Equity valuations too hot? Not for the value creators

Equity valuations continue to worry market participants, as valuations have inched higher with the market’s record-setting gains. As I will argue, however, an upward price trajectory is warranted in cases where earnings growth is powering the advance, particularly for those companies generating high returns on capital and that can compound those cash flows.

Asking whether the market is overvalued is perhaps the wrong question. A better question may be: Would I rather own something that creates value or something that erodes or sometimes destroys value? This may also be helpful for dispelling the notion that U.S. equity valuations are currently too hot to warrant anything more than cautious exposure to U.S. stocks.

The value destroyers

In my view, entire sectors might be classified as perennial value destroyers—sectors where the cost of capital is routinely higher than the return on capital. But curiously enough, these are some of the sectors that have occasionally moved into overvalued territory over the past 18 months.

I’ve never been able to get excited about investing in a company whose cost of capital exceeds its returns. In the first place, that’s a terrible-sounding idea for a long-term investor. Second, in this era of ultralow long-term interest rates, any company that can’t earn above its cost of capital must face serious structural challenges from an earnings capacity standpoint.

Telecommunication service stocks, particularly the large phone companies, are prime examples of value destroyers. Competitive intensity in this sector is high, and one of the main ways telecoms attract investors is their participation in a lively merger-and-acquisition (M&A) landscape. With traditional phone and cable companies perpetually on the lookout to acquire brand-rich media content providers and riskier smaller businesses that promise some content or distributional edge, the sector tends to rise or fall on the cost-squeezing opportunities inherent in M&A. In the absence of a strong method for generating free cash flow, telecoms haven’t been able to sustainably earn a return above their cost of capital. 

A similar story can be told for airlines, utilities, metal and mining companies, and many areas within the broader energy markets that are under intense pressure to take whatever profits they make and immediately plow them back into the ground for resource development. In most of these cases, a sub-cost-of-capital return is the order of the day.

Why, then, do these industries come into investment vogue, as they did for a good portion of 2016 and at times during 2017? Because many investors are drawn to higher dividend income, which appears to give these companies the façade of safety. These stocks have acquired a fictitious bond proxy status that’s deemed—for better or for worse—to be more important than actual value creation.

The value creators

Companies that generate returns on invested capital exceeding their costs of capital create value for shareholders. As a portfolio manager, I seek companies that are compounding cash flows, have sustainable competitive advantages, and are attractively priced—a winning recipe for value creation in the form of sustained higher free cash flows. Price-to-earnings ratios are the most widely cited metric in discussions of equity valuations, but they’re woefully inadequate at measuring a company’s capacity for creating value, in my view.

If a company is compounding its cash flows, what is its fair price? In my search for value creators, I frequently revisit my calculations of the base-case projections of companies’ fair values. For example, if I calculate the fair value of a stock to be $100 today, but factor in an 8% annual growth rate, then fair value a year from now would be $108, assuming nothing else changes.

As I look across sectors that I believe hold many attractively valued stocks today, I find numerous examples of companies whose compounding growth rates and cash flows are likely to move my estimates of their base-case values upward. An abundance of these companies can be found in the financials, consumer discretionary, and information technology sectors. A quick glance at the consumer discretionary sector, for example, shows a strong record over two decades of generating sustainable cash flows that consistently exceed the cost of capital.    

Macro tailwinds won't hinder the market's advance

Even in today’s supposedly late-stage economic cycle, there are attractive opportunities to be found in companies whose ability to create value over time defines the terms of their price discount today.

As I’ve described in the past, I believe that current macro conditions will only support the earnings revolution that I expect will drive the next phase of the market’s expansion. Strength in housing, the labor market, the U.S. consumer, and on the balance sheets of U.S. banks is likely, in my view, to act as a tailwind for U.S. equities broadly considered, and will do nothing so much as bolster the case for today’s compounding value creators.