Global Equity Views 4Q 2021
Themes and implications from the Global Equity Investors Quarterly
- Profits have soared around the world, breaking previous records. Although we see significant slowdown in revenue growth and some pressure on margins from rising costs, the outlook for profit growth remains pretty robust and broad for next year as well.
- Speculative activity has cooled a little in recent weeks, with many “never profitable” companies losing ground. High valuations for the most popular stocks remain a challenge, but many markets, industries and themes are much less expensive. Emerging markets, international equities, financials and many industrial companies all offer sensible value.
- Some themes from our quarterly discussion: The outlook for Chinese markets is tougher, but prices reflect that; financial companies in aggregate look attractive, but the challenge of fintech needs to be carefully assessed; the newfound capital discipline of many mining and energy companies is aggravating supply issues.
As equity investors, we are strong believers that focusing on corporate profits is the best way to understand stock prices.
And what an incredible year this is for profits. Our research team sees a 45% increase worldwide, taking profits way above previous peaks. Before the pandemic, the companies we research worldwide earned USD 2.3 trillion in a pretty strong year. In 2020, profits slumped to USD 2.0 trillion (for a while, it looked much worse than that), and we wondered how long it would take to get back to previous levels. Well, this year we will see USD 2.9 trillion—more than 25% higher than that pre-pandemic level. And the numbers have kept rising, too; our own forecasts are up an additional 6% worldwide in the last three months.
However, this may be as good as it gets. So far, most companies have done great work to mitigate the impact of the various pressures that have come along with this exceptional and unexpected surge in demand: jammed supply chains, worker shortages and soaring raw material costs. But this is getting more difficult as the problems multiply; profit margins are already at very high and in some cases unsustainable levels. Meanwhile, the surge in demand will likely moderate as we move past the peak of both government stimulus and the boost from reopening post-pandemic. Still, we see robust and broad-based profit growth next year as well, with strong participation from the indus- trial, commodity and financial sectors, as well as the usual suspects in technology and health care.
At first glance, it seems that all the good news is priced in markets, with the widely followed S&P 500 index trading at 22x forward earnings, a level of valuation rarely exceeded for long in history. But looking a little deeper, there are plenty of reasonably priced opportunities to buy stocks around the world. By region, multiples in Europe and Japan look closer to historical norms, and the woes of the Chinese market (see below) have left emerging markets appearing more attractive as well. Looking at valuations by theme, the real standout conclusion is that the price for investing in the fastest-growing companies is very high these days, and that hasn’t changed this year. In contrast, value stocks are, as a group, priced in line with past averages, and many high quality companies trade at a discount. The very high prices accorded to the most successful technology companies are not the whole picture.
Within the markets, we’ve seen more familiar patterns reassert themselves after a turbulent and unpredictable 12 months. Our measures of value, quality and momentum all worked in the latest quarter. Meanwhile, the speculative aspects of markets that looked troubling earlier in the year have faded; in the U.S., special purpose acquisition companies (SPACs) and meme stocks have lost ground, for example. The worst-ranked stocks in our equity failure model, which is designed to warn our team of potentially really bad investments, have underperformed by over 10% this year. And the group of “never profitable” companies that we follow has underperformed by 20% year-to-date, after racking up exceptional gains in 2020. We hear a great deal of debate about growth and value, but the real issue is risk: Markets have been exceptionally willing to embrace the riskiest names in many industries during the post-pandemic surge, and this is starting to change. Investing in high quality companies is as important as ever for our investors.
China: Near-term challenges, but much is in the price now
We wrote about this topic in our previous quarterly, but plenty has happened since. Like most, we believe that the financial distress of residential developer Evergrande has been well telegraphed (for years, actually) and will be manageable and containable. But the residential construction boom looks set to fade, and this will be a meaningful drag on growth in the Chinese economy for a while. This cooling is going to be exacerbated by the cost pressures for industrial companies and consumers of much higher energy prices, an issue by no means unique to China but having a clear impact as government pollution control measures take hold. So we expect less growth, and we have been revising down our profit expectations, too, in contrast to the prevailing trends in the rest of the world. But much of this is reflected in the markets; prices are down 30%, and our measure of equity market sentiment suggests that gloom, if not yet doom, is now the prevailing mood (EXHIBIT 1). After we have adjusted for both announced and anticipated regulatory actions, valua- tions on current earnings look reasonable but not yet cheap. Our research team still sees plenty of strong growth opportunities in technology, health care and other growth industries, while our measure of expected return for Chinese stocks has risen from the low to the high end of the past range in the last few months. So there are plenty of near-term challenges, but opportunities are building for patient long-term investors.
There’s gloom but not doom in Chinese equity markets
Exhibit 1: China expected returns are near a historical peak
Financials: Still attractive, but watch out for the fintech revolution
Many of our investors see the financial sector as offering some of the best opportunities from here, even after some strong returns over the past year. Valuations overall are still sensible, but with the deep discounts largely gone, the profit outlook becomes even more important. Higher forecasts for this group have actually been the biggest contributor to our increasingly optimistic view of this year’s profits, as the feared loan losses didn’t materialize and loss provisions have been quickly scaled back. But stubbornly low interest rates and sluggish demand for new loans still weigh on the traditional banking business. And many new fintech companies are now achieving a level of success that is starting to threaten the vast profit pools of the incumbents. Assessing these risks will be critical for stock selection. Fintechs make up a rapidly growing share of the opportunity set, with a combined market cap of over USD 300 billion listed in just the last 18 months. Valuations are very demanding, of course; we are focused on investing in those with the very best platforms and technology, recognizing that patience and a long time horizon are key. Among the incumbents, Europe offers interesting opportunities. European banks have, as a group, been one of the worst investments possible for a global equity investor over the past 15 years (alongside energy) and, indeed, one of the few ways to actually lose money. But our team sees real signs of improvement, with surprisingly positive profit news in the last four earnings seasons. Asset quality remains intact, provisioning is benign, and there is now plenty of excess capital (likely to be returned to shareholders). Market expectations are still very depressed, with only 1% earnings growth forecast for 2022. So better returns are in sight after a miserable decade.
Capital discipline in the mining and energy sectors is strengthening
With alarming news of energy shortages in Europe and Asia, U.S. consumers facing significantly higher heating bills this winter and talk of environmental, social and governance (ESG) driving demand for a whole range of industrial commodities, we took a look at the companies in the energy and metals sector. Even more than European banks, energy companies have in general been best avoided over the past 10 to 15 years. This has much more to do with poor capital discipline and wayward investments than with any trend in oil and gas prices themselves. But there are signs of change. Capital return is now the mantra—at least in the U.S.—along with deleveraging some very stretched balance sheets. Meanwhile, the leading metals companies are further into this process, with capital spending slashed by more than 60% for the big six over the past decade and cash flows now strong enough to already repay huge swaths of debt and reward long-suffering shareholders (EXHIBIT 2). Now many energy companies are following suit, although their debt levels remain elevated. What this all means for the supply of traditional carbon energy and newly in-demand metals such as lithium and nickel is clear, especially when the constraints of ESG-minded investors suggest that new capital for these sectors will remain limited.
The leading mining companies are ahead of energy companies in slashing capital spending and repaying debt
Views from our Global Equity Investors Quarterly, October 2021
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