A simulation-based valuation of American Eagle Outfitters (AEO): December 2019

Summary

- AEO is a clothing and accessories retailer based in Pittsburgh, Pennsylvania ().

- At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 9.95.

- A simulation-based (sim-based) valuation () suggests that the fair price-to-earnings ratio is 16.73, leading to a fair share value of $23.62.

- AEO currently trades at $14.05, so it appears to be undervalued, with a potential upside of 68.11%.

American Eagle Outfitters (AEO)

AEO is a clothing and accessories retailer based in Pittsburgh, Pennsylvania (). It focuses on casual apparel, accessories, and footwear for men and women aged 15–25 years. Notably, it sells intimates, apparel, and personal care products for women under the Aerie brand; this is a major growth engine for the company.

AEO does not own or operate any manufacturing facility. As such, it depends on third-party manufacturers for all of its merchandise. The company’s operations may be negatively affected by import disruptions. Trade-related unpredictability is not good for this company. On the other hand,  such unpredictability also regularly offers attractive entry points for investors.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of AEO.

At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 9.95. The growth in earnings for the past 5 years has been on average 27.87%, but has recently (trailing twelve months) gone down to 5.56%. To be conservative, we will consider the mid-point between these two numbers, or 16.76%, to be the sim-based earnings growth rate for the next 5 years.

Is the price-to-earnings ratio of 9.95 suggestive of undervaluation? As you can see in the table below, the answer to this question seems to be “yes”. Since our sim-based analysis uses a S&P 500 return as a basis, the fair price-to-earnings ratio should be 16.73, leading to a current fair value of $23.62. AEO currently trades at $14.05, so it appears to be undervalued, with a potential upside of 68.11%.

Is the fair price-to-earnings ratio of 16.73 too high?

Could the fair price-to-earnings ratio estimated above, of 16.73, be too high? Arguably the answer is “no”, because AEO’s price-to-earnings ratio for the past 5 years has been on average 19.80. In fact, given this, our potential upside may be underestimated.

Other pluses and minuses

AEO pays an attractive dividend of 3.64%, significantly higher than the average S&P 500 dividend, and with a comfortable payout ratio of 36.47%. It has an attractive balance sheet, with $317 million in cash, and no debt – unlike other retailers being affected by what has been called the Amazon-driven “retail apocalypse”.

Also, AEO has been steadily buying back its shares, and it has not been issuing any new debt to finance this.

Recently the stock has lost about 7% of its value in one single day, after it provided “soft” Q4 guidance in an earnings report. The forward guidance was below what analysts expected, but consistent with the conservative approach to guidance usually adopted by AEO.

Still, even with the soft guidance, AEO reported earnings (bottom line) in line with analyst expectations, and revenues (top line) that beat expectations.

Disclosure

The author owns AEO shares at the time of this writing.

The initial jobless claims data may be very misleading: What really matters is the trend of the “second derivative”

Summary

- Initial jobless claims seems to be going down sequentially as of late.

- But the year-over-year rate of change is clearly going up, and fast.

- Recently the popular business media have been largely reporting the initial jobless claims measure as evidence that the job market is strengthening.

- The reality is that it is weakening, based on this measure, at an alarming rate.

Initial jobless claims

In the US data on initial jobless claims is released by the Department of Labor every week. The measure tracks the number of people who filed initial claims for unemployment benefits in the previous week. This measure is closely followed by the financial markets.

Since the measure is “noisy”, usually the 4-week moving average is followed. As you can see from the graph below, from the FRED (), it seems to go up prior to recessions. The latest data is circled on the right, and it looks like it is going down.

What really matters is the trend of the “second derivative”

The above trend is misleading because, as with most leading indicators of economic slowdowns (including recessions), what really matters is the trend of the change in the rate of change. This trend is frequently referred to as the trend of the “second derivative” of the underlying measure.

Look at the graph below, also from the FRED, which is the percentage change in initial jobless claims compared to the same period in the previous year. It is important to consider the year-over-year rate of change, as we do here, because of the seasonal nature of initial jobless claims.

As you can see on the right, this rate of change (the "second derivative") has been increasing steeply in recent months. This essentially means that the year-over-year rate of change in initial jobless claims has been increasing at a fast rate more recently.

