With M&A Booming, Anheuser-Busch InBev Likely Plotting Its Next Big Move

Through the first half of 2015, the volume of announced merger and acquisition activity is on a record-breaking pace (the data go back 35 years). While using dollar volume is a bit misleading without adjusting for inflation (ever wonder, like me, why movie theater box office receipts are based on ticket sales dollars rather than actual attendance?), there is no question that M&A is booming right now. And yet, one of my favorite acquisition-hungry companies, Anheuser-Busch InBev (BUD), has been very quiet. It has been two years since BUD spent $20 billion to lock up 100% of Grupo Modelo. This market environment (low interest rates and lots of synergistic corporate deal-making) would seem to fit right into BUD’s business model.

Over the years rumors have surfaced about their possible interest in Pepsi’s beverage business, as well as SABMiller’s non-US beer business, and either of those deals would clearly be a boon for investors (but I am not picky — anytime hugely accretive deal would be a welcomed development). I am hopeful that over the next 6-12 months BUD makes a splash in the M&A market. The recently announced merger of Heinz and Kraft might indicate that a BUD deal is not far off. 3G Capital, the private equity company behind the Heinz deal, has also been instrumental in creating the behemoth that has become Anheuser-Busch InBev over the years. Now that the Kraft deal has been struck, I am hoping BUD is next on the to-do list.

Full Disclosure: Long shares of BUD and KRFT at the time of writing, but positions may change at any time

Wynn Resorts Down More Than 50% Is A Long-Term Opportunity

The holy grail for contrarian, value investors is buying great companies at bargain prices, typically during a time when they have hit a short-term speed bump. While this is not an everyday occurrence, and it is even more rare when equity markets are elevated as they are today, you can find great investments in any market environment if you pay close attention.

Last week I initiated a new position in Wynn Resorts (WYNN), a leading gaming and resort operator with a pair of properties in Las Vegas and Macau, with two new properties in development (a second resort in Macau and one outside Boston). I paid $108 and change for the initial group of shares, which represented a more than 50% decline from the stock’s 52-week high of $222. In fact, WYNN shares actually traded at $108 for the first time way back in early 2007.

I bought on a day when the stock was trading down more than 20 points after a disappointing earnings report. In addition, the company cut their dividend to conserve cash and fund the construction of their new resorts, each of which will cost billions of dollars. Wynn’s recent struggles are due to weakness in the Macau gaming market, as China has recently enacted policy restrictions which have hampered both visitor traffic and spend over the last year.

While these issues were well-known to investors, the dividend cut came as a surprise (the annual payout was reduced from $6 to $2 per share). There were many investors who were in the stock for the income and wanted out, as the dividend yield has gone from over 4.5% to less than 2.0%. I like to pay close attention to dividend cuts because they often result in dramatic stock price declines, even though not every company cuts their dividend for the same reason. In addition, company valuations are not impacted by changes in dividends, but rather changes in actual earnings. Oftentimes the two are not directly related (e.g. the dividend cut is more dramatic than the earnings decline).

In Wynn’s case, which is different from many instances where companies have seen their profitability evaporate and therefore are unable to continue paying a dividend out of free cash flow, the company is merely preserving cash now that sales levels are lower in Macau and they no longer have excess free cash flow above and beyond what they need to build out their new properties. The company remains very profitable. As a result, it is entirely reasonable to expect that once Wynn’s new projects open, their absolute profit dollars will increase while their required capital expenditures decline, which will support an increase in the dividend.

We see this a lot with growth companies who are in highly capital-intensive businesses. As capital needs fluctuate, the dividend is adjusted both up and down based on where they are in their growth cycle. While this does not match up with most dividend-paying companies, which pride themselves on maintaining their dividends no matter what (including steady and predictable annual increases), a company like Wynn really uses them as a way to pay out excess cash that they don’t need to build new or expand existing properties. In fact, the company also uses one-time special dividends to accomplish the same objective.

