The Two Risks We Manage: Earnings and Multiples
August 23, 2019
As we have said before, the good news about equities is that there are only two ways to lose money – falling earnings or falling multiples. At the end of 2017, we were worried about the market’s multiple. Following the de-rating in 2018, our main anxiety shifted to earnings. In one sense, this anxiety has proved relatively well placed, with 2019 estimates for the MSCI World Index down 7% since the start of the year. But in a more important sense, we were wrong to worry, as markets have ignored the subsiding earnings and revived strongly. The MSCI World Index’s multiple of 2019 earnings has surged from 13.4x to 16.5x, boosted by the monetary generosity of the U.S. Federal Reserve and Mr. Draghi at the European Central Bank. The multiple is probably helped by the perennial assumption of future earnings growth, with 2020 earnings expected to be 10% higher than 2019, arguably not a safe assumption.
Our global portfolios have performed strongly in this environment, up over 20% in 2019 so far and outperforming the index. Part of this has come from the resilient earnings holding up better than the market, but there has also been a re-rating. Our global portfolios are now trading on 20-21x the next 12 months’ earnings and, on this measure, are at a 28%-36% premium to the MSCI World Index, versus a 19%-35% average premium since the Global Financial Crisis (GFC) or, for those launched more recently, their inception dates.
Our priority is naturally absolute valuations but, looking at the relative position, it is our view that the portfolios should trade at a significant premium to the general market. The companies’ combination of recurring revenue and pricing power should protect revenues and margins and thus earnings in any downturn – indeed our flagship global portfolio’s earnings went up during the GFC. In addition, our portfolios’ earnings are less prone to the curse of ‘adjusted’ earnings or ‘earnings before the bad stuff’ than the market as a whole, be it ignoring paying employees in shares, restructuring charges or write-offs. In the U.S. alone, $600 billion, or 21%, has disappeared between the ‘adjusted’ number and the actual profit and loss statements over the last three years. The final point is that the high returns on capital of the companies in the portfolio drive a distinctly stronger free cash flow conversion than the market, meaning that any premium is significantly lower in free cash flow terms.
We would also argue that it is reasonable that the portfolios’ premiums are higher than usual at the moment, as they are less affected than the general market by some of the current market worries, be they the current drift down in earnings estimates, the impact of falling interest rates on financials, the possible effects of a worsening trade war or even an end to this very elongated economic cycle. If any of these scenarios bite, the market’s expectations for near double-digit earnings growth in 2020 could prove distinctly optimistic, while history suggests our portfolios’ earnings may well be rather more robust.
Interestingly, the relative re-rating does not seem to have happened across the board, but rather has been concentrated in the ‘growthier’ part of the portfolios. We are not growth investors, so by ‘growthier’ we mean companies with medium-term top-line growth outlooks in the mid-to-high single digits, as opposed to the 3%-5% top-line growth in some of the ‘steadier’ plays in the portfolios or the double-digit growth sought after by growth investors. Consumer staples, between 20%-40% of our global portfolios, can be seen as a rough proxy for the ‘steadier’ side of the portfolio. The sector as a whole is currently trading at a 21% premium to the MSCI World Index on the next 12 months’ earnings, very much in line with the post-GFC average of 22%. The consumer staples stocks in our portfolio are actually trading at a slight discount to the sector as a whole.
Source: Morgan Stanley Investment Management and FactSet.
The software & services sub-sector within information technology, which is around 30%-32% of our global portfolios, can be seen as a proxy for the ‘growthier’ side of the portfolio. This has re-rated to a 58% premium to the MSCI World Index, the level last seen before the GFC. While our portfolio holdings are at a slight discount to the sub-sector as a whole, they have re-rated as well. Looking at our holdings, we would argue that the re-rating is understandable, and that the current multiples are defensible. With the growth of the cloud, the whole software industry has gone through a major transition. This shift suppressed multiples for a while due to perfectly reasonable doubts about companies’ ability to manage the transition, aggravated by the pressure on margins as they built their new offerings. As they have started to emerge from the other side, it has become clearer that they are well-placed in the new environment, while margins have started to recover as the cloud propositions approach scale, most notably at an American multinational technology company we own. In addition, there is the extra plus that the growth of cloud-based SaaS (Software as a Service) revenues at the expense of traditional lumpy software sales means that the companies are more skewed to recurring revenue, which should make them more robust in a downturn. The revenues of a German multinational software company we own went from 43% to 65% recurring between 2008 and 2018, with the percentage still rising as the strong cloud growth continues.
Source: Morgan Stanley Investment Management and FactSet.
While we are generally comfortable with the absolute valuations of the ‘growthier’ names that we own, both in software & services and beyond, we have reacted to the re-rating move. Since the start of 2018, we have made net additions to consumer staples and health care and reductions to the ‘growthier’ software & services and consumer discretionary sectors across our global portfolios. Looking across the sectors, there have been around net sales of the ‘growthier’ stocks, those with estimated medium-term sales growth above 6%, with the cash being shifted to the ‘steadier’ side of the portfolios.
As we mentioned at the start of the piece, there are two ways to lose money in equities, falling earnings and falling multiples. For the market as a whole we worry about both, given that both are high, earnings look vulnerable and the current combination of falling earnings with rising multiples is unlikely to be sustainable. Multiples also look fairly full for the portfolios, in absolute terms at least, and we clearly cannot preclude the possibility of a multiple-driven drawdown. However, we do remain confident in the resilience of our holdings’ earnings and their ability to compound. Over the medium term, such compounding should mitigate any erosion of multiples.
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