“It’s not just what you make, it’s how long you make it that matters.” A wise old owl of an investment banker told me that in the early 1990s, and I have never forgotten it.
That saying applies to equity valuations as well. Our mental model for how stock markets capitalize a dollar of earnings comes down to:
- Return on invested capital. Earnings relative to capital employed in the business
- Cost of capital. What shareholders expect to make from their investment.
- The sustainability of returns that exceed that cost of capital. The “moat”, in other words, that defends a company’s business model from competition.
Consider how much all three of those inputs have changed for large cap US public companies since the start of the COVID-19 Crisis:
- The S&P 500 has an imbedded small business “put”, and it is global in scale. Almost 40% of S&P revenues come from outside the US.
For example: when 10 independent coffee shops in Madrid close, Starbucks gets some incremental business. When 20 affordable family bistros in Nice France shutter, McDonald’s should see more foot traffic. Yes, this is a harsh reality. But it is reality nonetheless.
- Larger companies have much better access to cheaper capital than smaller ones. There has been a slew of corporate debt and stock offerings in the last week. But if you are a small businessperson, good luck walking into a bank for a loan just now or winning the PPP lottery.
- Small business formation is cyclical; the next wave of small business competitors for S&P 500 companies won’t start up this year or perhaps even in 2021.
Now, the obvious pushback to this argument is that all those small businesses employ lots of workers who will lose their jobs and have less disposable income. That’s true, but in the US enhanced unemployment insurance will help tide many of them over for the rest of 2020. Past that, larger companies should be hiring because of the incremental business they receive.
So what’s all this worth to S&P 500 valuations? Here is one way to think about that:
#1: Start with current multiples based on consensus Wall Street analyst expectations:
Yes, these are somewhat flawed; the Street hasn’t brought down numbers enough for 2020/2021. On the plus side markets are looking through this year, so those overly optimistic numbers are probably close to what the market thinks of as normalized earnings.
The S&P 500 trades for 18.3x those forward 12-month earnings. Here is the breakdown by sector along with the index weighting for each:
- Technology (25.5% weight): 20.8x
- Health Care (15.7%): 15.9x
- Communications (10.7%): 18.0x
- Financials (10.4%): 12.4x
- Consumer Discretionary (10.3%): 26.5x (mostly because of Amazon)
- Industrials (7.8%): 18.2x
- Consumer Staples (7.7%): 19.5x
- Utilities (3.5%): 17.9x
- Real Estate (3.0%): 17.9x
- Energy (2.9%): 0x (no earnings, no PE)
- Materials (2.5%): 17.4x
#2: That’s a bit of an eye chart, so we’ll simplify things to answer one question: what sector revaluations deliver an S&P that has a 20.0x valuation rather than the current 18.3x? We only need to tweak 3 groups to get there:
- Put a 25x multiple on Tech. Yes, that’s higher than the current 20.8, but this group has seen a steady upward revaluation in the last 5 years. Also, many of society’s responses to COVID-19 (work from home, streaming media entertainment, even contact tracing in some countries) run through the Tech space before touching other industries. And whatever ends up being the new normal likely will as well.
- Apply an 18.0x multiple to Health Care, essentially today’s market multiple. Our logic is not so much any medical solution for COVID-19 as it is the stable earnings the group typically generates.
- Use a 30x multiple for Consumer Discretionary sector earnings. This is where the S&P 500 “put” on small business is most evident, whether it be in Amazon (25% of the sector), Home Depot (12%), McDonald’s (7%), or Starbucks (5%).
- And that’s it… leave every other group at their old valuations and you still get to a 20.0x S&P 500.
#3: Summing up: this analysis highlights there is actually no “market multiple” but rather an amalgamation of individual stock/sector earnings fundamentals that bubble up to a price-earnings ratio for the S&P 500. It can be lower than one might think rational, or higher, but disaggregating the index into its constituent parts gives a more thoughtful perspective. This doesn’t necessarily make the S&P 500 a “buy” just now since we don’t really know forward earnings. But if these revaluations come to pass – and we strongly believe that process is underway – then every dollar of earnings growth or contraction carries with it a higher multiple than the crowd understands. That is a recipe for further volatility.
FactSet Earnings Insight Report: https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_041720.pdf