Lastly, I think it is important to note that one future positive catalyst for Wynn will be a leveling off and eventual rebound in their Macau financial results. The Chinese government is not going to suppress gaming their forever. At some point, given the popularity of the area, we will see growth in Macau again, especially considering how much of a drop there has been in recent quarters. I am not going to pretend I know when exactly that inflection point will occur, but that is one of the perks of being a long-term investor; I am willing to be patient.

To sum up, I believe a price of $108+ represented an excellent value for a great company like Wynn. That does not mean that the stock will not drop further in the short-term (I am not trying to pick the bottom here, just a good entry point for the long-term), but I think the stock will be materially higher several years from now. If true, we will look back and say that 2015 was an excellent contrarian buying opportunity.

What do you think?

Full Disclosure: Long shares of WYNN at the time of writing, but positions may change at any time.

New Amazon Disclosures Reinvigorate Bull Case For Investors

Amazon (AMZN) is a fascinating company for many reasons and their latest investor relations move has gotten the markets excited about their stock once again (it’s up 57 points today alone as I write this). Bulls and bears on the shares have long had a disagreement about the company. Shareholders argued that Jeff Bezos and Co. were purposely “losing money” in order to invest heavily in growth and attain massive scale. Bears insisted that the spending was required to keep their customers coming back, and that if the company started to show profits the business would suffer dramatically. Regardless of which camp you are in, one thing is clear; Amazon chooses growth over profitability in the short term if it thinks they can be successful.

So when the company announced that it would break out the financial results of its Amazon Web Services (AWS) business segment for the first time in its nine-year history starting in 2015, the consensus view was that the division would show losses. After all, if Amazon embraces short term losses in exchange for growth, and AWS is its fastest growing business, why would you think otherwise? So imagine the surprise last evening when Amazon announced that AWS is profitable, and not just a little bit. Operating margins for AWS during the first quarter of 2015 were 17%. Add back an estimate of depreciation expense and EBITDA margins are likely approaching 50%. And the stock price is rocketing higher on the news.

All of the sudden it is possible that Amazon does not hate reporting profits (some have speculated that income tax avoidance is a motivating factor). Instead, maybe they are being sincere and simply invest capital when they think they have a good reason, regardless of whether it results in short-term GAAP profits. And maybe the thesis that Amazon’s business model does not allow for profits is incorrect. That is surely what investors today are thinking. Given their corporate philosophy, there is no reason Amazon should be running AWS at a large profit, but they are. Why? Perhaps they have built a very good business. Simple enough.

The implications for the stock are important. We now have evidence that AWS is probably worth the $60 billion or so that the bulls have long thought. At the lows of the last year (below $300 per share), Amazon’s total equity value was only a little more than double that figure ($130 billion). The bears on the stock will probably stick to their guns that the current share price (approaching $450) is irrational, but if you actually run the numbers, it is not that hard to value Amazon in a range of $200-$250 billion based solely on what we know today, given that non-AWS annual revenue will approach $100 billion this year and AWS alone can account for 25-30% of that valuation. The stock is getting close to my personal fair value target, but is not quite there yet. And given that Amazon could very well surprise investors more going forward (they don’t exactly set the bar very high), I am not in a big rush to sell.

Full Disclosure: Long shares of AMZN at the time of writing, but positions may change at any time

Which Company Is More Valuable: Shake Shack or Red Robin?

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rrgb

I wanted to follow-up my post about the Shake Shack (SHAK) IPO because I think the stock is presenting an interesting opportunity on the short side (finding shares to borrow is another story completely). Sometimes investors use paired trades – shorting one stock and going long another in order to bet on the valuation differential – to reduce their risk and still bet against a highly valued stock.

First, let me give a quick recap of Shake Shack today, post-IPO. At $45 per share the company’s equity is valued at $1.6 billion. This is for a company that had 63 restaurants open at the end of their most recently reported quarter, with more than half (32) franchised. The 31 units they own average $5 million in sales annually, but that figure will decline over time because the company’s focus on Manhattan (where each unit does more than $7 million per year in sales) will dissipate over time as Shake Shack goes national.

The key for investors is a tidbit included in the company’s IPO prospectus; over the long term Shake Shack sees room for 450 owned units in the U.S. with average unit volumes of $3 million per year and 20% four-wall margins. With less than three dozen U.S. locations today, you can see that it will probably take two decades to reach their 450-unit goal.