The job market is weakening at an alarming rate

This is an unusual situation because the measure itself, initial jobless claims, seems to be going down sequentially as of late. But its year-over-year rate of change is clearly going up. This tends to precede recessions.

Recently the popular business media have been largely reporting the initial jobless claims measure as evidence that the job market is strengthening. The reality is that it is weakening, based on this measure, at an alarming rate.

A simple analogy

Imagine that you are driving from Houston to Austin. Where you are, at any given time, is the measure. The first derivative is the speed at which you are traveling. The second derivative is the acceleration.

Someone that is following only your location would see any movement toward Austin as progress. Positive speed is also seen as progress. However, if acceleration is negative, at some point you may stop and start going back to Houston ...

A final note

This blog discusses, among other things, simulation-based valuations of companies. Those valuations are based on fundamentals (e.g., earnings and revenues), and assume growth rates that are generally different from those seen in steep economic slowdowns or recessions.

If the stock market “sees” a recession coming, expectations about growth change drastically, usually for the worse. As a result, stock prices (and thus valuations) tend to drop precipitously, often regardless of fundamentals.

A simulation-based valuation of Hong Kong (EWH): October 2019

Summary

- Shares of the exchange-traded fund EWH () track the MSCI Hong Kong Index, which consists of stocks of large companies traded primarily on the Stock Exchange of Hong Kong Limited (SEHK).

- The EWH pays a very attractive dividend of 3.15%, which is higher than the average S&P 500 dividend.

- In this post we provide a simulation-based (sim-based) valuation of shares of the EWH.

- Our sim-based analysis suggests a fair price-to-earnings ratio of 15.30 and a fair valuation of $27.23.

- The EWH currently trades at $22.53, so it appears to be undervalued, with a potential upside of 20.86%.

The Hong Kong exchange-traded fund (EWH)

Shares of the iShares MSCI Hong Kong Index Fund (EWH) track the MSCI Hong Kong Index (). This index consists of stocks of large companies traded primarily on the Stock Exchange of Hong Kong Limited (SEHK).

Estimating a fair value for the shares

In this post we provide a simulation-based (sim-based) valuation () of shares of the EWH.

At the time of this writing, the EWH had a price-to-sales ratio of 2.45 and a price-to-earnings ratio of 12.66, which combined suggest an average net profit margin of 19.35%. The sales growth was a high 8.37%. We should note that US corporations had profit growth of around 10% on GDP growth of approximately 3% in 2018. That is over 3 times as much profit growth as sales growth.

We will conservatively estimate the sim-based earnings growth rate for the next 5 years to be 15% for the EWH, which is less than 2 times sales growth. Taking these various numbers, we arrive at a fair price-to-earnings ratio of 15.30 and a fair valuation of $27.23, as you can see in the table below. The EWH currently trades at $22.53, so it appears to be undervalued, with a potential upside of 20.86%.

The current US-China trade war

The US and China are currently embroiled in a trade war, which is marked by the imposition of tariffs on each other’s goods. Even though Hong Kong is part of China, the tariffs that the US has imposed on China do not apply to Hong Kong. Maintaining this status quo is in China’s best interest, as it adds some room for maneuvering around tariffs in the future via transshipments.

Hong Kong trades more goods in value than its gross domestic product, and half of this trade is via transshipments; i.e., goods that simply travel through Hong Kong, as opposed to being manufactured there. If the US-China trade war intensifies, Hong Kong’s share of exports to the US may increase via: transshipments from Asian countries that are not targeted by US tariffs; shipments of goods manufactured in Hong Kong; and “disguised” transshipments from China.

If the US-China trade war eases, Hong Kong’s share of open (not “under the table”) transshipments from China may increase. This is likely to play out better for Hong Kong, which is also a major financial center. Interestingly, Hong Kong's GDP relative to mainland China's peaked at 27% in the early 1990s, and fell to less than 3% in recent years. This is primarily due to the massive cumulative economic growth in mainland China since the early 1990s. And continued growth in China means growth in Hong Kong as well.

The current protests in Hong Kong

Hong Kong has a history of protests, many of which have involved violence. Usually the protests have a negative short-term impact on the economy, and are followed by a strong economic rebound soon afterwards. If history repeats itself, the EWH, which is now undervalued, should rebound quickly as soon as the protests lose steam. In fact, the current protests are a key reason why the EWH is undervalued.

