Quota Bear Edition: OMXH to 5,000 points

Nasdaq Helsinki rallied sharply upwards for a few days, but has since returned to its familiar horizontal mode.

In this posts, let’s about a budding bull market, followed by annual bear comments. I've brought up so many encouraging comments about cheap Finnish stocks that it's time for a little variation.

The rise is - or at least was - a welcome change, as the stock market has had a stereotypically good buying season lately. The valuation of the stock market is favorable relative to earnings forecasts. The continued decline and unseasonably weak September led many investors to expect a further fall based on social media chatter. When enough people expect a further drop, it tends to be already reflected in stock prices.

Numerous news reports have condemned Nasdaq Helsinki as miserable and questioned the wisdom of investing here. Such news does not appear at the top of a bull market, but in an advanced bear market. You have to buy when others are afraid.

The way is clear for Nasdaq Helsinki to rise further if the global economy continues to grow at least moderately and inflation and interest rates calm down. The European Central Bank raised its key interest rate last week in the face of stubborn inflation, but the gray-headed leadership hinted that the peak of rate hikes was at hand. In other words, the price of money may no longer be rising, which is good news for equities. 

Investors' attention will eventually shift to the hefty dividend yields and soaring valuations. After stocks have risen for a while from the bottom of the bear market, you can hear cries about it being a "fake rise". Eventually, however, a rise in share prices changes sentiment and suddenly the investor's world looks brighter again. Thus, the psychology of investors alternates between fear and greed, and as long as there is a stock market, this will be the case because human nature does not change.

That is, if we are indeed in a bull market and the bottom turns out to be August 21.

Last fall, I was babbling about cheap shares in these posts (for example here). In retrospect, the world's stock markets, and many Helsinki-listed stocks did indeed bottom out so far at that time. In a way, the optimism was right, but at the same time, Nasdaq Helsinki as a whole has hit new lows this fall. So yeah, I don’t own a crystal ball either.

George Soros, one of the most successful investors of the last decades and now a figurehead of the internet's tinfoil hat circles, has said that he is always looking for angles that contradict his own views. So, if you are excited about a stock and you own it, try to find arguments against your own opinion. A bunch of yes-people are of no use to an investor. I think the best thing is if someone helps me understand that I am wrong about a stock or a market.

In this spirit of contrarian thinking, I would like to present arguments why Nasdaq Helsinki is not cheap and better places to buy are still ahead.

The present value of shares is their future cash flows to the present day discounted by a required rate of return. In layman's terms, shares are effectively driven by their results. Thus, the obvious way to dig for weaknesses in equities is their future earnings performance.

The earnings development of Nasdaq Helsinki has been poor. The weak global economy and simultaneous cost inflation are hitting results hard. We started the year on an optimistic note, which paid off in the form of profit warnings in the summer. In the second quarter, for example, organic growth in the IT services sector came to a standstill. Forest companies are in a pulpy pickle. Machineries are still enjoying thick order books, but less new business is coming in. It's raining profit warnings. Most recently yesterday, engineering house Etteplan issued one, even though the company revised its guidance last earnings season.

The low valuation of Nasdaq Helsinki, expressed in P/E, is based on recovering earnings. As per usual, analysts are predicting a strong recovery in results after the current weak year. The median or average earnings of the companies monitored by Inderes, i.e., almost all Finnish listed companies, are forecast to grow by 20% in 2024 and 15% in 2025. In other words, earnings should grow, and profitability should improve, as it did in 2021, when the economic environment was, in hindsight, bubble-level favorable for listed companies.

Unless Finland and the global economy, from which the domestic stock market that teems with international companies rips off its earnings, picks up more than expected, these forecasts seem exaggerated. If the US were to fall into a recession, which fewer and fewer people expect, current earnings forecasts would be nothing more than wishful thinking. The cheapness of shares would be pure window-dressing because it would be based on unrealistic and high earnings expectations.

In addition to earnings growth, the profitability of listed companies is under threat.