So why is that data crucial for investors? Well, consider that in 2014 fellow burger chain Red Robin (RRGB) operated 408 restaurants in the U.S. and each one averaged $3 million in sales. Furthermore, the average company-owned Red Robin had a four-wall margin of 21.4%. In addition, Red Robin plans to open 20 new units in the U.S. in 2015, so by the end of this year the company will have 428 units averaging $3 million in annual sales at a 21% profit margin. Essentially, Red Robin is today what Shake Shack will be in 20 years.

You probably see where I am headed with this. Red Robin’s current equity market value at around $80 per share is only $1.14 billion, compared with Shake Shack at $1.6 billion. How on earth can Shake Shack be worth more today than Red Robin? It can’t be, at least in any rational world (yes, I know, the stock market is not always rational).

By The Numbers:

Red Robin: 408 owned units, 99 franchised units, $1.14 billion equity value

Shake Shack: 31 owned units, 32 franchised units, $1.60 billion equity value

Bold investors can short Shake Shack by itself and hope the market comes around to realize the current share price is irrational sometime soon. Less bold investors can short Shake Shack and pair it with a long investment in Red Robin. As long as the valuation differential between the two converges over time, the trade will make money. Count me as one who does not think Shake Shake can maintain a 50% equity valuation premium to Red Robin over the long term. In the short term, though, anything is possible (as we see today).

Note: Shorting Shake Shack is difficult right now since it is a newly public company, but as time passes it will be easier to find shares to borrow (my broker, for instance, does not have any shares available as of now).

Full Disclosure: No positions at the time of writing but positions may change at any time

Why Carl Icahn’s $216 Fair Value for Apple is Unrealistic

You may have read Carl Icahn’s letter published yesterday in which he outlines why he believes Apple stock is worth $216 per share today. With the stock currently fetching an all-time high of $127, making it the most valuable company ever, you might be wondering if a company already worth nearly $750 billion can really still be 70% undervalued. Quite simply, I do not believe so. Let me explain why.

First, I think it is helpful to look at a snapshot of the last five years, to give you an idea of where Apple stock has traded relative to its business fundamentals. Below is a chart I constructed that shows Apple’s revenue, earnings per share, ending stock price, and ending P/E ratio since fiscal 2010, along with consensus forecasts for the current 2015 fiscal year and Carl Icahn’s above-consensus estimates.

apple-feb-2015From this chart you should be able to see how Icahn is getting such a sky-high fair value estimate for Apple; he’s using an extremely optimistic P/E ratio assumption. There are many reasons why Apple shares are unlikely to fetch a P/E ratio of 20+ ever again. Some that come to mind are:

1) Apple’s current size – With annual sales of over $200 billion, investors are unlikely to assume dramatic growth rates from here, which limits the multiple of earnings they are willing to pay.

2) Apple’s industry – Though it may be hard to fathom right now, the tech sector has a decades-long history of musical chairs when it comes to market dominant companies, so investors often will discount their valuations if it seems as though things can’t get much better and a technological shift in consumer preferences is likely at some point in the future.

3) Apple’s poor capital allocation – When you are keeping $141.6 billion of net cash on your balance sheet investors will not always give you full credit for it since it is not generating an adequate return. When the cash pile reached $100 billion people were miffed and the hoard is more than 40% higher. For comparison’s sake, Apple’s total cash outlay for capital expenditures and acquisitions was $13.5 billion in fiscal 2014, making their cash “buffer” equal to more than 10 years’ worth of growth investment.

4) Apple’s historical valuation – Over the last five years Apple’s average P/E ratio at the end of its fiscal year has been 15. Carl Icahn’s insistence that Apple is worth 50% more than that does not make much sense. Over that five-year period Apple’s sales have tripled. A higher P/E ratio usually implies the expectation of higher growth. It will be very difficult for Apple to triple its business over the next five years, which would mean that the average P/E ratio during that time could very well be less than 15 (not over 20).

