Longleaf’s second quarter letter to shareholders was just released and in it highly regarded value investors Mason Hawkins and Staley Cates make the case that equities are still attractive. They view the market as overly fixated on negative macroeconomic news, namely debt, demographics, doom and the possibility of a double-dip recession.
Equities offer a superior opportunity for investors today, particularly compared to fixed income. The earnings yield of the S&P 500 based on 2011 projected EPS is 9.4%. If adjusted for the approximately $100 of cash imbedded in the S&P, the operating earnings yield increases to 10.4%. The numbers are slightly more attractive overseas. Based on 2011 estimates, the EAFE Index earnings yield is 9.8%. If earnings grow organically from today’s depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor’s five year average annual return will be in the mid-teens.
By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce. The following table compares corporate earnings yields to bond yields at bear market lows since 1932. When stocks have been at their lowest levels, earnings yields have been an average of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks’ relative attractiveness to bonds at bear market lows.We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one.
Here’s a link to the letter. The table they reference with their data is on page 2 and is worth a look.
The potential flaw with Hawkins’ argument is that it is based on the assumption that 1) the S&P’s earnings in 2011 will be approximately $96 (the S&P was at 1022.58 on July 2; the yield of 9.4% assumes 2011 earnings of $96) and 2) interest rates will stay at these historically low levels. Both could happen, but I think it is prudent to consider that these assumptions could prove to be wrong. For the record, per Robert Shiller’s data the all-time high earnings on the S&P 500 were $84.92 in June, 2007.