The Globe and Mail

  Baby Needs a New Pair o' Shoes


Friday, October 25, 2002

As investors ponder price-to-earning ratios and the question of whether the bear market has yet brought valuations down to attractive levels, a key argument offered by optimists goes something like this: P/Es may still be rather high by historical standards (the S&P 500 currently sports a ratio of around 27, and 22 is the estimate for next year, compared with a long-term average of 15), but investors should be willing to accept an elevated ratio because the interest rates yielded by government bonds is currently very low. So if a stock has a P/E of 20, it means it has an earnings yield of 5 percent, better than what the "safe" money dishes out.

This line of reasoning may have a nice intuitive feel, especially when bolstered by the authoritative tone in which it is usually delivered. Alas, there is a hole in this logic big enough for the Exxon Valdez to pass through. To understand this, you need to look at the reasons why interest rates are at a 40-year low.

The flood of cheap money from the central bank is a desperate attempt to contain the damage of the deflating investment bubble. Banks are freezing up on lending just when companies' needs to borrow to cover losses are soaring. Lenders that are willing to extend credit are able to command usurious terms — high fees and options to convert to common stock in addition to sky-high interest rates. Even Warren Buffett has morphed from Value King to Vulture Capitalist under the current conditions.

The underlying reason for this phenomena is that ugly four-letter word: RISK. Credit card companies can charge ridiculous interest rates because of the increased risk of the consumer being unable to pay. Ditto for the holders of non–investment grade bonds. So if lenders can justify a risk premium, why not shareholders? Surely they are in the same boat, and they too deserve to be compensated for holding common stock during perilous times.

If the "average" company isn't profitable enough to justify its current price, should investors just stash their cash in savings bonds until stocks get cheaper? That is an option, but an alternative is to find companies that are above average and stick with them.

Such a company is children's shoemaker Stride Rite. Revenue has been drearily flat, but the P/E remains a middling 15. That generates enough cash flow to power a dividend yield of 2.8 percent while leaving enough funds available for a stock buyback program. The industry is defensive; parents will continue to appreciate good quality footwear for their precious lads and lassies even if they feel poorer as their retirement accounts plummet in value. Corporate debt is negligible, giving Stride Rite the manoeuvring room to challenge competitors and operate even if their retail climate chills with the weather. In terms of risk valuation, Stride Rite knocks the socks off the majority of alternatives.