So what do I think Apple stock is worth? Well, first off let me point out that I am far from an Apple bear. I have been long the stock for many years and some of my clients have an average cost basis in the single digits per share. I just think investors’ expectations should be more muted than Carl Icahn’s. Consistent with the points outlined above, I think Apple shares will trade at a P/E ratio between 10 and 15 going forward. Using a $9 EPS figure for fiscal 2015 and giving the company full credit for its cash position, that gets you to a range of $114-$159 with the midpoint being $136 per share. Relative to today’s price of $127 Apple stock is neither dramatically overvalued nor undervalued.

 

Shake Shack: Another Predictably Overvalued Consumer IPO

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Shares of burger chain Shake Shack (SHAK) are soaring more than 130% today to $48 on their first day of trading, after pricing at $21 per share. With 36 million outstanding shares, the company (which owns 21 restaurants and franchises another 19) is worth a whopping $1.75 billion. That equates to $83 million per owned restaurant. With the average unit volume for an owned location being $5 million, of which $1.25 million is profit, you should be able to see the wacky pricing for the shares pretty clearly. This is not surprising, though, given how much fanfare consumer brand IPOs have been generating in recent years.

Even if you consider that the company plans to open 10 units a year in the U.S. and let international franchisees open even more overseas, it is impossible to justify a $1.75 billion valuation for a company with a total of 40 units open globally. As a result, I suggest you visit the company’s locations rather than invest in the stock at current prices. As we have seen with other consumer IPOs such as The Container Store (TCS), Potbelly Sandwich Works (PBPB), and Noodles and Company (NDLS), it is not uncommon for these IPOs to come back down to earth over time, so definitely monitor the situation if you are tempted to invest in SHAK today, but try to hold off for now.

Full Disclosure: No position in SHAK at the time of writing, but positions may change at any time

Eddie Lampert Correctly Equates Sears And Kmart With Land Line Phones, Then Keeps Pitching Them To Consumers

With operational losses mounting at Sears and Kmart stores nationwide quarter after quarter, an interesting thing has happened. CEO and largest shareholder Eddie Lampert has started to speak publicly about the company, the reasons behind his previous decisions, and his vision for the future. This is notable because Eddie never used to speak to anyone about Sears Holdings. If you were a shareholder you could attend the annual meeting for a couple of hours and read his annual letter to investors, but that was it. Now that creditors, suppliers, and customers are becoming more and more concerned about the company’s viability as a retailer, Eddie is giving interviews and is writing on multiple blogs on a regular basis. For the first time, investors are getting a better sense of where Eddie’s company is headed.

Despite the policy of silence over the last decade, it has not been difficult to gauge the company’s progress under Eddie’s leadership (either as CEO, majority shareholder, or both). The operational results have been dismal, which made it clear to any financial analyst that Lampert and his team lacked the retail experience and were ill-equipped to compete against other large mass merchants. Eddie has been quick to admit that the company is struggling but he has also insisted on drawing parallels in history to describe the journey he is taking with Sears as it tries to transform and return to growth and profitability. The more Eddie speaks and writes, the more obvious it becomes that he does not have a firm grasp of why Sears and Kmart are losing a billion dollars every year. For example, consider this excerpt from a blog post Eddie published on December 15th:

“How much retail floor space do we need to deliver great experiences that meet or exceed our members’ expectations? Are our locations where they need to be? With more and more of our sales and member engagement happening online or via mobile and shipping straight to home, do we need the same kinds of stock rooms and warehouses?

Sears Holdings is far from alone in tackling these questions. To take just one example, in virtually every city across the country, real estate owners and communities are trying to figure out what to do with large, windowless buildings that once held essential – now useless – telephone equipment to make landlines work. Some developers are trying to convert them into offices or apartments. Other entrepreneurs think the solid construction and robust electric power could support data centers for new generations of businesses. None of these transformations are simple.

