There has been much debate around market valuation recently, with general agreement that the many markets is “expensive” vs. history and compared to current (uninspiring) fundamentals. I will use the S&P 500 as an example:
On an earnings basis (the yellow line – price to adjusted earnings per share) the S&P 500 is indeed slightly over valued vs. history; although still well off the peaks we had seen at the end of previous bull markets. However, when you look at the value of the firm as a whole (the green line – enterprise value to earnings before interest, tax, depreciation and amortization) you can see we are 95% of the way back to the peak valuation of March 2000 (back then stocks were overvalued; today it’s the bonds, in my opinion.)
While I agree assets in aggregate are overvalued today thanks to the central bank "wizards", the good news for active managers like us is that we don’t just buy the market we invest in specific businesses. When you dig below the surface, opportunities are presenting themselves and risks are clear in others.
Starting from a sector perspective, let’s compare and contrast the divergent price performance of the different sectors of the S&P 500 over the last five years:
What is interesting across sectors is the source of the returns we have seen: when you compare price performance to earnings growth you can see how much of the return has come from fundamental earnings growth (possibly sustainable) and how much has come from multiple expansion (unsustainable).
Let’s focus on health care, staples and utilities which have been very strong performers over the last five years. In many of these cases the multiple expansion makes logical sense: as rates continue to be depressed they become the best option for those in search of yield. As you reach, or go beyond, the zero bound for rates, capital is forced out the risk curve to find income. With demographics where they are today, and the pain from the 2008 crash still fresh in the minds of investors, the focus on current income is intense.
Next, let’s examine the actual drivers of earnings growth (adding Telecom to the analysis):
A few things stand out. First, share prices have exceeded earnings growth for each segment, but net debt has also been increasing substantially. Increasing leverage has added to earnings growth but has also added to financial risk for these companies as well. On top of this, declining interest rates, falling commodity prices and a general consumer recovery have been tailwinds to growth. By labeling these sectors as “defensive” or “low volatility” I believe the risk perceived by buyers is much lower than the actual fundamental risk, which has left a large gap between what people (or should I say ETFs) are paying for them today and what the fundamentals justify.
Across the market today, investors are overpaying for certainty ($10T of sovereign yields are in negative territory). While interest rates may remain low or even drop further, we do not think its prudent to expect these fundamental earnings drivers and multiple expansion to continue over the next five years at the same rate of the last five years.
On the flip side, anything deemed volatile or cyclical is being avoided these days. Areas where we are finding selective opportunities include industrials, financials, materials and technology due to a combination of low expectations, low valuations, solid balance sheets and higher growth potential for the next five years vs. the last five.
So while many investors simply look at the index as a whole and declared "stocks are expensive, time to move on" we believe this misses the key point – below the surface there are both areas of attractiveness and overvaluation. Areas of opportunity are in the more economically sensitive areas of the market today, making a disciplined philosophy and process more important. We are fortunate at Cambridge to have the freedom to look for absolute value across all sectors and all geographies, unburdened by a relative performance mindset. With a diligent investment philosophy and a consistent process we continue to find pockets of attractive risk-reward in a market where value has become increasingly difficult to find.