The global economic outlook is strengthening, and this view has been reinforced by many companies reporting expectation-beating earnings for the last quarter of 2020. But while good business results go some way towards explaining the confidence in equity markets, are they enough to justify inflated prices?
As always, it’s important to dig beneath the rhetoric to understand what is really going on and where investment opportunities lie. Chart 1 compares growth stocks, whose perceived ability to outperform the market over time is due to their future potential versus value stocks, which appear undervalued given their earnings forecasts and which tend to be more dependent on a strong economy. We compare these categories of stocks using a common valuation metric: enterprise value (EV) to earnings, before interest, tax, depreciation, and amortisation (EBITDA).
A bubble in the making?
As you can see, growth companies are now nearly twice as expensive as value companies. Indeed, since the pandemic struck, the gulf between these two categories of companies has widened considerably. This has been driven by expanding valuations in growth stocks, rather than increased earnings expectations, which suggests investors are getting carried away by the promise of a post-Covid boom buoyed by central bank support. As a result, growth stocks could be entering bubble territory, and we look at this in more detail in Investment View.
Position for growth, but prepare for volatility
Bursting bubbles aside, we should expect continued volatility in markets as the world emerges from the pandemic. Last month, government bond yields on both UK gilts and US treasuries began to climb rapidly, which spooked equity markets – a case in point. Despite this, equities remain the asset class with the highest long-term return potential and play an important part in client portfolios. Current conditions make our approach to careful stock-picking even more critical.
“Developed market economies are expected to recover as Covid-19 vaccines continue to be rolled out. There should be a strong economic recovery over the next few years and financial conditions, such as low interest rates, will remain extremely favourable until CPI inflation has been above target for a significant amount of time.”
Philip Smeaton, Chief Investment Officer
Investment View: What does a bubble mean for investors?
It has been over 20 years since the dot-com bubble - a fine example of how markets can get carried away with a narrative (in this case the promise of phenomenal growth in internet and technology companies) without the business fundamentals necessary to fully justify it. Indeed, it has taken most of the last two decades for the technology sector’s business performance to live up to the hype.
The definition of an investment bubble is, “a surge in asset prices that is driven by exuberant market behaviour. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset's intrinsic value.”
Are we in an inflating bubble?
What is concerning is that this definition could describe the trend we’re seeing in equity markets today. Thanks to government financial stimulus funded by central bank printing presses, there is approximately 30% more money in the world than this time last year, and investors are searching for a place to put it. This has resulted in a flight to equities which has pushed up prices far beyond their true valuations – especially in businesses that have been able to ride out, or benefit from, the pandemic. Ironically, many tech businesses!
To best understand these dynamics, let’s look closely at PayPal - a company that exemplifies some of the forces at play. Chart 2 shows PayPal’s earnings per share (EPS) versus its share price. Before the pandemic struck, its earnings and share price were closely aligned. Since March 2020, its earnings have largely stayed on this gentle upward trajectory, while the share price has skyrocketed, completely decoupling from earnings.
In addition, Chart 3 shows the price to earnings ratio, which can be used as a gauge on whether a company is over or under valued. Before the pandemic struck, the ratio was around 35 times. Now it is nearly double that, at 65 times. Unless there is an acceleration in earnings, higher prices mean lower future returns.
Should we be concerned?
On a case-by-case basis it is possible for richly priced equities to grow faster for longer to justify high valuations. But this is an unlikely outcome for a single company, and it is almost impossible for large numbers of stocks to achieve such growth.
There is no such thing as certainty when it comes to investing. Our job is to analyse uncertainty and to assess the risk to portfolios. Fortunately, not all stocks have soared in the same way, and there are still good, solid companies that are perhaps not riding the current wave of post-Covid euphoria, but can offer stable longer-term returns as the economy recovers.
While our approach of carefully selecting quality companies with solid earnings potential and a valuation that makes sense may not feel as exciting as diving headfirst into Reddit’s newest favourite stock, we would rather have our feet on solid ground than be part of a bubble that could burst at any moment.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.