Similarly, some of our stores are simply too large for our needs, given that populations shift, new roads are built and new retail areas open constantly. Restoring them to profitability has been a challenge. At the same time, many of our stores are in some of the most attractive mall locations in the country. Though we expect most of them to stay open for the foreseeable future, in some places mall owners and developers have approached us with the opportunity to reposition our stores for other uses and are willing to compensate us. When they’ve offered us more money to take over a location than our store there could earn over many, many years, we’ve accepted offers. We’ve used this funding to invest more in our transformation. We have also adjusted the size of our stores by partnering with retailers like Whole Foods, DICK’s Sporting Goods, Forever 21, Primark, and others. In these cases, we continue to operate in the same location, in a smaller (but still large) space, leasing out the rest to retailers who will drive traffic and who compensate us for that space.”

So to summarize: Eddie would like you to believe that with the advent of e-commerce big box retail is dead. His company is losing money hand over fist because they have too many stores that are too large and therefore cannot be operated efficiently to serve today’s customer. The Sears and Kmart stores you grew up with are like land-line telephone equipment facilities and now you have disconnected your land-line, leaving those locations grossly misappropriated.

Do you buy this argument? I don’t and I think it illustrates that Eddie and his team do not understand why Sears and Kmart are getting clobbered in the retail sector. Before I share my view on what the problem is, let’s first squash the idea that it is too many stores that are too big. Below I have put together some data on store counts and retail selling square footage for major big box retailers from 2013.

SHLD-store-prod

The numbers are striking. Compared with four major big box chains (Costco, Sam’s, Target, and Wal-Mart), Sears and Kmart stores are not too big. In fact, if you combine Sears and Kmart the average store is approximately 112,000 square feet in size, less than all four of the competitors. It is also hard to argue that they simply have too many stores, relative to the competition. Sears and Kmart together have about the same number of stores as Target and less than half as many as Wal-Mart.

Simply put, if big box retailing was dead and there was a glut of selling square feet across the country, all of these other brands would be struggling like Sears and Kmart are right now. But they’re not. Even with Target’s credit card hacking issues recently, they are still extremely profitable. As you can see from the chart above, Sears and Kmart lag other stores considerably on a sales per square foot basis. They have the same selling space to work with but are failing as merchandisers. Consumers are simply voting with their wallets and they prefer shopping at other stores. No surprise there to anyone who has a pulse.

Eddie Lampert seems to be ignoring the obvious when it comes to fairly and accurately assessing his company’s fortunes. To me the problem is clear as day; the Sears and Kmart brands are dead. Unless you offer something very compelling and unique (and therefore have brand loyalty), consumers do not want to shop at your stores and will not do so. Even when Eddie took control of Kmart in 2004 the brand was dying (it was in bankruptcy proceedings at the time after all). He either didn’t see the brand’s shrinking relevance, didn’t place enough importance on it, or thought he could energize it. In 2005 when he merged Kmart with Sears, it added fuel to the fire. The Sears brand was also dying, so merely combining those two retail brands was not a recipe for success. As long as people think that Sears and Kmart are not good places to shop, like Target and Costco for example, there is nothing that Eddie can do.

Now, you may have noticed that Eddie’s team created a rewards program for Sears and Kmart called “Shop Your Way.” It’s not called “Sears Rewards” or “Kmart Rewards” so kudos there. A separate name is the first step towards a new, fresh brand. Progress? Maybe a little, but it’s not being emphasized. The TV commercials for Sears and Kmart this holiday season mention the old brands multiple times but barely reference Shop Your Way. They say things like “Members get more” but then you ask yourself “members of what?” The Shop Your Way program is not being advertised as the focus. Sometimes they flash the logo up silently at the end of the commercial for a split second, which is hardly engaging. It’s still all about Sears and Kmart for the most part. And that is why things are not going to get materially better unless the current strategy is changed and the company moves away from Sears and Kmart brands. Put a fork in them.

Contrarian Opportunity of the Moment: Oil Stocks

You may remember back in 2008 there was a debate about whether financial market participants (“speculators”) and the billions of dollars they moved around every day were impacting prices to such an extent that it severely widened the gap between what was “real” in the world and what the markets were supposedly telling us. Efficient market believers want us to think that the market always reflects reality and things rarely get off track. As we saw in 2008, however, market prices often did not accurately gauge the underlying fundamentals of the financial industry. Many companies were in trouble, no doubt, but when pretty much every single asset is mis-priced at the same time, there are clearly instances where the short-term traders have overcome the system regardless of what the underlying fundamentals truly are.

