“I’ll Get Back in When the Market Corrects”

Do comments like these sound familiar? I would give them a slight bit of credence if this was May, when fundamentals had not yet been proven, but now the Bears are running out of arguments to at least have some equity exposure.  

In the spring of 2009, companies had limited visibility of demand and were aggressively slashing costs. The credit markets were still in a major recovery stage. The banks were getting "stress-tested." A housing bottom was still a question mark, and unemployment was still rising at a frightening pace.

Although the market had begun its rally, the Bears still had a case to avoid the equity markets. However, since Sept. 30, the S&P 500 is about flat, although it was up approximately 4% about a week ago, with fundamentals remarkably better than six months ago. The recent U.S. GDP results confirm the economy is out of a nasty two-year recession and have avoided a financial meltdown. Housing starts, sales, and prices have bottomed/turned up. Industrial production has improved, albeit at lower capacity utilization rates. Although a tremendous amount of liquidity has been pumped into the system, inflation remains non-existent.

From a micro standpoint, now that the shock and awe of 2008 is over, management teams of every company have had time to adjust. Inventories have been rationalized. Debt has been paid down, or refinanced to longer maturities and at cheaper rates. Dividends have been cut, and share repurchase and capital expenditure programs suspended--equaling to a higher amount of free cash flow. Overall, companies are now in a better capital structure than before 2008 and working in a leaner operating environment, which will translate into huge operating leverage and higher earnings power when demand truly kicks in.

During this earnings season, a large majority of companies have met or exceeded analyst earnings expectations, and have commented on increased orders, sustainable backlogs, and offered future earnings guidance, which means there is light at the end of the tunnel.  

In my opinion, we are in the proverbial correction phase now because investors have been selling, even though earnings and fundamentals are improving--money is being taken off the table which is surely a short-term phenomenon. Investors are capturing massive gains because of a percentage runup, not looking at underlying fundamentals. If using a P/E (price-to-earnings) multiple as a standard way to value a business, one must determine what the "E" is and its growth rate. If management is seeing demand start to improve and confidence being restored, has right-sized inventory and operating expenses, and repaired the balance sheet, then it is fair to say in most cases, the "E" will prove to be understated and thus the market is undervalued.

I am not prognosticating on the shape of a recovery. If one looks at a chart of the Dow Jones since 1920, one would find many V's, U's, W's, J's (rarely L's), N's, etc., but the shape of the line is generally up-and-to-the-right. I am looking to find a strong business model trading at a discount to its intrinsic value, with solid earnings growth capabilities over a long-term horizon. That being said, I am also not looking at the world with "rose-colored" glasses. I know the consumer is still stretched. I know banks are still suffering losses even though they are better prepared today than one year ago. I know the weakness in the commercial real estate market is upon us (along with the CMBS market). I know the government's new involvement in corporate America frightens die-hard capitalists. Concerns still exist, but fundamentals are improving, too, and if we have learned one thing from the financial crisis over the past year, it is that households, corporations, and governments have adjusted and responded to changing times like never before.

The equity markets have pulled back some, yet fundamentals have bottomed, if not begun to improve. Visibility has returned to the market. We're still buyers of this market, as our value discipline forces us to be so. I will end with this thought in relation to where we are today fundamentally; ask yourself this, do you remember where we were a year ago? If investors were afraid to take risk then, what about now?