by Jonathan Greenberg, CEO OCE Interactive

Although we are unlikely to double dip into a recession, growth continues to remain anemic as the consumer has yet to come back into the market with full steam.  Although an improvement over last year, hardline retail didn’t exactly knock the cover off the ball on Black Friday with the exception of a much anticipated big step up in online spending.  That being said, as Nainesh Shah of Roosevelt Investments pointed out in an interview on TheStreet.com today in an article titled ‘Stocks in 2011 to Get ‘Full Support’ from Fed’, think twice before betting against the Fed.  “As long as Ben Bernanke is shoveling money into the system, it’s safe to be bullish on stocks.”  Now of course, as Shah points out, anything can happen.  Ireland is being bailed out and there is always a further risk of contagion (e.g., Portual and Spain).  Now a rational investor should expect the market to cycle up and down.  And there is certainly a risk of fall out from geopolitical developments (Korean peninsula, Middle East, Wikileaks).  But the Fed is keeping short term borrowing rates at all time lows and there are no signs of inflation.  So assuming away risks outside of its control, the Fed has demonstrated its willingness to put a marketwide protective put in place.  We might see a continued softening in the market as we approach year end as investors book their gains.  But for 2011, as long as Uncle Ben continues to shower the market with his monetary affection, onward and upward!

By Jonathan Greenberg, CFA
President & CEO, OCE Interactive LLC

It never ceases to amaze me how the media will provide a daily explanation as to what drove the stock market higher or lower.  When is the last time you saw a headline that simply read “Stock Market Rises 100 Points – No Identifiable Catalysts”?  Unfortunately headlines are notoriously more volatile than the stock market itself as they are typically driven by short term surface level market movements and the need to provide something attention grabbing. 

At the end of July, headlines emphatically declared that the market had its best one month performance of the past year and was once again off to the races.  But just eight days later, they reverted back to concerns about the health of the v-shaped recovery and questioning whether July was in fact just a head fake.  This weekend, editorials increasingly discussed the growing fear that a prolonged downturn in the economy could in fact lead to what may be the most feared of all scenarios, deflation, which would result in low growth and high unemployment for a protracted period of time.  If you bought and sold based on these headlines, you would almost certainly under-perform the market by a wide margin; buying when you should be selling and selling when you should be buying.   

Looking past the headlines, what can we learn by focusing directly on investor preferences during the July rally?  Using the Market Topographer® benchmarking platform that my colleagues and I at OCE Interactive developed to explain what drives relative valuation of stocks, we were able to see that although the S&P 500 rose 9% in July from its intra-day low, much of the risk aversion that crept in over the prior two months still seems to linger.  You can see this in the outsized premium the market continues to afford stocks sporting high dividend payout ratios and low financial leverage — both remaining well above 20 year averages — and the historically low differentiation it is assessing based on Wall Street’s expected long term earnings growth rate.    

On the economic front, earnings continue to be dominated by inventory restocking as opposed to consumer purchases which are necessary for a recovery to be sustainable.  And recent surveys of institutional investors suggest investors are increasingly becoming concerned once again about economic deceleration and most disconcerting the possibility of deflation.  Aversion to financial leverage and most notably, the market’s strong preference for the safety of dividends even when faced with a scheduled increase in taxes on dividends likely around the corner, sure seems to suggest the market could be preparing itself for such a scenario.   

Combine this with a sharp increase in the premium for September VIX futures, and the rise in the market from the lows achieved on July 1^st appears to have been more attributable to the correction of an oversold market than a rejuvenation of the rally.      

Of course, I hope the market can shake off the Fed’s less than optimistic assessment of the economy reconfirmed yesterday and can resume July’s upward trend.  And it’s possible that the press was correct two weeks ago when it suggested the rally was back.  Then again, continued evidence seems to suggest that the press was more likely correct this past week.  But one thing is pretty certain.  If past experience is a guide, a sustainable rally will ultimately be accompanied by a renewed preference for growth versus dividends and less aversion to financial leverage.  And for that to happen, we will need to see renewed signs that the economic recovery is once again regaining steam or at least indications that the deceleration has once again floored.    

Conclusion?  I would suggest investing with caution over the next couple of months and studying closely the type of stocks that are rising or falling, whether with a sophisticated platform like Market Topographer® or by simple observation.  And certainly do yourself a favor.  Whatever you do, don’t invest based on the headlines!

(7/19/2010) Google’s (GOOG) stock closed down $34.41 per share on Friday, July 16, 2010 as a result of a “disappointing earnings announcement.”  Apparently 24% year over year revenue growth, which beat analyst estimates, was less important to investors than its 1% earnings miss due to incremental expense associated with staffing up, which was hmmm, incurred to fuel future growth. 

In fact, at Google’s closing price on Friday, it was trading within spitting distance of what we at OCE Interactive would refer to as its Average Experience Benchmark Price.  Average Experience Benchmark is the price at which the average company in the marketplace with a similar fundamental profile would be expected to trade given the market’s current likes and dislikes.  This scenario is relatively shocking for a company that remains so dominating in its space. 

Google’s problem appears to be that fewer and fewer investors are willing to classify it as a growth stock given the size of its earnings base and its still above average but slowing growth rate.  Ironically, that’s the reason why investors penalized the company for spending more to support future growth.  And at the same time, income-oriented investors remain sidelined due to the lack of a dividend.    

Especially Today, Dividends can be a Sign of Strength

But there is a simple fix to this problem.  Start paying a dividend!   With over $90 per share of cash and strong free cash flow, the company can certainly afford to do so.  Earlier this year, Starbucks (SBUX), which is expected to grow its earnings at a rate similar to Google’s 15-17%, came to the realization that although it expects to maintain above average growth, its growth prospects nevertheless were slowing.  It responded by initiating a 25% dividend payout ratio.  The stock didn’t sell off as many had feared.  On the contrary, if you stripped away the systematic impact of the recent market sell-off on its stock price as we did, Starbucks’ P/E multiple actually expanded. 

Google should strongly consider following in the path of Starbucks.  It can comfortably pay out 25% of its earnings in the form of a dividend.  And given the cash it has been accruing, this would unlikely impact its growth prospects.  But management shouldn’t hide from the reality that it is maturing and as demonstrated by scanning OCE Interactive’s database of historical fundamental achievements, little precedent exists for a company its size sustaining growth north of 15% for more than a few years. 

Based on this, we used our Market Topographer® platform to put Google’s stock price into historical context and to run a number of “what if” scenarios.  OCE Interactive calculates that if Google were to introduce a 25% dividend payout ratio, even if growth were expected to slow to 12% a couple of years out, given today’s market environment, its fair value would be in the range of $540 to $570 per share, a 16-22% premium to Monday’s close.  Improving market conditions or Google’s ability to sustain higher growth for longer would result in greater upside for investors.     

Dividend policy aside, as the market recovers, Google’s price will likely rise with the tide.  But Google management should realize that paying a dividend is not a sign of weakness.  Instead in today’s market, it would add confidence that its cash flows will remain strong and should translate into a valuation premium.  Most importantly, it will gain the company access to a growing, more stable universe of post-financial crisis investors who would love to own Google stock if it only paid a dividend.  If Eric Schmidt needs any convincing, he should simply speak to Howard Schultz. 

- Jonathan Greenberg