Trading and Investing

With Google stock now over $500 per share, investors need to stop and think about whether Google stock is worth buying.

It’s pretty clear that Google has the makings of a great company. They have the best search engine on the web, they attract top talent, and they appear to have good vision for the future of the Internet. But I’m still not convinced it’s worth $500 a share, and here’s why.

First off, Google has publicly declared that they do not plan to pay dividends, ever. Here’s a quote from Google’s Investor web site:

“Does Google pay a cash dividend?

No, we have never declared or paid a cash dividend nor do we expect to pay any dividends in the foreseeable future.” (http://investor.google.com/faq.html#dividend)

Why would anyone buy stock in a company that never pays dividends? How will you ever get your $500 back if the company never pays its shareholders? Maybe Google will change their mind and someday start paying dividends, but most Google owners I know bought because they think that they will be able to sell their shares for a higher price in the future.

But is $500 cheap or expensive? What if I told you that Google shares were $1,000? Or $10,000? Would you still be a buyer? Most people have no idea how much Google as a company is worth. Prior to this post, I had no idea either. Fortunately, all it takes is a simple investigation of GOOG at finance.yahoo.com to find out.

Right now Google has $10 billion in cash. Wow! That’s a lot!…except that there are a lot shares out there so that cash per share is only $34. In total assets (including property, computers, etc.), Google is worth only $47 per share. If Google were liquidated right now, your $505 share of stock would be worth $47. Not a great deal.

What about cash flow? In 2005, Google earned $2.5 billion in operating profits. If Google earned $2.5 billion annually, it would take 39 years before Google should be worth $505 per share. Even if Google’s profits grew at an amazing rate of 25% per year, it would still take 10 years before the company would be worth $505 per share. And that’s just to break even!

Say my investment horizon for Google were 10 years and that I was hoping to earn a 10% annualized return on my money. That means that I’m hoping to sell Google stock for $1,310 in the year 2016. For this to happen, Google’s profits would have to grow at an incredible 42% per year, at which time they would be around $83 billion.

By comparison, Microsoft’s average annual profit for the last three years was around $15 billion. And they own Windows! (on a side note, Microsoft paid out $36 billion in dividends last year. Google paid out, you guessed it, zero)

Finally, let’s compare Google to another company that never pays dividends: Warren Buffett’s Berkshire Hathaway (BRK-A). Berkshire Hathaway’s current stock price is $107,610. Wow! But a look at the company balance sheet reveals that Berkshire holds assets worth $66,293 per share, $27,392 of which is cash. If the company continues to earn $9.5 billion profit per year as it did in 2005, it will take only 3 years for Berkshire as a company to be worth it’s current stock price. Now that’s a stock worth buying! (ps. Berkshire is one of my top picks these days. I “bought” BRK-A in my fake Yahoo portfolio for $99,000 in August…too bad I don’t have any real money…doh!).

Warren Buffett is no dumb-dumb. Berkshire Hathaway has $45 billion in cash right now because Warren is waiting for a good buying opportunity. Warren looks for stocks that have intrinsic value rather than ones that he thinks he can sell to the greater fool. I’ll let you know if he buys Google stock, but until then don’t hold your breath.

- defo

Let’s take a quick look at the history of gold prices and the Dow Jones Industrial Average since 1970.

Dow

After being flat for nearly a decade during the 1970s, the Dow grew at an astonishing 15% a year between 1982 and 1999. After a correction between 1999 and 2001, the average is back up and pushing new highs.

Gold

After going through possibly one of the biggest market run-ups in history, gold went through a 20 year bear market in which the price dropped over 70% between 1980 and 2001. Adjusting for inflation, the purchasing power of gold declined 85% during this time period. Since 2001, the price of gold has increased about 20% annually.

Dow/Gold Ratio

Gosh, I wish I had seen this data in 1999, when the Dow/Gold ratio reached a historical high. Even the current ratio is nearly as high as its level just before gold’s huge 1970s rally. You’ve got to ask yourself whether this ratio will continue its way down or slingshot it’s way back up to 1999 levels.
In my view, 2001 began a gold surge that will last at least a few more years. The ratio may climb up in the near term, but I think the overall trend looking forward has got to be downward.

Summary: I think gold is still a buy relative to US equities. Watch for inflation data to see how gold moves in the short term. More updates in the future…

- defo

You may be asking yourself why I focus so much on P/E ratios in my analysis of the U.S. stock market. Certainly there are other factors that should also matter for investors. But I think this is one of the most important ones because it gives a sense for how the stock market price reflects the fundamental value of what you are buying.

You’ve got to ask yourself what it is you own when you buy a share of company stock. Owning a share of stock entitles you to a variety of rights as a company shareholder (see wikipedia for an overview: http://en.wikipedia.org/wiki/Stock). But at the end of the day, owning one share of stock entitles you, directly or indirectly, to one share of future company earnings.

