In June, we moved to a zero weight in US equities across all our funds. This is obviously a very high conviction position given that the US accounts for more than one third of total global equity market capitalisation. However, it has caused our funds to slip a bit in the peer group rankings in recent months, given the substantial outperformance of US equities since the end of April.
"As value investors we refuse to participate"
I make no apologies for being high conviction – over time, this is really the only thing that can produce alpha for our customers well in excess of costs. That said, I thought it would be worth reminding readers of our reasons for holding no US stocks.
We are value investors so, to put it simply, we think US equities are considerably overvalued. At some point in the months and years ahead we expect the US equity market to be well below where it is today. This does not of course mean it will not continue to go higher in the short term but as value investors we refuse to participate in what we now see as speculative (late cycle) moves higher. Our promise to our investors is that we will remain rational, committed and patient.
So, how do we value the US equity market? Our methodology is simple, but then ‘keeping it simple’ is a philosophy that permeates much of what we do on the investment team. As asset allocation specialist, what I seek to do is estimate current trend or normalised earnings, then assess the PE ratio of the market based on these trend earnings.
The process I use to estimate current normalised earnings is to normalise a) sales (in relation to both trend and GDP, b) operating profits in relation to sales, and c) net profits (EPS) in relation to operating profits. It must be emphasised that this is not a precise, scientific exercise. There are all sorts of simplifications and assumptions that are made here. The point is that a valuation ratio based on normalised earnings that is either very expensive or very cheap is meaningful on the basis that the same would apply even if some margin for error were built in. This is particularly the case if some conservative assumptions are used along the way.
Chart 1 shows the progression of S&P 500 sales per share since 1989 (the starting point of the data series) along with the trend line. On the face of it, it appears that current sales are bang in line with trend, suggesting that no adjustment is required.
However, on the basis that there should be a link of some sort between sales per share and GDP, it must be noted that the Great Financial Crisis (GFC) saw a trend change in GDP that should be taken account of. This trend change is evident in Chart 2, and it is clear that since the GFC, GDP is marching to a new beat.
This I believe means that (since the GFC) sales are also very likely following a new trend. Charts 3 and 4 depict this new trend and suggest that current sales are 3% above it. In other words, normalised sales are 3% below current sales.
Chart 5 suggests that operating profit margins are currently well above historical average. But on the basis that some of this may be attributable to structural (permanent) factors, a conservative estimate of normalised operating profit margin would be 12.5%.
The final chart (chart 6) shows the ratio of net profit to operating profit. In many respects, this is a proxy for the inverse of corporate tax rates. The fact that it has been increasing steadily in recent decades rightly reflects falling tax rates over the period, but of course this cannot continue indefinitely (unless the US government wants to bankrupt itself).
While the historical average of the net profit to operating profit ratio is around 65%, it would not be right to suggest that this is a normalised level. But then the current 81.1% seems unsustainably high. So, a normalised ratio of 75% is assumed, which can be considered conservative.
Applying the three adjustments (sales down by 3%, OPM to 12.5%, and NP/OP to 75%) to current sales, one comes out with normalised earnings (EPS) of 116.5. Based on the S&P500 index level of 2,900 as of end August, this implies a normalised PE ratio of 25 times.
In absolute terms, this is very high, suggesting that US equities are now very expensive. One mitigating factor is that real bond yields, that represent a valuation benchmark for equities, are quite low at the moment and will probably remain so for years to come. This might mean that US equities are not quite as expensive in relation to expensive bonds (low yields). However, by the same argument, equities in the UK, Europe and Japan are even more attractive.
This analysis does not provide a guide as to when US equities will stop rising – this is more about inflation and monetary policy. But it is the basis of our valuation methodology and thus provides the required evidentiary support for our zero position in US equities.
Coincidentally, Robert Shiller, well known for his CAPE (cyclically adjusted PE) ratio, was cited in the press recently saying that his measure now stands at 33 times. This is higher than any time since the late 19th century, other than a few months leading up to the end of the tech bust that began in March 2000. This certainly represents further support for our position.
Published in Investment Letter, September 2018
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.