Valuing Legends

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Some time ago a sportswriter asked legendary quarterback Johnny Unitas what he thought he was worth relative to the enormous salaries being paid to today’s best quarterbacks. Unitas said, “Maybe about $750,000.” The sportswriter was incredulous and said, ” Mr. Unitas, the top quarterbacks today make several million dollars a year.” To which Unitas replied, “Well, you have to understand, I’m 75 years old.” I love that story. It tells you so much about one of the greatest players in NFL history, but it also serves as a reminder that the process of valuation is far from an exact science.

In February of this year Facebook paid an astonishing $19 billion for a messaging service called WhatsApp, a five year-old company with only $300 million in revenues and 50 employees. In comparison, Pfizer is purportedly offering to pay $100 billion for London-based drug firm AstraZeneca, a more justifiable price tag given AstraZeneca’s $25 billion in revenues across a diversified product line.

The M&A wave is just beginning…
For the last few years corporations in the US have been building an unprecedented mountain of cash. Current estimates approach $2 trillion, and this unprecedented amount continues to grow despite dividend increases and share buy-backs, which have gained momentum as well. Recently, an even more powerful use of cash flow has taken center stage in the form of record-setting M&A activity. On a global basis, M&A activity has topped $1 Trillion year-to-date, up over 40% from a year ago, the highest level in 7 years.

Which leads to one gigantic critical question…
Can these friendly-to-shareholder forces drive stocks higher for the remainder of the year? Before answering this question, let’s set the stage. The overall stock market is in the 5th year of a bull market which began in the first quarter of 2009. In the post-war era, there have been six bull markets lasting between 5 and 9 years, so based on previous cycles, the current bull market could have further to run.

Meanwhile, the current economic landscape supports the case for higher stock prices. First of all, while the Fed will eventually start the process of raising short-term interest rates, it is unlikely to do so any time soon, given relatively benign inflation and stubbornly weak labor markets. Second, corporate profits remain solid, and are expected to grow nearly 11% for 2014. Moreover, with the S&P 500 selling at a modest 15X the 2014 EPS consensus estimate, stocks seem to be reasonably valued.

But stocks never move in a straight line…
While a compelling case can be made for a further advance in stock prices this year, the market is likely to experience a few pull-backs along the way. Stocks routinely correct when valuation becomes stretched relative to the strength in underlying fundamentals. These readjustments can occur by a drop in stock prices or by a passage of time during which the fundamentals catch up to the valuation. These periods of consolidation can be frustrating for impatient investors, but they are healthy for an ongoing bull market. It seems to me that the market has been in one of these readjustment consolidations so far this year. Given last year’s impressive gains, this should not be unexpected.

Risk on or risk off…
There has been a good bit of discussion so far this year about how the market is being buffeted by periods when momentum stocks are either in favor or out of favor. Momentum stocks, as currently being analyzed include: emerging technology and biotechnology. These two have been far and away the most volatile groups in a relatively flat overall market thus far in 2014. While fundamentals are evolving in these two fast growing industries, valuation trends have been significantly more volatile, reflecting the market’s mood, or what is called the risk on – risk off trade. Since such momentum swings are emotionally driven they are very difficult to time. But there are a couple rules that can help investors take advantage of these wide swings in stock prices.

There are two points in virtually every momentum trade, that being extreme pessimism (risk off) or extreme confidence (risk on). The goal is to buy as close to the point of extreme pessimism and to sell as close to the point of extreme confidence as possible. If this can be accomplished consistently, one can profit from the momentum trade, over the long run. The second guiding rule is to ease your way in and ease your way out. In other words, it is better to buy and sell early rather than buy and sell late, and this is especially true with momentum stocks.

The M&A catalyst...
Heightened M&A activity could serve as a catalyst to propel stock prices higher over the balance of the year. The ride is unlikely to be continuous or smooth, but in uncertainty there is opportunity.

Not all corporate deals will enhance shareholder value. Some, in fact, will be disastrous. Insatiable corporate egos and massive cash flow can be a dangerous mix. Yet, some combinations will significantly enhance shareholder value, by creating, in essence, a corporate Dream Team.

Basketball legend Larry Bird, a member of the original Dream Team, was asked once if there would ever be another Dream Team. Bird replied, “Only if I’m on it.”

If only it could be that simple…

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