Expecting High Expectations to Fall
RJ Steinhoff, CFA Investment Process
Global equity markets have run up with U.S. returns leading the way. The S&P 500’s P/E ratio is 23x 2021 earnings. Since the 1920s, there have been only on a handful of periods where the S&P 500’s P/E has breached and maintained above 20x. The CAPE ratio, which uses 10 years of inflation-adjusted earnings to smooth out corporate profits, is 33x, a level only exceeded during the dot-com bubble. The index’s next-twelve-months EV/EBITDA multiple currently hovers near 15x, exceeding its 2000 peak. Other proxies for value are also at or near all-time highs.
Some argue that low interest rates justify these high valuation ratios. Our favourite valuation method, which factors in interest rates, measures implied growth. The implied growth calculation reverses the typical valuation equation (discounted cash flow), setting valuation at current market prices and then solving for the implied long-term growth rate. We use normalized earnings as a proxy for cash flows, trailing 3-year betas (a measure of a stock’s volatility compared to its local market) for each company’s cost of equity, and the 10-year Treasury rate for the risk-free rate.
As seen in Chart 1 below, the S&P 500’s implied growth is higher than it was during the 2000 bubble. Implied growth for the median S&P 500 constituent (dark blue line) is close to 5.3%. Using aggregate earnings for the index, implied growth is 5.4%. Each is close to extremes, indicating the index and the average stock are both expensive. A market expectation of 5.5% nominal annual earnings growth in perpetuity is outlandish; buying U.S. stocks at this juncture requires the belief that annual earnings growth will continue uninterrupted.
CHART 1. 20-YEAR S&P 500 IMPLIED GROWTH
SOURCE: FACTSET, GENERATION IACP
The most overvalued and speculative areas of the market have already experienced significant corrections. Meme-stocks such as AMC and GameStop have been cut in half from their summer-highs. Much-hyped stocks like Palantir, Zoom, and Peloton are down significantly. Even still, large-cap U.S. equities remain expensive with embedded growth expectations too high. As a result, navigating the markets recently has required extra patience and discipline.
Looking for Value
Value investors have struggled to keep pace with the tech-heavy S&P 500. Value has underperformed since the 2009 bottom—the last five years being particularly challenging. Since 2016, the S&P 500 has outperformed the S&P 500 Value index by 50%. The S&P 500 is ahead of the average stock (Value Line Index) by an incredible 80% in that same period. Such underperformance tempts managers to chase performance and stray from their investment mandates. With no margin-of-safety offered by most companies, we are not prepared to pay up and we are sticking with our value discipline.
Looking Elsewhere
Most major international markets have lagged the U.S. year-to-date and underperformed over the last five years. Chinese- and Hong Kong-listed stocks have been particularly beaten up. The Hang Seng China 50 is down 12% year-to-date and an index of Chinese Internet stocks is down a staggering 63% from its February high.
Forgotten Midcaps
It should be no surprise that with the strong performance of large cap tech since 2009, the S&P 500 has beaten its equal weighted counterpart over the same period. This outperformance has widened over the last five years with the cap-based S&P 500 ahead by over 30%—normally it’s the opposite. The Russell 2000 Index is up just 12% for the year, less than half the S&P 500. Globally, the MSCI World Small Mid has trailed the MSCI World Index, too.
Historically, the performance differential between a cap-weighted approach and an equal weighting approach has been cyclical, correlated with the performance of capitalization, value, and momentum factors. The same outperformance of large caps was observed during the late ‘90s. After the bubble burst, equal-weighed indices outperformed. We see much more value in forgotten mid-caps and believe the stage is set for them to outperform.
Discerning High from Low Quality
The broader U.S. market is priced for perfection. And it does not appear to be differentiating between higher and lower quality companies. We seek both a high-quality business and an attractive valuation. We prefer companies with strong franchises, loyal customers and pricing power that enables them to generate healthy free cash flow, even in a challenging economic backdrop. Furthermore, higher quality businesses tend to be resilient during corrections. For example, companies with high return on invested capital (ROIC) and low variability in year-to-year ROIC typically outperform baskets based on other metrics such as low beta, low volatility, and popular leverage and profitability ratios (see The ‘High-Low’ Approach to Identify Outperformers).
Businesses are juggling multiple headwinds, from supply chain disruptions, component shortages. rising input and labour costs, and higher borrowing costs. Companies with strong franchises and scale are better positioned protect margins.
Staying Hedged
Historically, valuation has been unreliable for market timing—expensive markets can turn into bubbles and cheap markets can experience sharp declines when economic conditions are deteriorating. While unusual for us to be hedged outside of periods where we are concerned about a recession (e.g., in early 2020), we view valuations to be extreme enough to hedge (by shorting U.S. stock market ETFs in Growth accounts or holding inverse ETFs in registered or long-only accounts).
We sleep better knowing that we are partially hedged in case today’s elevated expectations are quickly tempered and normalized valuations again prevail. The U.S. market is so pricey that any exogenous shock could bring the market back down quickly to more appropriate levels.