Stocks are worth only as much as people are willing to pay for them. In good times, people are willing to pay a lot (sometimes too much) for a share of the stock market. In bad times, buyers are scarce and prices can drop very quickly. As an investor, I’d like to own something that has *fundamental value* over time, even if nobody else wants to buy it. A portion of future company earnings, while uncertain, has fundamental value. Even if nobody was willing to buy my Google stock from me, I would at least be entitled to a portion of all of Google’s future profits.

The same holds for real estate. Property is worth only as much as other people are willing to pay for it. But ownership also entitles you to a future stream of rents that you can collect from the property. I’d rather buy property at prices where I would be happy holding the real estate investment for 10 years or more.

When the stock market is backed up by solid company earnings, there is a limit to how far the stock market can fall.  But if psychology turns sour in today’s market, then watch out below.

Is the S&P overvalued right now? Or is it the beginning of another huge bull market? This post revisits historical P/E ratios collected by Robert Shiller, author of Irrational Exuberance (all data can be found on his web site at www.econ.yale.edu/~shiller/).

The following chart tracks the Price to Earnings ratio of the S&P 500 over the last 100 years. For those who do not know, a P/E ratio is the stock price (in this case the whole market) divided by the sum of all corporate earnings. For these calculations, Shiller uses the average earnings of the previous 10 years.

The stock market reached P/E ratio peaks in 1929, 1966 and 1999. Each of these years was preceded by price growth of over 10% annually for a decade or more. Using Shiller’s data, I have organized the expansion and contraction cycles of the U.S. economy for the last 100 years in the chart below. The dates were chosen to coincide with the P/E ratio peaks and valleys.

As you can see from the charts above, the length of cycles last anywhere from 9-25 years. The rip-roaring 20s saw the stock market increase 19% annually over 9 years while corporate earnings grew only 8% a year. The result was a massive stock market collapse between 1929-1933 where the stock market lost 85% of its value. The Great Depression followed as the only time in recent history where the U.S. had negative average earnings growth for over a decade.

The second growth period occured after WWII and lasted nearly 25 years. The S&P grew at 11% annually while earnings grew only 7% per year. After the 1966 peak, the stock market stayed flat for over a decade while rampant inflation ate away at investors’ purchasing power. In 1978, the stock market was at an almost identical nominal level as in 1966 even though it’s real value had decreased over 50% due to inflation.

From 1980 to 1999, the stock market had its greatest run of all time. Although not as explosive as the 1920s, the latest stock market surge lasted 20 years and was much greater in terms of overall price growth. The P/E ratio of the S&P 500 reached an all time high of 44 in 1999. The stock market has finally reached its 1999 nominal peak again even though it has declined by more than 20% in real terms. The P/E ratio has declined, but still remains as high as every other peak in the last 100 years besides 1999.

How can the biggest growth period in history be followed by anything other than an extended recession?

I see two options for how a stock market correction might play out: either a 1929-like stock market crash or a 1970s-like inflation cycle. We seemed to have dodged a 1999 crash by the Fed lowering interest rates to 1% in 2001. Combine that with a post-September 11th patriotic optimism and you can fight off a recession. I’d bet more on the latter although either scenario is possible. If the stock market keeps pushing up like it has in the last four months, a future crash might be more likely.

Corporate earnings dropped almost 50% from 1999 to 2001, but then rose almost 150% in the last four years. Have we had such a productivity revolution in this country that we can expect this kind of growth to continue? Can we think of any bubbles in the last four years that might have artificially driven up earnings? (think: housing!)

In no other time in history was a P/E level of over 20 sustainable. I’m betting this time is no different.

– defo

Gambling Against the Dollar

If you’re wondering why people are worried about a potential US dollar devaluation, then perhaps you should check out this article in the New York Times (click the link above). The graphic of the US trade deficit says it all:

How are we going to pay for all this? What happens when China stops buying our dollars? At some point something is going to have to give. The key questions are how and when.

Below is an insightful quote from the article (it’s actually worth reading the whole thing…I send out a lot of articles that I find about dollar devaluation but this is one of the best):

“The big question now is how will the situation reverse itself. It could happen gradually, with other countries slowly reducing their purchase of dollars. This wouldn’t be horrible, as Americans discovered when the dollar dropped in the 1980s. But most of us would be worse off for the simple reason that foreign loans would no longer be letting us live beyond our means.

The other possibility is that an unexpected event — a spike in oil prices, say — could cause foreign investors to cut their dollar purchases sharply, bringing all sorts of economic havoc. Edwin M. Truman, an economist who spent a quarter-century at the Federal Reserve, compares the situation to a merry-go-round that is moving too fast for its underlying mechanics. It gradually loses speed, leaving its riders disappointed but unscathed, or it stops suddenly and throws some of them off their horses.”

– defo