On the back of the predicted sixth consecutive quarterly decline in the earnings per share of the S&P 500 I decided to see how we would have done if we had done a leveraged buyout of the S&P 500 in 2014 and then again in 2015. I did two separate fictional LBOs of the SPX at 11.5x its trailing twelve month (TTM) EBITDA as of December 31, 2013 and then again at 12x TTM EBITDA for December 31, 2014. The nosebleed multiples of EBITDA at which the S&P 500 trades today are not significantly greater than the typical large company buy out, but they are nonetheless historic for the public markets during this last decade. According to data compiled by the Wall Street Daily in an article by Alan Gula dated Feb 1, 2016 the following was the data set for the S&P 500:
You can see that in 2012 the multiple was slightly less than 8x but that in 2014 and 2015 it had reached and exceeded 12x. It is also instructive to see how the SPX- the ETF for the S&P traded during that period. It increased from 1500 to 2200 as shown below and the PE multiple based on TTM earnings increased during that period from 14.87x to an estimated 25x through Q3 of 2016.
It Is All About Earnings in a LBO
I was actually quite surprised to see that if I did a complete buyout in 2014 based on TTM EBITDA for the year ended December 31, 2013 and sold at the end of 2016 I would have returned $1.34 for every $1.00 invested for a 10% compounded return on equity over that 3 year period. Conversely, if I waited one year to do the LBO I would have returned slightly less than $1.00 for each dollar invested, in essence I just got my money back.
The LBO model is highly sensitive to the big variables like entry price, earnings, interest rates, taxes and capital expenditures. For my analysis the only big mover was earnings. My first buyout of the SPX in 2014 had 11 quarters of earnings above the level at which I priced the buyout. The second buyout was done at peak earnings and the earnings have only declined since then. In fact, the S&P 500’s earnings per share for Q3 2013 ($88.97) is almost identical to the estimated $86.96 for Q3 2016.
Possible Arbitrage between Markets
One of the reasons the EBITDA multiple in the public markets is so high is that public earnings and EBITDA are falling. This is remarkable given the record number of share buy backs which typically boost EPS by lowering the shares outstanding. One question an investor should be asking is whether the liquidity of owning the S&P 500 is worth the sky high entry price? Likewise, is that liquidity premium likely to go away when central bank monetary policy becomes less favorable?
Without permanent liquidity, the entry opportunity in the lower quadrant of the private markets is significantly better because the median entry price is 6.5-7.0x EV/EBITDA. The smaller companies have also demonstrated an ability to grow, albeit slowly. A good trade might be to lighten up on the expensive, but temporarily liquid, large company market and trade into the private markets where the return possibilities should be better, but illiquid. I raise the question of liquidity because many other trading markets have experienced declining liquidity as the commercial banks no longer lend their balance sheets to most trading markets after Dodd Frank. At some point central bank accommodation may stop at which point the liquidity premium could evaporate like it did in 2008. At that point you will be happy to have traded out of a market whose only sustaining momentum may be the promise of liquidity.
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