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Investors Paying Little Attention to Valuation-For Good Reason?

June 29th, 2010

Despite a free cash flow multiple that would normally signal a rally in the equity markets, stocks are sinking.

Even we started to believe, after being negative most of  the year, we would see such a rally, given the past 25 years of data. Investors are not lengthening their time horizon, preferring to focus on an increased cost of capital, rather than potential return-unfortunately, there is no way of forecasting an end to this current valuation/risk matrix, which can, in fact, exist for many years.

Why has this been the case? The answer lies in the cost of equity capital, the true and only real measure of fundamental risk, which began the year for the S&P Industrials at 8.3%, but now stands at 9.1%. Simply put, investors are demanding a 9.1% return to invest in the average equity, or else are content to “sell” or sit on the sidelines. At CT Capital, we measure at least 60 metrics of cash flow, credit, and other variables, fundamental in nature, which measure everything from a firm’s cash flow consistency to its credit spreads-and, by and large, the cost of equity has been increasing, with minor exception, throughout the year. We believed the low valuation multiple would overcome this, but thus far has clearly not been the case. Currently, 9.1% expected returns are not readily available, and thus despite a 16.2x free cash flow multiple, compared to the average 21.5 multiple of the 1990’s, a rally is not in sight.

Equity markets are normally volatile when cost of capital and free cash flow multiples are moving in opposite directions, so that alone does not scare us.

Despite the S&P, when looking at our free cash flow/cost of equity model, showing undervaluation of 7.1%, we should not expect an equity rally until there is a sustained improvement in risk. While at market peaks, little attention is paid to risk, at current, the 7.1% undervaluation is not sufficient reward to entice investors given the risk to corporate cash flows. This risk may not be apparent with the upcoming earnings season, even though much of the free cash flows reported last quarter represented managed expense and catch-up spending, rather than add-on growth.

As such, we would move portfolios back to maximum cash until cost of capital falls back to below 8.5%.

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