Multiples Are Down, Risks Are Not
January 15, 2019
The good news about equities is that there are only two ways to lose money – falling earnings or falling multiples. A year ago, it was the multiples that worried us most. After the markets’ bull run in 2017, the MSCI World Index passed 17x the next 12 months (NTM) earnings,1 implying that markets were pricing in the improbable upside scenario of synchronized growth everywhere… and threatening considerable downside if things did not go quite according to plan. By contrast, 2019 starts with the MSCI World Index on 13.4x forward consensus estimates, 14% lower than the 20-year average price-earnings (P/E) ratio of 15.5x, and 20% below a year ago.2 As a result, our primary fears have moved from multiples to earnings.
“Our primary fears have moved from multiples to earnings”
Our generic fear about forward earnings estimates remain – the fact that they are guesses about lies. The guesses are because the sell-side is persistently over-optimistic, by an average of 8% one-year forward, slightly higher than the 7% earnings growth expected for the MSCI World Index in 2019.3 The lies are down to the gaping gap between the ‘adjusted’ earnings used to power consensus numbers (and management pay) and the actual IFRS/GAAP4 number at the bottom of the profit and loss statement. Over the last three years, $600 billion has disappeared between the adjusted and actual earnings totals in the U.S. alone, overstating earnings there by an average of 21%.5 Our more specific anxiety is fed by the fact that it is only on the leveraged earnings metric that markets look cheap. Looking at forward enterprise value (EV)/EBITDA6 rather than P/E, the discount to the historic average disappears, and the market is on a slightly higher multiple (9.2x versus 9.0x) than it was in 2003, when the P/E ratio was at a lofty 17.6x.7 Lower corporate taxes have helped, but so has the sharp increase in leverage, of which we discuss further later in the piece. Looking at EV/sales, the MSCI World Index is 1.8x, still 16% above its 20-year average.8 The combination of an expensive market on sales with a ‘cheap’ market on earnings reflects the really high profitability at present, particularly in the U.S., where all the drivers look fairly maxed out in favour of profits at present, be it fat margins, low tax rates, high leverage or low interest rates.
We have no greater insight than anyone else on whether the expected earnings growth for 2019 will be delivered, or even exceeded, but we do have opinions (as usual) on the key variables to watch. The current China slowdown is an earnings risk, particularly for cyclical companies, and the extent (and success) of the gathering reflation is crucial. Even if the reflation does happen, and is successful, earnings could be soft in the first part of the year until it takes effect. As mentioned above, U.S. margins are very high, and while elements of this look structural, given the emergence of lucrative platform businesses and the way the country’s political system has systematically advantaged capital against labour and consumers over the last four decades, tight labour markets and tariff impacts may cause margin issues for those without pricing power.
Leaving aside the tail-risks, such as a full trade war, utter paralysis of the U.S. government, Mid-East conflict or a collapse of the euro, one thing that would definitely cause a margin squeeze would be a significant slowdown in the U.S., or a further slowdown in Europe. The U.S. recovery is now very long in the tooth, and while recoveries do not just die of old age, the change at the U.S. Federal Reserve (the Fed) may be an extra cause for concern. It is still early days, but Jay Powell seems more interested in the state of the real economy than the exact level of the equity markets or the fate of anyone outside the U.S. who chooses to hitch their currencies to the U.S. dollar – i.e., emerging markets. He may, therefore, continue to tighten via a combination of interest rates and unwinding quantitative easing until he sees weakness in the U.S. economy. He will back off at that point, but this may be too late for markets.
2018 has ended with the combined balance sheets of the four major central banks – the Fed, the People’s Bank of China, the European Central Bank and the Bank of Japan – finally shrinking after the massive build post the Global Financial Crisis (GFC). This means that the world is now in a liquidity squeeze, combining (depending on the geographic bloc) shrinking central bank balance sheets and tightening interest rates. It is precisely the opposite combination that drove up asset prices (and consequent levering up) since the nadir of 2009.
Our concern is that the combination of potentially falling earnings and a liquidity squeeze could be a truly toxic one for asset prices. We mentioned that we were unclear whether earnings estimates would be met this year, but we are clear that the world is an asymmetric place, with earnings downsides in bad times far higher than the upsides in good times. This is often forgotten, as is the fact that the asymmetry is magnified by leverage – and there is more leverage than ever, particularly in the U.S. corporate debt market. Corporate America as a whole is not inexpert at levering itself up at the wrong time, most spectacularly, just before the GFC last time round. Given the scale of corporate leverage now and – more particularly – the component of high yield or near-high yield (or as we prefer to call it, given that the interest rates are not that high, junk or near-junk), Corporate America has to be right that earnings will hold up.
We worry in particular about the outlook for near-junk, i.e. BBB. This has been at the epicentre of the buildup of corporate debt, ballooning from $0.7 trillion in October 2008 to the current c. $3 trillion.9 Moreover, the component of near junk (BBB) and actual junk (BB, B, and CCC and below) has increased from 46% of the U.S. corporate bond market in October 2008 to 58% currently,10 so the quality of the overall corporate bond market has clearly deteriorated. If U.S. earnings do fall significantly, then there could be significant downgrades from BBB to junk. We do not think the currently quiescent so-called high-yield market is pricing in such an outcome. In that event, the equity market is sure to hear about it – big problems in the credit market invariably mean big problems in the equity market, especially as they would have a common cause: falling earnings and too much debt.
“A combination of recurring revenue and pricing power should protect revenues and margins in a downturn, preserving earnings”
In this uncertain and acutely asymmetric world, we would continue to advocate owning compounders. The combination of recurring revenue and pricing power should protect revenues and margins, respectively, in a downturn, preserving earnings. They are also likely to be insulated from any financial distress if the corporate bond markets have a seizure, given the lower operational and financial leverage. The soft markets of the fourth quarter have deflated the portfolio’s multiples a little, with the estimated 2019 free cash flow yield now over 5%, reducing the absolute downside risk.11