When equity prices are either directly or indirectly rising in response to monetary policy, what role should a traditional investment decision factor such as valuation play?
The quick answer is that investment decisions should always be guided by valuation. From a simple perspective, using forward price-to-earnings (P/E) ratios, it is easy to see that equity markets, with the exception of Asia, are trading above their respective historical averages. For example, in the United States, the forward P/E ratio for the S&P 500 Index currently stands at 16.8x, which is well above the 5- and 10-year historical averages of 14.4x and 14.2x, respectively.1 In isolation, the data might not mean a great deal, apart from suggesting that valuations might be veering toward the higher side; however, given that these figures include the magnitude of recent corrections, it isn't difficult to conclude that stock prices in the United States are relatively expensive.
The importance of deconstructing earnings
When you consider the earnings multiple expansion within the context of sluggish sales growth, condensed profit margins, and high leverage, a more worrisome picture emerges. Sales per share for the stocks in the S&P 500 Index universe rose by an annualized 4.3% since 2009, but that is significantly below operating earnings per share, which grew at 12.4%. This might suggest that the bulk of earnings improvement we saw in the past six years was powered more by healthier profit margins and share buybacks than top-line growth. While it points to greater efficiency, it masks the lack of equivalent growth in revenue. If sales do not pick up, it is fair to say that earnings growth will soon slow because it's difficult to foresee stretched margins expanding any further.
Sales growth continues to lag operating earnings growth
In addition, the outlook for revenue growth is appropriately bearish. S&P 500 Index companies are expected to post five consecutive quarters of year-on-year revenue declines since the first quarter of 2015, which will mark the first time since 2008 this has occurred.1 Earnings are also expected to decline for the fourth consecutive quarter.
The dividend, buyback, and debt relationship
Dividends and buybacks can temporarily enhance the perception of a company's value because they can give a short-term boost to a company's share price and earnings per share. But there are downsides to the short-term gain: S&P 500 Index firms spent almost $1 trillion on share buybacks and dividend payments in the 12 months ended September 15, 2015, which was a record for a one-year period.
The disturbing trend is that U.S. corporations have been increasingly funding their dividend and buyback programs with debt, so it's no coincidence that U.S. corporate debt hit a record high in 2015. Investors, then, would do well to pay more attention to overall leverage levels and ask the following two questions:
- Are these programs funded at the expense of future growth?
- From a valuation perspective, have investors been rewarding companies for taking on more debt?
The opportunity between value and quality
Investors have a tendency to overpay for companies perceived to be engaged in exciting ventures. By the same token, investors tend to undervalue perfectly good businesses with robust business models if these firms are perceived to be decidedly less exciting. We believe this tendency represents an opportunity to purchase quality companies at attractive relative valuations. It is during challenging moments like this—when the macro outlook is weak, valuations are questionable, and margins are stretched—that we believe high-quality companies are able to distinguish themselves from the pack.
1 FactSet, 4/15/16.