12 Oct Tanking markets force investors to relearn pricing fundamentals
As published by Business Day on 9 October, 2022
In getting back to pricing shares correctly, the bad techniques used in bull markets have to be unlearnt and the basics revised.
Markets are in complete disarray. There is a war in Ukraine, contradictory fiscal and monetary policy in the UK, a coming recession in Europe, high inflation and commodity prices and a strong dollar wreaking havoc on central bank tightening plans. Investors, who for over a decade have been taught to ‘buy the dip’, have been crucified for executing on their training this year.
At the time of writing, we have come off the of one of the worst Septembers, worst Q3s and worst YTD of many investors’ careers in terms of asset value declines. No asset class or sector has been spared, with some market observers heralding the death of traditional 60/40 bond/equity portfolio construction technique favored for so long.
Behind these losses lie a more serious conditioning that has taken place, and which needs to be interrogated.
For years, investors have been trained to repeat, “it always comes back.” In saying this, it’s easy to forget that starting points matter: the decade of easy monetary conditions which led to equities outperforming since the GFC can be followed by S&P 500 returns below T-bills, and even below zero, for more than a decade (when looking at the 1970s for example).
I still recall in 2010 when markets were recovering from the GFC how the S&P500 only reached it’s 2000 level (10 years prior) in that year. This was an entire decade of zero returns from global markets. Yes, it came back. But not in a rush.
Chart: S&P 500 from October 6 2000 to October 6 2010
Or
Chart: S&P 500 from October 6 2000 to October 6 2010
What makes investing difficult is that things don’t unfold in an even, or predictable, manner. There are some great sequences of events, there are unanticipated drawdowns and there can be prolonged periods where you seem to go nowhere.
If you can’t rely on monetary policy to reflate your assets for you, then you need to rely on the asset to do the work for you.
Whether inflation will be with us for one year or 5 years, shares undoubtedly remain the asset class with the best prospects for real growth longer term. However, investors need to get back to pricing them correctly. Going forward, investors will have to unlearn the bad techniques used in bull markets, and relearn their fundamentals.
Let’s look at the PE for example. The price-earnings multiple is the principal method investors use to value shares. Yet, most investors don’t have a clear idea of what a certain multiple implies about a company’s prospective financial performance. They also don’t understand how and why multiples change over time.
The untidy use of multiples is everywhere you look. Some investors (and I’m sorry to say even this investor has been guilty of this) use multiples in an apples-to-oranges comparison between businesses with different economics. They use growth rates as the only differentiator between businesses trading at different multiples. Most alarmingly, they also claim that a company’s multiple should revert to levels that it has traded in the past without a solid economic justification to do so.
Price-earnings multiples are widespread in use yet remarkably poorly understood. Let’s use an example to dig into this.
Imagine we have 2 companies, A and B.
Let’s say both companies will earn $1 per share next year, and will also grow their earnings 10% per year going forward. Suppose A trades at a (forward) P/E Ratio of 10x. So, each share of A costs $10. And B trades at a P/E Ratio of 20x. So, each share of B costs $20.
Which company is the better investment? A right? After all, both companies earn the same ($1/share) and they are growing at the same rate (10% per year). But A is cheaper than B (10x vs 20x P/E).
Choosing A would be wrong. Because it’s not just about earnings, or how fast earnings will grow.
Rather it depends entirely on how efficiently these two companies grow. How much does 10% growth cost for A versus B?
Let’s say A is able to generate a return on investment of 8%. This means it deserves to trade at a low multiple, as this is barely above its cost of capital.
If B can generate higher returns, then it deserves to trade at a higher multiple.
Capital efficiency matters: in order to grow, A needs all the money it makes and has less surplus available to pay dividends and buy back shares while B can do both. The table below (from Credit Suisse) provides a potential framework for investors to use when assessing P/E multiples and returns on invested capital.
Beyond the sloppy use of multiples, there is also a lot of adjustments that have been allowed to creep into earnings over the past 10 years.
Most of you will be familiar with the (as far as we are concerned, settled) debate around whether share-based compensation is an expense or not. ‘Adjusted’ earnings tend to add back this line item, for example. When falling share prices increase the universe of potentially attractive opportunities, investors can afford to be fussier and look at firmer measures of earnings power.
Conclusion
As has so often happened in history, a dramatic change of economic direction is at hand. Many features of the low-interest world have gone into reverse. Investors need to brush up on their fundamentals and ensure the companies they are investing in are going to generate their returns for them. Relooking at PEs is one place to start, but there are many other areas that need reteaching.
About Pieter Hundersmarck:
Pieter is a fund manager and member of Flagship’s global investments team.
Pieter has been investing internationally for over 13 years. Prior to Flagship, he worked at Coronation Fund Managers for 10 years in the Global and Global Emerging Markets teams, and also co-managed a global equities boutique at Old Mutual Investment Group. Pieter holds a BCom (Economics) from Stellenbosch University and an MSc Finance from Nyenrode Universiteit in the Netherlands.
