone!