The Five Year Market Metamorphosis

The U.S. market has gotten much more expensive in the past five years following the incredible buying opportunity in 2009.  One great valuation measure is EBITDA (earnings before interest, depreciation, and amortization) divided by Enterprise Value (sometimes called ‘takeover value’, calculated as market value of a company, plus debt, minus cash). I’ll shorten the name and call it ‘EBITDA yield,’ a higher yield means the market is cheaper.

Using this measure to look at all investable stocks in the U.S.[i], it’s clear that the market as a whole has gotten more expensive since 2009. The EBITDA yield at the end of February, 2009 was roughly 14% for the entire U.S. market—today it is 9%.  But the market’s overall valuation only tells part of the story. The market in 2009 offered a wide variety of valuations, whereas today, in 2014, the opportunities are much more clustered. Stocks today are more expensive, but valuations are also much more homogeneous. Here is a look at U.S. stocks[ii] and how their valuations were dispersed in 2009 and 2014, compared to their very long term average.

This change is being driven by a convergence of valuations. In 2009 cheap stocks were very cheap; now, they are less so (blue line below). The EBITDA yield for the cheapest stocks (10th percentile) has come down dramatically, from 35% in 2009 to 17% today. In contrast, expensive stocks (90th percentile) are about as expensive today as they were in 2009 (red line below).  The market median (green line below) has also gotten more expensive–mainly because the cheaper stocks have done so well. This is driving the clustered valuations we are seeing today. Fewer big bargains have led to a more uniform market.

This doesn’t suggest that you should abandon valuation as a key component in stock selection (quite the contrary), but it does suggest there is less of an edge today in cheap stocks than there was five years ago: there are far fewer U.S. stocks that are very cheap.  International markets offer more diverse valuations (see Meb Faber’s CAPE calculations for countries), but that is a topic for a different post.

 

[i] Market Cap> $200MM

[ii] Stocks with market caps>$200MM inflation adjusted