We’ve mentioned our equity valuation paradigm before, but here is a brief review. Stock prices incorporate expectations about:
- Future trends in return on invested capital (ROIC). Most times you’ll see this shorthanded to “earnings growth” since typically that is higher than incremental capital invested in the business. EPS growth is less useful for cyclical companies, of course, where earnings can vary substantially under different economic conditions. Also, industry structure can have a powerful effect on structural ROIC across all companies in the space.
- Competitive advantage. This is a combination of industry structure and the individual attributes of the company in question.
- Reinvestment rates on incremental capital. Say a company earns a 10 percent return on its current business and then expands into a new market with less competition. Its marginal return on capital will rise, and that’s good for the company’s overall valuation.
- Cost of capital. At a macro level, the most important swing factor here is long run risk-free interest rates. When you’re talking about a specific company, the weighted average cost of capital calculation applies (cost of debt, cost of equity capital).
- The important thing about this paradigm is that stock prices reflect marginal changes in each of these factors, so valuation is never just about one of these factors.
With that construct in mind, let’s consider where US/global stock and sector prices are now versus the last 5 years. The idea here is to consider where asset prices are now relative to pre-pandemic valuations and evaluate if these pre- and post-crisis prices make sense against the framework we’ve just laid out. Here’s the data:
- S&P 500: +15 percent over February 2020 highs
- Russell 2000: +29 percent over August 2018 highs
- MSCI EAFE: flat with January 2018 highs
- MSCI Emerging Markets: +3 percent over January 2018 highs
US Large Cap sectors (split between groups that are up more/less than the S&P from prior highs):
- Better than S&P:
- Communication Services: +29 percent over February 2020 highs
- Technology: +28 percent over February 2020 highs
- Materials: +20 percent over January 2018 highs
- Consumer Discretionary: +19 percent over February 2020 highs
- Worse than S&P:
- Industrials: +12 percent over February 2020 highs
- Financials: +9 percent over February 2020 highs
- Health Care: +9 percent over January 2020 highs
- Consumer Staples: +1 percent above January 2020 highs
- Real Estate: -10 percent below February 2020 highs
- Utilities: -13 percent below January 2020 highs
- Energy: -33 percent below May 2018 highs
Before we discuss how to make money with this analysis, let’s spare a thought for the role risk-free interest rates play in pre- and post-crisis equity valuations. In the US, 10-year Treasury yields went from a high of 3.2 percent in November 2018 to 1.5 percent today. One would think that must have helped the S&P 500 produce that 15 percent premium to pre-crisis peak valuations…
But the German 10-year bund yield is down from its February 2018 peak of 0.66 percent to -0.31 percent and MSCI EAFE has gone nowhere. On top of that, rate-sensitive US Utilities are the second worst performing group when comparing pre- and post-crisis peak valuations. The bottom line here: for all the attention paid to lower rates lifting valuations, once you dig into the details it is clear our other valuation factors play a far larger role in setting stock prices.
Now, on to the investment insights, each framed as a question tied to the data above:
#1: Did all the disruptions around the pandemic fundamentally improve the long run earnings potential/return on capital, reinvestment rates and competitive position of US Big Tech (the leadership names in Comm Services, Tech and Consumer Discretionary) by 20 – 30 percent? That’s what’s in stock prices, as we showed you.
Our take: we’re inclined to say “Yes”. Our reasoning is that the bulk of their valuations come from strong competitive advantage and high returns on capital. The first assures they will benefit from incremental demand and the second means they will earn at least their current ROIC on that demand. However much life returns to normal in the next 6-9 months, these companies should hold on to much of their newfound relevance.
Recommendation: this is why Tech is not an underweight despite better opportunities elsewhere, a position we outlined a few weeks ago and still hold today.
#2: Do cyclicals like Industrials and Financials deserve to trade for a larger premium to prior-cycle valuations?
Our take: yes they do, but for different reasons than how Tech achieved its premium. Very few of these companies have anything close to the competitive advantages, structural ROIC, or reinvestment opportunities of an Apple or Microsoft.They do, however, have good capital discipline and will either buy back stock with excess cash or in the case of smaller Financials consolidate the industry through M&A. This is not as exciting as Tech’s story, but it is the next leg of the cyclicals story in our view.
Recommendation: We still like sector plays like XLI, KRE AND KBE.
#3: How does Energy fit into this valuation paradigm?
Our take: Energy is cheap to its pre-crisis valuation for very good reasons but we still like it here. The simple truth is that most of the world’s cars still burn gasoline, so as global economies recover demand will increase. And as the carbon-based energy industry faces a future of more consumer alternatives, it will have to consolidate. Again, this is not as juicy a narrative as Tech but it is a recipe (the only recipe, in fact) for higher sector valuations over time.
Recommendation: we still like PSCE (S&P Small Cap Energy) and both of us own this name personally. It trades 68 percent its January 2017 highs.
Summing up: the approach we’ve laid out here is one we’d recommend you use more broadly than just the examples we’ve cited. Most US stocks are above their pre-crisis highs, and many EAFE/EM equities are at least near them. This is a signal that the near future will quickly resemble or even improve upon the recent pre-pandemic past. While we’re broadly on board with that idea, it doesn’t apply everywhere and the framework with which we started this analysis is a good one to use when evaluating asset prices today.