The depressed interest rates due to central bank easy money policies have been a major factor in today's stock valuations. History tells us that a reversion to the mean is inevitable and these low interest rates are not sustainable. Compared to the real inflation which runs above 3%, the 10-year U.S. Treasury note yield of 1.7% provides a negative real return.
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Consider the table below of some of the high quality businesses today which trade at an average P/E of 20 and thus have an earnings yield of only 4.96%. The equity risk premium which is defined as the premium that market participants require for investing in equities over 10-year Treasury notes now stands at 3.27 (327 basis points). This equity premium being meaningful makes stocks appear reasonably valued on a relative basis, but the stock valuations on an absolute basis (5% earnings yield compared to historical 10-year note yields greater than 4%) are not attractive. As and when interest rates rise in the coming years (not sure when) the U.S. Treasury 10-year notes will again yield 4% or above, and then there is high probability that the P/E ratio on these high quality stocks will revert to the 15 to 18 historical range which produces an earnings yield of 6.67% to 5.56%.
We can't predict the stock market direction, but it is however possible to estimate future earnings to a reasonable extent for these companies. It is advisable to note that based on the earnings projections for the next five years these select nine quality companies will likely produce a total return of 8.16% per year (dividends included but not re-invested). Considering the effect of taxes and inflation the real return would likely be even lower at 6.53% and 3.53% (assuming a 20% overall tax rate and 3% real inflation).
There is no question about the quality of these companies, they are all wonderful and will be thriving decades from now. However, the question needs to be asked whether they are good investments to buy at current prices and to hold if they appreciate further. We should never forget the fact that in any investment the most important factor is the price we pay.
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I currently do not own shares of any of the companies mentioned. I am long BRK.B which owns shares of KO,PG,JNJ,WMT.
Comments and questions welcome.
I have used information from Yahoo Finance.
About the author:Mritik Capital Inc. is a financial advisory firm with focus on identifying quality businesses with durable competitive advantages that are undervalued. Our first goal is to preserve the capital of our clients and look for strategies for enhancing their net worth based on opportunities that present compelling risk adjusted reward.
Please note that investing offers both risks and rewards. Before investing do your own due diligence and consult your financial advisor.