A Forgotten Metric Is Uncovering Value In This Market

Many important stories seem to be getting lost in the headlines lately. One that many analysts and investors seemed to miss was about Amazon.

The Financial Times carried the news:

Amazon locked in some of the lowest borrowing costs ever secured in the US corporate bond market on Monday, underscoring the rise of the ecommerce giant during the coronavirus pandemic and the boost the Federal Reserve has provided through its historic interventions.

The company raised $10bn in an offering that included three-year notes carrying an interest rate of just 0.4%, according to people briefed on the matter.

The interest on the new three-year note was less than 0.2% above the rate investors charged the US government when it issued debt of a similar maturity in May — a stunning turn for a company whose debt was considered junk as recently as 2009.

The rate it secured on Monday was below the previous record low of 0.45 per cent secured in 2012 and 2013 by companies including Apple, IBM and Walt Disney.

Amazon’s new seven and 10-year borrowings carried coupons of 1.2% and 1.5%, respectively, also the lowest ever in the US corporate bond market, toppling a record set by the retailer Costco earlier this year, according to the financial data provider Refinitiv, whose records go back to 1980.

Why This Matters

Bond yields are important because they can provide information about whether stocks are overvalued.

Ben Graham, Warren Buffett’s renowned teacher, believed stocks and bonds are competitive investments. Intelligent investors will seek the highest and safest returns. When bonds offer high yields, they are the best choice.

Graham defined the relationship by comparing interest rates to earnings yields (the inverse of the price-to-earnings ratio). He believed stocks should have higher earnings yields than bonds to attract investment.

With a P/E ratio of 70 based on next year’s estimated earnings, the earnings yield on Amazon is about 1.4%. The 10-year bond tells us the stock would be fairly valued with a P/E ratio of about 66.

Math Corner: Earnings yield is equal to the reciprocal of the P/E ratio, so 1/(P/E). That’s 1/70 for AMZN, or 0.014 (1.4%).

The bottom line is that Amazon looks expensive, but the bond market tells us that’s not the case. The same is true for many other stocks.

I’m not saying every stock is undervalued… but current interest rates do justify many stocks at their current levels.

How I’m Trading Right Now

Some stocks are even bargains at current prices. That includes my most recent trade recommendation over at Income Trader.

Our most recent trade was with 3M Company (NYSE: MMM), which has an earnings yield of 5.6%. Bonds maturing in 2028 yield 2.8%, which means the stock is undervalued.

More Math: MMM is expected to earn $8.91 next year. Based on yesterday’s close of $157.64, that’s a P/E ratio of 17.7. The earnings yield — which is the reciprocal of 17.7 — is 1/17.7, or 5.6%. Bonds yield less than that (2.8%), so the better investment is the stock since the intelligent investor (in Ben Graham’s words) would buy the higher yield.

MMM planned to spend this year cutting costs and integrating recent acquisitions. Economic shutdowns have affected the company, and investors don’t have insights into the progress of these initiatives. But analysts’ earnings estimates have been fairly stable, indicating they believe the company is making progress.

The stock recently gave an Income Trader Volatility (ITV) “buy” signal. This is the award-winning indicator we’ve been using to identify trades since 2013. And it’s delivered winning trades more than 90% of the time.

Action To Take

While long-term investors may want to wait for conformation that the company is meeting its operating goals, I believe there is a short-term income opportunity available.

And while I can’t share the exact details of that trade with you today, what I want to emphasize is this… There are opportunities available in today’s market — even if what we normally think of as “value” isn’t readily apparent. But you need to do your research and be precise with your trades.

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