Global equities: Investing wisely amidst market peaks

This article first appeared in Glacier’s Funds on Friday.

To understand where global equities are headed, it is worth considering how we got here.

The MSCI World Index returned 9.7% annualised over the 10-year period ending May 2024, which is a good result in historical context. Returns earned by investors are a combination of a company’s business economics and what people are willing to pay for those economics. The change in these variables over time determines investors’ returns.

Specifically, total return is calculated as follows: earnings per share (EPS) growth x change in price-earnings (PE) multiple + dividend yield.

Over the short term, PE multiple expansion/contraction is usually the main source of return, but earnings matter the most over the long term.

Considering the three elements of total return separately may help investors form an idea of what returns might look like over the next decade.

1. EPS: To sustainably achieve returns, earnings need to grow.

We break down EPS into (1) sales growth, (2) change in share count, and (3) margin expansion, to provide a more granular view. Over the past decade sales growth contributed 2.1%, share count decreased, adding 0.13%, and margin expansion contributed 2.3%. Overall, EPS contributed approximately 4.6% out of the 9.7% 10-year total return achieved by the MSCI World Index.

Sales growth

Sales growth over the last 10 years was below the 20-year compound annual growth rate (CAGR) of 3.7%. This was roughly inline with GDP growth in developed markets, but at a company level sales growth has varied substantially, with the mega-caps leading the pack. It’s reasonable to assume that average sales growth for listed equities will remain in lockstep with GDP growth going forward. Making economic forecasts is not something we do, but innovation gains should be weighed against ballooning debt levels when attempting to estimate what GDP growth over the next decade might be.  Approximately 2.5-3% sales growth for the MSCI World Index seems prudent, but the range of outcomes are wide.

Change in share count

Over the last decade, share count decreased as many companies bought back considerable amounts of shares, often facilitated by cheap debt. The return attribution from lower share count was small since the impact was offset by new shares issued, including those for share based compensation, masking the total impact at index level. Going forward, the trend of buybacks and dividends should be dictated by companies’ cash flow generation abilities and balance sheet strength. Larger companies are likely to continue returning capital to shareholders, while many smaller companies may struggle.

Margin expansion

Corporate margins have ticked up over the past 20 years and are currently well above the longer-term average of around 8%. Capitalism will teach you that excess profits will be competed away eventually and, therefore, margins should revert to long-term averages. However, margins have been elevated for a while. This is mostly attributed to the stellar margins of the big tech companies like Alphabet, Meta, Apple and Microsoft. These companies have low capital intensity and large network effects that have resulted in margins north of 20% for the last five years. And, as has been widely documented, they are increasingly sizeable in the index. See figure 1 for a longer term perspective.

Jeff Bezos famously lived by the ’always day one’ mentality at Amazon, fearful of slowly becoming irrelevant as many of the formidable companies that came before them did. Whether or not the tech titans of today can keep their competitive advantages and lucrative margins are multi-trillion-dollar questions. However, it has become increasingly clear over the last year that the mega-caps are not capital light businesses anymore. They are investing billions to compete in cloud, data centers and AI and the returns are mostly not clear yet. Until (and if) those returns kick in, returns are more likely to be lower. Furthermore, if competition does not succeed, regulators might want a bigger slice of their pie. The period of normalisation is likely to take many years and we have no doubt that they will continue to grow ahead of GDP for a while longer, but the risk is that current profitability may not be sustained.

It is not just the mix of the index that has contributed to higher margins. Lower corporate taxes, globalisation (which is deflationary), and record-low interest rates that have lowered interest expenses have boosted profitability. Leverage in particular is something investors have to pay close attention to. Many of the big companies are sitting on piles of cash, while much of the rest of the market is indebted. All else equal, it is unlikely that future movements of these variables will be a tailwind for margins.

Figure 1: Corporate margins over the last 20 years

*  Mega-cap 8 includes Apple, Microsoft, Alphabet, Meta, Tesla, Nvidia, Netflix and Amazon. Source: FactSet, 31 May 2024

2. Multiple expansion: The current PE multiple is well above its long-term average.

The rerating in the PE ratio added 2.1% to the total return over the last decade. PE multiples indicate the price investors are willing to pay for each dollar of a company’s earnings (they are willing to pay more if return expectations are higher, as is reflected by the current elevated PE ratio). However, when stocks are priced for good things, it shouldn’t be surprising when bad news cause a big reaction.

Figure 2: PE multiples over the last 20 years

Source: FactSet, 31 May 2024

Multiples should not be considered in isolation; the strong growth and high margins of the mega-cap stocks justify PE premiums, especially considering the lackluster performance, higher debt levels and more economic dependency of some of the other stocks. Readers might find it surprising to know that 10 years ago Microsoft and Apple traded below 15x PE, a discount to the market at the time. Today they trade at 32x and 28x respectively. The rerating, combined with the unrelenting growth in earnings of a handful of stocks have led to the index becoming significantly more concentrated over the decade.