I am not saying that today’s oil market is anywhere near as mis-priced today, but when the price of a barrel of oil fetches $100 in late July and then in December drops to $58, when very little in the world has changed during the interim, investors need to ask themselves if the daily ebb and flow of the capital markets, and the computers that largely control that flow these days, is materially impacting the price action we are seeing in the oil market.

Is the U.S. energy production boom helping contribute to a temporary glut of oil? Yes. Has the supply-demand picture shifted so much that $58 oil reflects the true balance between supply and demand in the end markets for crude oil? I suspect probably not. Now, if $100 per barrel was the “wrong” price based on supply and demand then you can certainly argue that prices should have come down quite a bit. But when prices drop so quickly and then the fall accelerates lately as it has, I have to think financial “speculators” and short-term hedge fund traders are controlling the near-term price quotes.

CRUDE OIL PRICES HAVE DROPPED BY 43% IN LESS THAN 6 MONTHS

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If you think we will look back a year or two from now and think $58 oil was a bargain, as I do, then now is the time to think about increasing exposure to the sector. Below are some of the names I like along with their current quotes (long all except EOG as of this writing).

Mega-cap integrated dividend payer: BP PLC (BP) $36

Large cap E&P growth: EOG Resources (EOG) $86

Small cap E&P growth: Halcon Resources (HK) $1.95

Pipeline infrastructure: Enlink Midstream (ENLC/ENLK) $29/$25

 

As Losses At Sears Holdings Continue, The Need To Raise Cash Helps Simplify The Investment Analysis

The bullish case for Sears Holdings (SHLD) stock has always been a sum-of-the-parts story. But for many years since CEO Eddie Lampert orchestrated the merger of Kmart and Sears in 2005 the company has been quiet about its various businesses and seemed content to stick to business as usual. That strategy has not worked in the face of intense retail competition, and over the last three years a slow break-up of Sears Holdings has been ongoing. Shareholders have yet to benefit, even though the bullish thesis was predicated on such an event, mainly because the core retail operation has been losing so much money and accumulating so much debt in the process, but there are many investors who remain hopeful.

Consider the moves made and/or announced since 2011:

*Orchard Supply Hardware spin-off (2011)
*Sears Hometown and Outlet Stores rights offering (2012)
*Partial Sears Canada spin-off (2012)
*Sears Canada special dividends (2012 & 2013)
*Lands End spin-off (2014)
*Partial Sears Canada spin-off (2014)
*Proposed Sears REIT rights offering (2015 – estimate)

Cumulatively, SHLD investors have reaped approximately $20 per share of value from these transactions, assuming they held onto all of the separate entities. Now, that has not resulted in any profits (SHLD shares started calendar year 2011 trading at $73.75 and presently trade for $43), but the company has been liquidating slowly like they wanted. The 15% or so loss sustained by equity holders over the last four years has been driven by less-than-expected financial performance of the retail operations.

Today we learn that yet another transaction is in the works; the rights offering of a REIT that will hold 200-300 stores owned by Sears Holdings. The new entity will lease back the properties to Sears. The stock is up more than 30% today on this news, but in reality nothing has changed. The company has the same asset base and is operating at the same level of losses as it has been. Combine short covering with a small float and the clear sign that the liquidation is accelerating, and you can explain the $10 increase in the share price today.

So if the assets are the same, but the price is higher, is there anything positive to come out of this for those investors who are watching from the sidelines? Yes, simplicity. As Sears breaks up it becomes a lot easier to value each of its parts. First, with every spin-off we get to see the segregated financial statements for each entity, which we could not previously. Second, as the parent company becomes smaller and smaller, it becomes far easier to value. SHLD today really consists of the retail operations of Sears and Kmart in the U.S., the proprietary brands Craftsman, Kenmore, and Diehard, and about 700 owned properties. As a result, it is a much less tedious process to value SHLD than it was when you had the Canadian operations, a clothing company, a couple thousand franchised hometown and outlet stores, and a hardware chain in the mix. And if SHLD goes ahead with the plan to sell nearly half of its owned real estate to a public REIT entity, we will be able to better pinpoint the value of the real estate owned by each company with the additional disclosures.

