What’s cheap?

Ouch. As of the 16 June, my portfolio is down 9.5% so far in June. Admittedly, my portfolio is leveraged (don’t try this at home, or arguably anywhere else!). Presumably at some point, it’s time to rustle down the back of the sofas, sell off the candlesticks, or forgo a weekend out and use the cash to start buying?

Swallowing knives

I have been nibbling at falling things for a few months now. That’s partly how I’ve ended up in my predicament – my leverage is higher than it’s been since the halcyon days of 2016. Everything I bought cheaply earlier in 2022 has now dropped further. For instance:

• In January I bought my first SHOP for just over $800 (40% down on peak – me spotting a bargain). A bottom-hunting Limit Order then bought more in March, at just over $500. Then I bought more in May at closer to $300. Today, it’s at $305. My January purchase is down over 60%.
• In February I topped up ULVR, deliberating rotating into something ‘inflation friendly’. In February ULVR traded at around £38. Today my February purchase is down about 6% at £35.61.
• In March I topped up MMM, a long term hold, at the price I first paid for it over 6 years ago – around $145. Back then its dividend was around $4.44; now the (ever increasing) dividend is over $6. That was a third more income for your money. But since March it’s down 10% at $131. That dividend is going to keep increasing though, you watch.
• In April I thought HL had become cheap, at under £10/share (down from a peak of £24 in 2019). In 2019 that £24 bought you a dividend of 33p – a yield of 1.4%. But the share price has dropped in the last 2 months over 20% to £7.66. Now the dividend is over 40p – that’s a 5.2% yield. That’s 3.7x more yield in 2 years.
• In May I’m hurting some, but stretch my margin / appetite / common sense and buy AMZN for (old money) $2200. In the last month it’s dropped over 6%, with a 20:1 stock split not making an appreciable difference. I also bought ADS, thinking branded trainers feel reasonably inflation proof too, on a dip at €180. In the same month, ADS is down 10%.

The tech sector is where the pain is most acute. The car dealing companies CZOO and CVNA catch a lot of headlines, both down over 90% since January alone. Unprofitable growth businesses have typically dropped 60-80%. The FTSE doesn’t have any of these, which has helped protect it. But AMZN makes far more profit than its critics ever imagined, as does GOOG and META and of course MSFT. These are all down 30-50%.

Tell me when this stops

At what point do we hit the floor? A big problem right now is knowing where the floor is.

For profitable businesses it feels reasonable to think that long term earnings ratios are a guide. The S&P P/E of 18.5 doesn’t look particularly cheap yet. It’s dividend yield is still only 1.4% (long term mean: over 4%). But dividends are out of fashion. If S&P’s P/E were to drop below 15 I think we’d sniff value. With inflation of 10%, S&P could remain unchanged for a year and earnings growth would pull the multiple into ‘cheap’ territory. Or the index could drop about 10% more.

In the meantime, if you want to buy decent earnings at 12x, and have growth, META at $161 is your stock. GOOG’s P/E is 19.6 – barely higher than S&P’s. Give me a choice of a random S&P500 stock or LaMDA-inventing Google and I know which I’d rather own.

But for unprofitable businesses, it is very hard to see the floor. The relevant multiples here are usually revenue multiples. Docusign has dropped from 27x revenues to 5.4x revenues. It’s apparently about to break even. But is 5.4x revenues fair, or not? What if 4.3x revs is a fairer number? That’s 20% lower than today.

What about bonds?

As to bonds. These have had a miserable run of things for months. Finally those bond bears who said bonds couldn’t keep going up have been proved right – after missing many years of strong returns. The UK Index Linked Gilt index is down over 25% from peak. Regular bonds are down 19% (less hard hit than inflation-linked bonds, go figure). I don’t really have a feel for ‘cheap’ in relation to bonds, but it feels like it is to do with their yields. And for now the yields remain low – iShare’s INXG trailing 12m yield is 0.00% (possibly?). IGLT’s yield is 1.0%. I hold bonds for their (lack of) equity correlation, not because I understand them or love their returns profile.

My high yield bonds / preference shares are holding up reasonably well. NWBD, LLPC, NTEA etc are trading within their usual ranges – and still producing yields of around 6% p.a. This isn’t quite so nice relative to 9% inflation but it certainly is welcome as my equity holdings continue their slide down the cliff.

When WACC doubles, growth get whacked

In reality with base rates rapidly rising off the floor, the future is not worth what it was. If you think base rates have been about 0, and the equity risk premium is 2.5-3.0%, then you’d probably accept P/Es of 33-40x. But once base rates are on course to hit 2.5-3.0%, that means the total cost of equity capital (which is the risk free rate plus the equity risk premium) has just doubled, which implies that P/Es have just halved. That suggests perhaps the old economy dividend stalwarts, which have not yet halved, have further to drop.

A ‘cheapometer’ for finding cheap equities

So for now my cheapometer only starts vibrating on equities when shown the following:

• Profits – decent ones – that are several years old
• Revenue growth of 5%+ p.a. How hard can that be, with inflation of 8-10%? Stay away from things that aren’t clearly on track for this.
• Price down at least 30% from trading highs – this is a very low bar at the moment
• A P/E of under 20, preferably under 16. This is still quite rare.
• Where there is a track record of dividend growth, dividend yields are near record highs – usually above 4%.

GOOG is cheap. META looks cheap too. DOM might be cheap. HL’s lack of growth stops it being properly cheap. MMM is reasonably safe, if not technically cheap. ADBE is tempting, but not yet cheap. ULVR is the only stock I checked that had my cheapometer thrumming. I don’t think S&P500, FTSE-100 or ASX200 are cheap. And even the cheap stuff can absolutely still get cheaper – who dares, can take years winning!

(updated to include table)