Other pluses and minuses

The EWH pays a very attractive dividend of 3.15%, which is higher than the average S&P 500 dividend. Since Hong Kong is a country, it is very unlikely that it would go “bankrupt” in the sense that a company could. The companies that make up the EWH could go bankrupt, but they would have been removed from the EWH way before that happened and replaced by companies with better performance.

Moreover, Hong Kong prints its own currency, which gives it some flexibility to stimulate its economy, should that be needed. This flexibility is limited by the fact that the Hong Kong dollar is currently pegged to the US dollar, which may change in case dire circumstances emerge. Any effective stimulus would probably move the EWH up, well before the main street economy actually felt the jolt (the EWH is a leading indicator).

Disclosure

The author owns EWH shares at the time of this writing.

A simulation-based valuation of Johnson & Johnson (JNJ): September 2019

Summary

- JNJ () manufactures and sells various health care products worldwide, primarily in three segments: pharmaceuticals, medical devices, and over-the-counter products.

- It had a market capitalization of $347.45 billion at the time of this writing, and an attractive dividend yield of 2.89%.

- JNJ has a comfortable payout ratio of 30.11%. It has an attractive balance sheet, with $15.3 billion in cash.

- In this post we provide a simulation-based (sim-based) valuation of JNJ.

- Our sim-based analysis suggests that the fair price-to-earnings ratio should be 23.22, leading to a current fair value of $140.02.

- JNJ currently trades at $131.65, so it appears be undervalued, with a potential upside of 6.36%.

- The potential upside could possibly be much higher, given that JNJ’s price-to-earnings ratio for the past 5 years has been on average 76.05.

Johnson & Johnson (JNJ)

JNJ manufactures and sells various health care products worldwide, primarily in three segments: pharmaceuticals, medical devices, over-the-counter products. JNJ had a market capitalization of $347.45 billion at the time of this writing, and an attractive dividend yield of 2.89%.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of JNJ.

At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 21.83. The growth in earnings for the past 5 years has been on average a relatively low 3.12%, but has recently (trailing twelve months) shot up to 43.45%. To be conservative, we will consider the mid-point between these two numbers, or 23.28%, to be the sim-based earnings growth rate for the next 5 years.

Is the price-to-earnings ratio of 21.83 suggestive of undervaluation? As you can see in the table below, the answer to this question seems to be “yes”. Since our sim-based analysis uses a S&P 500 return as a basis, the fair price-to-earnings ratio should be 23.22, leading to a current fair value of $140.02. JNJ currently trades at $131.65, so it appears to be undervalued, with a potential upside of 6.36%.

Is the fair price-to-earnings ratio of 23.22 too high?

Could the fair price-to-earnings ratio estimated above, of 23.22, be too high? Arguably the answer is “no”, because JNJ’s price-to-earnings ratio for the past 5 years has been on average 76.05. In fact, given this, our potential upside may be underestimated.

JNJ typically trades at a premium because of its dominant position in the health care industry. Also, like many consumer defensive stocks, it is considered to be a low-risk investment that holds up well during economic downturns.

Other pluses and minuses

JNJ pays an attractive dividend of 2.89%, higher than the average S&P 500 dividend, and with a comfortable payout ratio of 30.11%. It has an attractive balance sheet, with $15.3 billion in cash, although it has $29.4 billion in debt.

This debt is not as problematic as it may seem, because JNJ’s income before tax is approximately $18 billion. That is, the combination of cash and income before tax exceeds JNJ’s debt, which means that the company can pay down its debt in a relatively short amount of time should it need to do so.

Recently in one of the first state opioid cases, an Oklahoma judge ruled against JNJ, awarding the state $572 million. This was well below the over $17 billion the state was seeking in damages, and JNJ is going to appeal. This is generally good news.

Disclosure

The author owns JNJ shares at the time of this writing.

A simulation-based valuation of AVX Corporation (AVX): August 2019

Summary

- AVX is an American manufacturer of electronic components headquartered in Fountain Inn, South Carolina.