Despite today’s announcement, my view of SHLD has not changed. I did not like the equity when it was worth $3 billion yesterday because of the $6 billion of debt in front of it and the continued operating losses. That same equity at a value of $4.5 billion today is even less attractive. However, if we get a new real estate entity it will be a worthwhile exercise to value that and see how the market prices it. Given that Sears will be the main tenant (the more diversified the REIT, the higher the valuation), coupled with the fact that small spin-offs often fly under the radar, it is possible the new REIT could be a good investment. We will know more when SHLD discloses which stores it will hold and what the ultimate price will be.

Lastly, since I anticipate many will ask about my current position (long Sears debt maturing in 2017 and 2018), I can tell you that little has changed on that front as well. The thesis for owning the debt is that Sears has enough assets to pay back its creditors for at least several more years. Today’s announcement does not change that, it just maybe gives some people more confidence that it is actually true. Accordingly, I am happy that the debt is trading up nicely today and I will continue to hold it (after all, it has outperformed the equity with lower risk).

U.S. Stock Market Approaching Attractive Levels

The U.S. stock market has finally rolled over, after going 3 years without so much as a single 10% decline. We are not quite there yet (at today’s S&P 500 low of 1,837 the index is down 9% from its peak reached last month), but for all practical purposes this is what a correction looks and feels like. So does it matter? Are stocks down to a point where investors should consider adding to their stock holdings? Let me share some thoughts as to how I am viewing the market’s current position.

Entering 2014, the S&P 500 sported a price-earnings ratio of about 17 based on trailing 12-month earnings (1,848/107). While this was justifiable given how low interest rates were, it was at the high end of historical norms and did not provide a lot of room for multiple expansion. The best that bulls could hope for was that earnings would continue to grow and rates would stay low, allowing for stable P/E ratios. And up until a few weeks ago, that is exactly how things played out. Earnings for 2014 are slated to come in around $119 (+11% year-over-year) and the S&P 500 index reached a high of 2,019 in September, up about 9% for the year excluding dividends of 1.5%.

While everybody has been worried about when interest rates will rise, and by how much, I think it is far more important to look at P/E ratios relative to those rates. If the average P/E ratio over the long term has been 14-15x, in a low rate environment a 17-18x P/E ratio would be fair but not compelling, assuming you expected rates to trend upward in the intermediate term. However, if stocks were trading at 15x earnings with low rates, it changes things.

Let’s assume the 10-year bond normalizes to a 4% yield (vs 2% today) over the next 3-5 years, which is the consensus view. If U.S. stocks would be likely to fetch a 15 P/E in that scenario (average rates, average P/E’s), then stocks would be attractive if I could pay 15x earnings when yields are just 2%. Essentially, even if rates doubled, there would not be any P/E multiple compression. If, however, I pay 17-18x earnings and rates rise/multiples fall, then I should expect that P/E compression will offset corporate earnings gains, and my stock returns will be muted.

Why is this important? If the S&P 500 index were to drop to 1,800 (about 2% below current levels) and earnings for the index are $119 for 2014, the trailing P/E ratio for the S&P 500 would be 15x at year-end and interest rates would be near record lows. That would make me want to add fresh capital to my stock market investments. If rates stay low for longer than people expect, then multiples could go back to 17x and equity gains will result. If rates rise and we only see average P/E ratios of 15, then stock returns will largely track corporate profit growth, which continues to be strong.

Paying above-average prices in a low rate environment is justifiable but offers minimal upside. Paying average prices for stocks in a low rate environment offers you some downside protection if rates rise and solid upside potential if they are steady. As a result, I think U.S. stocks look attractive at around 1,800 on the S&P 500. And many people would suggest starting to buy even with the index at 1,840 because it’s “close enough.” Bottom line: it’s time to make a shopping list because stocks are on sale.