I have often repeated this point, so I will simply say that in a rapidly inflating economy, it’s difficult for listed companies to maintain their profitability. In theory, one would think that companies would easily pass on the increased costs to their customers. But in practice, raising prices without losing market share is not easy unless you have the pricing power of Apple and Microsoft. Not that many companies do. Therefore, margins are under pressure.

Secondly, most businesses require investment just to stay in business. Factories, equipment and computers wear out. Investments are becoming more expensive, but because it’s difficult to raise prices, the return on those investments is lower than before. Consider, e.g., UPM's major investment in a biorefinery in Germany, which exceeded previous cost estimates. The poorer the return on invested capital a company has, the less it is worth paying for.

Figuratively speaking, why give your money to a listed company if you can get a better return on the stock market yourself?

In addition to falling earnings, higher inflation makes stocks less interesting.  This next perspective is borrowed from none other than Warren Buffett in his inflation-related writings of the 1970s.

Equities are shares in real-world companies, but they can also be compared to bonds. Or, because Finns are more familiar with investing in savings accounts, let’s say savings accounts.

If the interest rate on a savings account is a guaranteed 5% and inflation is 0%, the investor's purchasing power increases by 5% per year in real terms. However, if inflation is 5% a year, everyone realizes that the purchasing power of the saver is stagnating.

From what I've seen in historical data, the return on equity has hovered around 12%. Although this level of return fluctuates with the cycle, especially for Finnish companies, the return on capital has been surprisingly stable over time. Warren Buffett talked in the 1970s about how the return on equity in previous decades has been around 12% for US companies, and the S&P 500's return on equity has averaged just over 13% for the last 30 years. Nasdaq Helsinki’s equivalent level in the 2000s has been in the ballpark of 11%.

In effect, the investor buys a portion of a stock’s equity. In general, you have to pay more than the book value for stocks and therefore investors do not necessarily get the same return that companies get on their equity. But overall, investors' wealth grows through the accumulation of companies’ capital, and the return on capital reflects the rate of that accumulation.

If the ROE of a listed company is 12% and inflation and interest rates are low, the situation is particularly pleasant for the investor. Listed companies pay out part of their profits as dividends and part of the profit is reinvested back into the business, further increasing profits.

But if inflation is hovering, e.g., around 6%, a 12% return on equity is no longer so attractive. It is still above inflation, but purchasing power is growing much more slowly than before. In other words, the higher the inflation rate, the lower the real return that listed companies get on their capital. And the poorer the return for the investor.

The evidence does not suggest that listed companies as a group can significantly improve their return on capital in the face of rapid inflation. In addition, investors will continue to pay tax on their profits, even if their purchasing power does not increase much in real terms.

I discussed this relationship between the return on capital and inflation in more detail in a post a year ago.

This same point can also be made simply by saying that high inflation is pushing up interest rates, and with risk-free fixed rates offering juicy returns, it’s not worth paying as much for equities as before. In such a situation, real assets and commodities can perform better.

We have a somewhat extreme historical example of how investors started demanding higher returns on equities as inflation soared and interest rates rose to much higher levels than they are today. In the 1970s, the P/E ratio of the S&P 500 index eventually fell to as low as 7 when inflation fluctuated wildly between 5% and 15%. I'm not saying that the inflation storm of the 1970s will be repeated this time, but I wanted to remind you that people are paying very little for shares in an environment where inflation is a constant nuisance. Although inflation now seems to be receding, its return is a big risk.

I also commented on this possibility on X (Twitter) a while ago which generated a good discussion. Tuure Parviainen linked to this good Crestmont Research graph of how the P/E ratio of the S&P 500 index has moved in different inflation environments. As the graph suggests, with higher inflation, stock valuations fall. Deflation is also bad for stocks.

If inflation were to spiral out of control again and investors were to rush into equities, a 7x P/E valuation for Nasdaq Helsinki at current earnings forecasts would mean a level of around 5,000 points, or 50% less than today.

Hence the populist title OMXH -50% to 5,000 points. It is a far-fetched scenario, though by no means impossible in historical terms. But, this would indeed require years of rapid and unexpected inflation and high interest rates.

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