Posted on October 17, 2008 by David Laidlaw
The bursting of the housing and credit bubbles is now causing problems in the “real “ economy. The latest statistics show that consumer spending is slowing and that the unemployment rate is climbing. Given the lack of funding for business projects, the economy could slide into recession for the next year or more. This slowdown will impact the sales and earnings of almost all businesses throughout the world.
Given this situation, the question becomes “Why would any rational person hold or even buy stocks now?”
The answer is that stocks are so cheap now that future conditions will most likely be better than indicated by the prices for strong companies. Many public companies will continue to produce positive earnings even during a recession. Some of these earnings will be paid out as dividends and other funds will be retained to grow the business or buy-back shares. Companies are organic organisms that will evolve and exploit business niches similar to biological organisms or populations. Those with slowing prospects will reduce their expenses and increase productivity. Conditions will also improve eventually and companies that survive will be well-positioned to exploit underserved markets.
Stock prices as so depressed that many businesses are selling for 10x earnings or less. This suggests that if their earnings remain stable for 10 years that an investor could expect to receive his or her original investment back in the form of earnings over the next ten years. This analysis ignores discounting those earnings; however, it also ignores the terminal value that the company will be worth in ten years. During normal periods, this terminal value is usually the largest component of a stock’s value. Now, that component is being dismissed.
We also do not see compelling alternatives to common stocks. Real estate values will languish for years to come even though some areas of the country such as Florida and the Southwest may represent good long-term value. Treasury bonds and cash which pay about 4% (10-year Treasury Note) and 2% (money market) respectively provide returns that are so low that their values will not keep pace with inflation. Therefore, we prefer to hold and even buy stocks that provide 10% cash flow yields with the prospect of future growth.