- It had a market capitalization of $2.5 billion at the time of this writing, and an attractive dividend yield of 3.15%.

- AVX has a comfortable dividend payout ratio of 28.70%. It also has an attractive balance sheet, with $790 million in cash and no debt.

- In this post we provide a simulation-based (sim-based) valuation of AVX.

- Our sim-based analysis suggests that the fair price-to-earnings ratio should be 12.41, leading to a current fair value of $19.71.

- AVX currently trades at $14.52, so it appears to be undervalued, with a potential upside of 35.74%.

AVX Corporation (AVX)

AVX is an American manufacturer of electronic components headquartered in Fountain Inn, South Carolina. It is in fact a subsidiary of Kyocera Corporation, which is a Japanese multinational ceramics and electronics manufacturer headquartered in Kyoto, Japan. AVX had a market capitalization of $2.5 billion at the time of this writing, and an attractive dividend yield of 3.15%.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of AVX.

At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 9.14. The growth in earnings for the past 5 years has been 16.51%. To be conservative, we will consider the lower industry average projected earnings growth of 10.81% to be the sim-based earnings growth rate for the next 5 years.

Is the price-to-earnings ratio of 9.14 suggestive of undervaluation? As you can see in the table below, the answer to this question seems to be “yes”. Since our sim-based analysis uses a S&P 500 return as a basis, the fair price-to-earnings ratio should be 12.41, leading to a current fair value of $19.71. AVX currently trades at $14.52, so it appears to be undervalued, with a potential upside of 35.74%.

What if future earnings growth is more in line with the past 5 years?

As noted above, we used as sim-based earnings growth rate for the next 5 years the industry average projected earnings growth of 10.81%.

What would happen if we used the growth in earnings for the past 5 years of 16.51%?

In that case, as shown in the table below, the fair price-to-earnings ratio should be 16.51, leading to a current fair value of $26.22. The potential upside then becomes a very attractive 80.58%.

Other pluses and minuses

AVX pays an attractive dividend of 3.15%, with a comfortable payout ratio of 28.70%. It has a non-leveraged balance sheet, with $790 million in cash and no debt.

On the other hand, it missed estimates in its last earnings report in late July. And, like many other companies in the industry, is predicting a significant drop in earnings for the next two quarters.

Disclosure

The author owns AVX shares at the time of this writing.

A simulation-based valuation of Workday (WDAY): July 2019

Summary

- WDAY was founded in 2005 as a human resources management software by former Peoplesoft pioneers.

- Its market capitalization was almost $49 billion at the time of this writing, and with an attractive balance sheet.

- In this post we provide a simulation-based (sim-based) valuation of WDAY.

- At the time of this writing the company had a negative net profit margin of -15% and a price-to-sales ratio of 16.19.

- Our sim-based analysis suggests a fair value of $194.48. WDAY currently trades at $215.50, so it appears slightly overvalued.

Workday (WDAY)

WDAY was founded in 2005 as a human resources management software company by former Peoplesoft pioneers. This happened after Peoplesoft was acquired by Oracle in a hostile takeover. Since then it has grown quickly. Its market capitalization was almost $49 billion at the time of this writing, and with an attractive balance sheet. For example, it is not leveraged at all, having more cash than debt.

Estimating a sim-PE

In this post we provide a simulation-based (sim-based) valuation () of WDAY.

At the time of this writing the company had a negative net profit margin of -15% and a price-to-sales ratio of 16.19. The growth in sales for the past 5 years has been a very high 43%. We will consider this to be the sim-based earnings growth rate for the next 5 years, which is a somewhat optimistic prediction given that the 5-year earnings growth forecast is 28%.

Taking the numbers above, we can arrive at a sim-based valuation by making a few additional assumptions. One of these assumptions is a net profit margin of 24%, which is the average for information technology services companies. With this, and the price-to-sales ratio above, we arrive at a sim-based price-to-earnings ratio of 67.46.

Note that we assumed a positive net profit margin of 24% for a company that actually has a net profit margin of -15%. This type of assumption is useful in valuing companies that have a negative profit margin, which is often the case with high-growth companies that have been publicly-traded for only a few years.

