Tuesday, March 24, 2009

Market Sector Valuation Breakdown

I really should apologize for my utter lack of posts in the last few weeks. As noted before, it’s been a combination of unsuitable-for-posting work, lack of inspiration and real-life requirements that have reduced my output to a trickle. Plus, what’s the point of posting work that relies on a data set that might literally be worthless overnight? (See: PPIC announcement, SPX reaction to as Exhibit A.) Anyhow, now that the SPX rally seems to have hit some local maxima, I figured I’d have a go at looking at valuations from a sector perspective. I thought this would be interesting on its own merits, but also because tons of bulls out there continue to state that financials aside, stocks are cheap, cheap, cheap. My belief is that they are not but unexamined assumptions have a way of biting you and giving you rabies. (Look no further than the current real-estate malaise infecting the system for proof of that assertion.)

So, here’s the background: I downloaded data on PE(ttm) and PE(fyf) for 5,214 stocks on the evening of 3/23. Included in the set was the Sector, Industry, and sub-Industry information. Not included were OTC stocks.

The first thing that I noticed was the sheer number of companies with an unreported PE, or perhaps more correctly an undefined PE. Unsurprisingly, the percentage of companies reporting an undefined PE varied considerably by sector. Here’s a snapshot:

Surprisingly, the financial sector did not have the highest percentage of unprofitable companies – that honor went to health care, though largely due to the substantial number of biotech start-ups that have never turned a profit. Anyone that has dabbled in that industry knows how many of those companies fail. On the other end of the spectrum, consumer staples and utilities were the two lowest which makes sense considering their positions in the standard “defensive” portfolio. Please note, this says absolutely NOTHING about the volume of loss within each sector. Case in point, as is clearly stated in the SP500EPSEST sheet by H. Silverblatt: AIG alone accounts for -$7.10 of the -$23.04 reported EPS loss. (Yes, AIG is apparently still in the index!) One bonus: here is a table of the PE Breakdown by Industry, which provides a bit more detail than this sector overview.

Anyhow, one can further refine this by removing the pharmaceutical and biotech industries from the overall total which reduces the overall percentage of undefined PEs to 37.8% making the relative value of the financial group that much worse. The reason for explaining this is that I have never read someone discussing average PE that talked about how they treated the “undefined” result. In the discussions below, the average of any group is defined as the average of the numeric response PE. To illustrate if there were 3 companies with PEs of 5,10 and undefined then the average of the group would be 7.5. Including the breakdown of unprofitable companies really helps add needed detail to the analysis.

Here’s a chart of the major sectors and their PE(ttm) binned out. The sub-0.1 bin is an artifact of an Excel quirk and is a stand-in for the “undefined” bin. This is a percentage chart within sector so that the sector-to-sector comparison is a bit easier to see. Again, it is pretty easy to see the lower representation of the utilities and consumer staples in the “undefined” bin and the very large proportion of the healthcare sector for the reasons mentioned above.

So considering the percentage of unprofitable companies in each sector and the average multiple of the remaining issues, it would appear that energy is perhaps the best value right now if one were to buy into a sector ETF for the long term. What makes this also an attractive sector to me is the average yield – at least on a trailing basis – is the 2nd highest of any sector. The first is the financial sector but this will soon change as the dividend cuts in this sector will far outweigh the devastation in the share price. While the popping of the crude bubble will have similar effects, it will likely not be as drastic going forward. (I did not include the dividend breakdown here.)Further, if/when the demand side returns in energy the price in commodities could be shocking since so many projects were cancelled. And finally, it must be mentioned that the Fed is clearly bent on inflation and commensurate dollar devaluation which can only serve to boost most commodity prices. Let’s just hope the inflationary cycle has both legs – price AND wages. If the latter fails to keep up, the demand side will fall slack as I don’t think the credit will be around to offset the lack of earning power. But that’s a long digression that will be far better covered in more professional places.

Again, all of this must be put in the context that valuation is whatever the market feels like it being. There's a funny quote about how, "only god knows the right PE," and it's true - it's totally a function of supply and demand. And I believe I have made the case in past posts (see here & here) that only earnings recovery will signal a true bottom and demand for equities will far outweigh any concerns regarding valuation when that happens. I would conceded that there are sectors where the market is "cheap" relative to historical norms and further, that within each sector there is some skewing that is occuring due to a small-ish number of very high multiple issues. These types could offer some interesting pair trades with long sector ETFs and short on the high multiple componenets. However, these observations do not support just buying a sector or index but rather very selective stock-picking. Something to investigate further...

(If anyone is interested in further industry/sub-industry breakdowns, let me know and I’ll try to post up some additional charts as requested.)


Steve said...

In looking at P/E (or P/Sales, P/Book, etc), I'm thinking the median values give the most accurate portrayal - due to the inevitable outliers. However, when looking at industries (as opposed to sectors), there may not be too many companies comprising that industry. In such cases, the median is not so great. What are your thoughts.

Median P/E by Sector
As of 03/20/09

Basic Materials 8.35
Capital Goods 7.5
Conglomerates 8.6
Consumer Cyclical 7.25
Consumer Non-Cyclical 13
Energy 5.8
Financial 10.6
Health Care 12.45
Services 10.9
Technology 12.95
Transportation 6.4
Utilities 10.55

Mr.Sparkle said...


In almost all cases, I am of the opinion that the more descriptive your statistics the better, since as you rightly point out the mean can easily be pulled by a few outliers. This is why I presented the histogram in the post, even if the distribution stats are omitted. That's also why I included the percentage of "undefined" since they represent such a large fraction of each sector. In the case of the consumer discretionary and information tech sectors, you certainly don't have to go far beyond the "undefined" bin to get past 50% of the group!

Looking at your median values, I would have a couple questions: first, do those numbers omit the "undefined" PEs? and second, do you know if they are based on reported or operating earnings?

Either way, the point about having to pick the stocks with actual value remains. As I said, I don't believe the market in aggregate is cheap - a simple look at the percentage of unprofitable enterprises should put the lie to that belief. However, there *are* some cheap ones out there. Or at least there were before this 25% run!