RJ STEINHOFF, CFA
HEAD OF RESEARCH
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation IACP Inc. may or may not continue to hold any of the securities mentioned. Generation IACP Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation IACP Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation IACP Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
Global equity markets have run up with U.S. returns leading the way. The S&P 500’s P/E ratio is 23x 2021 earnings. Since the 1920s, there have been only on a handful of periods where the S&P 500’s P/E has breached and maintained above 20x. The CAPE ratio, which uses 10 years of inflation-adjusted earnings to smooth out corporate profits, is 33x, a level only exceeded during the dot-com bubble. The index’s next-twelve-months EV/EBITDA multiple currently hovers near 15x, exceeding its 2000 peak. Other proxies for value are also at or near all-time highs.
Some argue that low interest rates justify these high valuation ratios. Our favourite valuation method, which factors in interest rates, measures implied growth. The implied growth calculation reverses the typical valuation equation (discounted cash flow), setting valuation at current market prices and then solving for the implied long-term growth rate. We use normalized earnings as a proxy for cash flows, trailing 3-year betas (a measure of a stock’s volatility compared to its local market) for each company’s cost of equity, and the 10-year Treasury rate for the risk-free rate.
As seen in Chart 1 below, the S&P 500’s implied growth is higher than it was during the 2000 bubble. Implied growth for the median S&P 500 constituent (dark blue line) is close to 5.3%. Using aggregate earnings for the index, implied growth is 5.4%. Each is close to extremes, indicating the index and the average stock are both expensive. A market expectation of 5.5% nominal annual earnings growth in perpetuity is outlandish; buying U.S. stocks at this juncture requires the belief that annual earnings growth will continue uninterrupted.
CHART 1. 20-YEAR S&P 500 IMPLIED GROWTH
SOURCE: FACTSET, GENERATION IACP
The most overvalued and speculative areas of the market have already experienced significant corrections. Meme-stocks such as AMC and GameStop have been cut in half from their summer-highs. Much-hyped stocks like Palantir, Zoom, and Peloton are down significantly. Even still, large-cap U.S. equities remain expensive with embedded growth expectations too high. As a result, navigating the markets recently has required extra patience and discipline.
Looking for Value
Value investors have struggled to keep pace with the tech-heavy S&P 500. Value has underperformed since the 2009 bottom—the last five years being particularly challenging. Since 2016, the S&P 500 has outperformed the S&P 500 Value index by 50%. The S&P 500 is ahead of the average stock (Value Line Index) by an incredible 80% in that same period. Such underperformance tempts managers to chase performance and stray from their investment mandates. With no margin-of-safety offered by most companies, we are not prepared to pay up and we are sticking with our value discipline.
Looking Elsewhere
Most major international markets have lagged the U.S. year-to-date and underperformed over the last five years. Chinese- and Hong Kong-listed stocks have been particularly beaten up. The Hang Seng China 50 is down 12% year-to-date and an index of Chinese Internet stocks is down a staggering 63% from its February high.
Forgotten Midcaps
It should be no surprise that with the strong performance of large cap tech since 2009, the S&P 500 has beaten its equal weighted counterpart over the same period. This outperformance has widened over the last five years with the cap-based S&P 500 ahead by over 30%—normally it’s the opposite. The Russell 2000 Index is up just 12% for the year, less than half the S&P 500. Globally, the MSCI World Small Mid has trailed the MSCI World Index, too.
Historically, the performance differential between a cap-weighted approach and an equal weighting approach has been cyclical, correlated with the performance of capitalization, value, and momentum factors. The same outperformance of large caps was observed during the late ‘90s. After the bubble burst, equal-weighed indices outperformed. We see much more value in forgotten mid-caps and believe the stage is set for them to outperform.
Discerning High from Low Quality
The broader U.S. market is priced for perfection. And it does not appear to be differentiating between higher and lower quality companies. We seek both a high-quality business and an attractive valuation. We prefer companies with strong franchises, loyal customers and pricing power that enables them to generate healthy free cash flow, even in a challenging economic backdrop. Furthermore, higher quality businesses tend to be resilient during corrections. For example, companies with high return on invested capital (ROIC) and low variability in year-to-year ROIC typically outperform baskets based on other metrics such as low beta, low volatility, and popular leverage and profitability ratios (see The ‘High-Low’ Approach to Identify Outperformers).
Businesses are juggling multiple headwinds, from supply chain disruptions, component shortages. rising input and labour costs, and higher borrowing costs. Companies with strong franchises and scale are better positioned protect margins.
Staying Hedged
Historically, valuation has been unreliable for market timing—expensive markets can turn into bubbles and cheap markets can experience sharp declines when economic conditions are deteriorating. While unusual for us to be hedged outside of periods where we are concerned about a recession (e.g., in early 2020), we view valuations to be extreme enough to hedge (by shorting U.S. stock market ETFs in Growth accounts or holding inverse ETFs in registered or long-only accounts).
We sleep better knowing that we are partially hedged in case today’s elevated expectations are quickly tempered and normalized valuations again prevail. The U.S. market is so pricey that any exogenous shock could bring the market back down quickly to more appropriate levels.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation IACP Inc. may or may not continue to hold any of the securities mentioned. Generation IACP Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation IACP Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation IACP Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
