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The valuations in the software sector known as Software as a Service, otherwise captured by the ungainly acronym SaaS, are said to be rich. Nobody likes to pay up, but value investors, in particular, are skinflints and balk at them. Salesforce. com (ticker: CRM), for example, trades at an enterprise value to sales (EV/S) ratio...

How SaaS Removed Value Investing From Software

Equity Valuation Support Strong; US Looks Inexpensive

If you don’t mind a little instability, U.S. equity investors really can’t complain about the first half of 2019. Sure, it was a little volatile and who likes that? But with a roughly 17% return, the year is on track to be one of the strongest years since 2009. Source: FS Insight, Bloomberg, Factset So far, it’s been a tale of two markets, with two abrupt operating modes: risk-on when stocks rose, and risk-off when stocks fell and bonds rose. Now, as I have noted previously, recent incoming economic data is softening. However, it’s important to note, US purchasing manager indexes should rebound in 2020 after eventually dipping below 50 by 3Q19. This movement is predicted by the US Treasury 30 year-10 year yield spread curve steepening, which began in earnest 16 months ago. Ironically, the weaker data is, on balance, a positive, as the combined headwinds of trade wars, last year’s U.S. federal government shutdown, and Brexit fears are also motivating the Federal Reserve Board to shift towards a rate cut from its previous tightening stance. And since 1971, the first Fed rate cut—in instances when the US economy wasn’t in recession—has led to a stock rally 100% of the time, three, six, nine and 12 months later, with a median nine-month gain of about 17%. (See table on the right.) This potentially implies some 500-600 added points to the S&P 500 by spring 2020. Talk about a nonconsensus view. Few expect that. Moreover, the cash return yield—defined as the combination of the dividend yield and the buyback yield—is 5.2%, a strong valuation support for stocks. It’s up considerably since 2017. Source: FS Insight, Bloomberg, Factset The S&P 500 buybacks yield has risen to 3.3%, and coupled with an elevated dividend yield of 1.9% make stocks on a “cash return basis” the cheapest since 2011. The chart above highlights how the relative valuation of the market has improved, as cash return yields have risen considerably. To add fuel to the fire, more valuation support for U.S. stocks comes from the fact that the divergence of the equity cash return yield to the investment grade bond yield, 3.5%, has increased since the end of 2017, suggesting stocks are also cheap vs. bonds. Source: FS Insight, Bloomberg, Factset Finally, compared to the rest of the world, the U.S. cash return is superior. For instance, Europe’s cash return yield is 4.5% and Japan’s is 4.3% while the Emerging Markets’s (EM) is 2.8%. These figures are adjusted by sector weights to mimic the composition of the S&P 500, which tends to have much more in tech stocks, for example. While dividend yields in these other regions are higher, their corresponding stock buyback rate is considerably lower— hence, on bond proxy basis, US equities are the cheapest. Thus, is it any surprise S&P 500 is the beneficiary of the global TINA (There Is No Alternative) trade? Not only are U.S. yields higher than the rest of the world, but the stocks are also cheaper. Consequently, I expect upside to the equity market coming from on Fed rate cuts and the S&P 500 reaching about 3,100 by year-end. What could go wrong? U.S. election politics and the ongoing trade and tariff dispute between the U.S. and China is worrisome and are unpredictable. And if the Democrats make a strong showing, investors could see a Trump loss in 2020. Bottom line: I remain bullish on equities, even as we may go through some choppy times in the third quarter. I expect the S&P 500 index to post new highs before year end and my target hasn’t changed: 3125. While equity markets are taking a necessary breather given the strong move since late May, we still see a pathway to strong gains into yearend. Technology and Financials lead cash return and cyclicals broadly. I’ve identified 22 cyclical stocks with a cash return yield higher than the S&P 500, and which are also ranked in the first quartile of the Doctor Quant Model. The tickers are RL, F, HD, BKNG, EBAY, CAT, CMI, ROK, MMM, NSC, CSCO, IBM, LRCX, QCOM, AAPL, LYB, EMN, BLK, NTRS, COF, WFC and PRU. Figure: Comparative matrix of risk/reward drivers in 2019 Per FS insight Figure: FS Insight Portfolio Strategy Summary – Relative to S&P 500 ** Performance is calculated since strategy introduction, 1/10/2019

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