US is going private and we’re invited

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This past Friday I got the call. Again. Right when I was settling in to think about writing this column for the Financial Times, a producer from CNBC’s On the Money show called and asked what I thought about the market.

I got excited because this is the sort of tension I think is interesting for a financial show. Some people think the market will go up. Some people think the market will go down. There is tension, maybe there will be a little bit of drama. Melissa Francis would be hosting.

Melissa is fast on her feet and is not afraid to drill down on an issue if she does not believe your facts. But most important was this anecdote – the last time I was on the show, she was also interviewing one of the other guests. He was a “celebrity guest” in Los Angeles, so we only saw him on the link-up on the screen. He was entered into the CNBC stock-picking competition and he had said something funny. Melissa laughed and shouted something to the effect of, “If you were here I’d love all over you!” I like that kind of lightness on a financial show and I was looking forward to seeing her in action again.

So the question was: “Why are you bullish on the S&P 500?” This is an easy one to argue. Of course I am bullish. For the past 200 years if anyone had said: “Well, I’m bearish on the US markets and the US economy so I’m going to short the market forever,” you would have lost money.

Yes, you can say to me, but note you used the word “forever”. When you short, it is not forever. When you short you are supposed to top-tick the market (have you ever met a short-seller who didn’t?) and then call the bottom.

But as for me, I am lazy. That is too much work, especially when there is something easy instead. You could have bought the market any time in the past 200 years and be enjoying record highs right now. In fact, if you had bought into the small-cap indices you would be destroying the rest of the markets this century.

But OK, point taken. Markets do correct. So why be bullish right now?

First off, with a forward price/earnings ratio of 16 on the S&P 500 this means that the market itself is yielding 6.25 per cent. Ten-year Treasury bills are at 4.68 per cent. The so-called Fed Model suggests that when you can yield more money by buying equities than Treasuries, the market is cheap and you should buy equities.

There is a fundamental reason this works and it has led to an important statistic. I will describe the statistic first.

This year will probably be the third consecutive year that the supply of shares outstanding in the US will shrink. It is as if the entire US market is slowly going private. The last time there were even two straight years (2001-2002) the market went up considerably in 2003.

In fact, it has never been three years in a row because two years has been such a bullish condition that initial public offerings start to happen, the market goes up a lot and so forth, and people stop buying back shares because they think the market is too expensive.

The US market is like any market. It is like your local grocery market, for instance. When there is less supply of a product and demand for that product stays the same, prices go up. With the supply of shares outstanding going down, prices for the US market will go up.

So what does this have to do with the Fed Model? Because it makes sense for companies, leveraged buy-out funds, hedge funds and others to borrow money at present interest rates and to buy assets that yield more cash than the coupon of the bonds. That is called making money.

That is why companies are repurchasing shares and management is borrowing money for leveraged buy-outs. Companies are buying other companies, and so on. In other words, the US, if conditions last, is slowly taking itself private.

It is a condition that won’t continue, of course. The way it resolves itself is for equities to go up. I like Cigna here, for instance. The company reduced its shares outstanding from 130m in 2005 to 112m last year. It bought back $3.5bn worth of stock. Meanwhile, it trades at just seven times earnings before interest, taxes, depreciation and amortisation. Its earnings yield (before taxes) is a massive 14 per cent.

IBM is another stock I like – it just increased its dividend and buyback programme. It is giving back so much money to shareholders that it is practically taking itself private. I wrote about IBM several weeks ago and the shares are now at a one-year high, $102.21 at the close on Monday, up from a low of $73 last year.

And if you think the consumer is weakening, no problem. I have just the pick for you – Dollar Tree Stores. The company trades at eight times ebitda and has increased earnings for 10 straight years. Knock yourself out.

james@formulacapital.com

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