Estimating a fair value for the stock

Is the sim-based price-to-earnings ratio of 67.46 suggestive of overvaluation? As you can see in the table below, the answer to this question is “yes”. Since our sim-based analysis uses a S&P 500 return as a basis, the price-to-earnings ratio should be 60.88, leading to a current fair value of $194.48. WDAY currently trades at $215.50, so it appears slightly overvalued.

What if future earnings growth is more in line with forecasts?

As noted above, we used as sim-based earnings growth rate for the next 5 years the growth in sales for the past 5 years, which has been a very high 43%.

What would happen if we used the 5-year earnings growth forecast of 28%? In that case, as shown in the table below, the price-to-earnings ratio should be 29.37, leading to a current fair value of $93.84. This highlights the key challenge of valuing growth stocks - growth forecasts can vary widely.

Keep in mind that the company could grow even faster at the top and bottom lines, which would suggest that it is currently undervalued. I would think this to be unlikely since sales growth has been slowing down as of late.

Disclosure

I do not own WDAY shares at the time of this writing, nor do I intend to buy shares within the next 72 hours.

Fed rate cuts and the two recent recessions

Summary

- The last two recessions were preceded by Fed rate cuts.

- Stock market reactions were somewhat different in the two recessions.

- In the early 2000s recession (March 2001 to November 2001) the stock market was already going down by the time the Fed started cutting rates, and continued going down.

- In the Great Recession (December 2007 to June 2009) the stock market reaction to the Fed cutting rates was more optimistic, with a three-month rally that saw the S&P 500 go up by a little less than 10 percent.

- After that initial rally, the stock market dropped by more than 50 percent (in early 2009), with several “sucker rallies” in between.

- Generally speaking, a Fed rate cut at a period when the signs of an upcoming recession are pilling up should be a source of concern for stock market investors.

The last two recessions were preceded by Fed rate cuts

The graphs below are for the period from January 1999 to June 2019, and were generated using Yahoo Finance and the US Federal Reserve Economic Data (FRED) (, ). The graph at the top shows the weekly variation in the S&P 500 index together with its 50-month simple moving average. The graph at the bottom shows the effective federal funds rate.

As you can see, the last two recessions were preceded by Fed rate cuts. The dashed lines suggest that stock market reactions were somewhat different in the two recessions. In the early 2000s recession (March 2001 to November 2001) the stock market was already going down by the time the Fed started cutting rates, and continued going down.

In the Great Recession (December 2007 to June 2009) the stock market reaction to the Fed cutting rates was more optimistic, with a three-month approximately 10 percent rally in the S&P 500. After that, the stock market dropped more than 50 percent, with several “sucker rallies” () in between. Those rallies are common in recessions, including the early 2000s recession.

We want the debt that we do not need

Since there have been many previous recessions before the last two, some business commentators refer back to several of those other recessions to predict the future, and to frame Fed rate cuts in a positive light. Lower rates stimulate economic activity by making credit more easily and widely available, which could in theory prevent a recession.

The problem is that it is human nature to buy more than we can afford, or need, if we can fund those purchases through debt. Most people will want to buy a more expensive car on credit than they can afford either paying cash or with higher interest rates; the latter increase monthly payments. The same goes for homes.

This is all about perceived status, and extends to corporations. Other things being equal, a CEO of a larger and more dominant company will have a higher status among peer CEOs. As a result, companies tend to take on more debt, if it is easily available at low rates, to fund acquisitions or “buy” market share prior to recessions. Conservative use of funds goes out the window if credit is easily available.

As noted above, many business commentators refer back to recessions other than the last two to predict the future. The problem is that the farther back you go, the more different the socio-economic environments tend to be from today. This is why it is probably a good idea to look at what happened more recently when trying to extrapolate to now and the near future.

A Fed rate cut prior to a recession is not a good sign

Should a Fed rate cut at a period when the signs of an upcoming recession are pilling up be a source of concern for stock market investors? Any way you look at it, the answer is “yes”.

Human nature does not change that easily, and greed will not be checked unless things go really bad. When things go really bad, behavior changes. Individuals and organizations become more conservative regarding their finances.

Very likely a Fed rate cut prior to a recession will sustain or even exacerbate the types of behavior that are at the source of the recession.

Having said that, Fed rate cuts are important for the economic recovery and renewal that are normally seen after recessions.