Future innovation gains, including AI, are expected to be supportive of future returns, which will impact the justifiable multiples. However, we warn that trees do not grow to the sky and AI may take longer to monetise than what some investors may expect.

Historically, a lower PE meant a higher subsequent long-term compound return, although near-term returns are known to be all over the place. This is a nice reminder that the short term is nothing but a voting machine. Investors generally do well over the long term when they invest in a good company at a reasonable price – this is what history tells us. Fortunately, there are many great companies that have been overlooked, trading at low multiples and that can expand margins over the next decade, making for fertile hunting ground for active investors. We include some examples in this article.

3. Dividend yields: Dividend yields have decreased as the last decade progressed.

Over the last 10 years, dividend yields have contributed 2.5% to returns. Going forward they may continue to  contribute around the same level, between 1.5% and 2.5%.

4. In summary, total returns over the next decade are unlikely to be as lucrative as over the past decade.

For illustrative purposes, to generate a ~10% return over the next decade, assuming margins and PE multiples remain stable, and a 2% dividend yield, will require sales per share growth of over 7%. This is a huge ask.  The outcomes of the variables that will drive return might turn out very differently. The future will definitely teach us new lessons but, more likely than not, extrapolating from the past might leave index investors disappointed. Returns are likely to be just ’normal’. Figure 3 below shows that returns over the last few years have been higher than they’ve been historically.

Figure 3: Rolling annualised returns over the last 20 years

Source: FactSet, 31 May 2024

There are pockets where we see good opportunities in global equities.

Although the overall valuation of the market is useful to consider, it is just one data point. The good news is that dispersions in valuation and earnings prospects are wide, meaning there are alternative options available for active investors. It is no secret, as also explained above, that most of the returns have been derived from only a few top-performing companies. Below we outline where we see some other opportunities. This makes a clear case for active management, where capital can be deployed to attractive alternatives.

1. We see opportunities outside the mega-cap stocks.

As earnings growth recovers in the rest of the market, we could see the breadth of the market increase. Excluding the top 10 market cap companies, the PE ratio of the remaining stocks is much closer to the long-term average, as per figure 4 below.

A recent Wall Street Journal article divided stocks into tenths by size and found that valuations rise steadily as company sizes rise. We, in particular, see good opportunities in the small and mid-cap space. Examples of what we believe to be attractive investment opportunities with a market cap below $15bn are: Atmus, a filtration company that was spun-out of Cummins; Essent, a mortgage insurer that has gained significant share; and Masco, a paint and plumbing manufacturer.

2. Outside the US, stocks are more attractively priced.

Barring the US, most countries appear attractively priced, trading at, or just below, their 25-year average PE ratios. Following the decade-long bull run in the US, the weight of US companies in the MSCI World Index has increased to 71%. However, there are many great companies outside of the US, trading at relatively more attractive valuations, as shown in figure 5 – making a good case for increased diversification to other parts of the global developed equity market.

Japan, for example, has recently attracted attention post corporate governance and equity market reform. The UK market, the FTSE 250, is trading at a 20-year low PE ratio relative to the MSCI All Country World Index.  Sentiment towards Chinese companies is very low, despite good fundamentals.

A few examples of interesting companies outside of the US include: ASML, a semiconductor equipment manufacturer with a monopoly share in extreme ultraviolet machines; Howden Joinery, the UK’s leading kitchen supplier that sells exclusively to trade customers; and Melrose industries, a transformed company that focuses on aerospace technology. Some global staples companies listed in the EU, like Heineken, have also derated and now look relatively more attractive to their US peers.

Figure 4: PE ratio of the top 10 and remaining stocks on the S&P 500

Source. J.P. Morgan (FactSet, MSCI, Standard & Poor’s)

Figure 5: PE ratio at country level

Source: J.P. Morgan (FactSet, MSCI, Standard & Poor’s)

3. Many sectors are trading at average long-term price metrics and can improve margins over time, specifically outside the technology sector.

We think that stocks in the life sciences and industrial sectors could be interesting and should benefit from a potential cyclical recovery. We are also finding exciting opportunities in more defensive sectors like healthcare and staples.

4. Disruption also creates opportunities for fundamental researchers and active managers to capitalise on unwarranted fears, overreactions, and new innovations.

For example, excitement around the advancement in obesity medication, specifically GLP-1 drugs, has put pressure on many companies that stand to potentially be disrupted if large scale adoption materialises. Companies in the food and beverage industry have sold off with fear that these medications will reduce calorie intake, specifically impacting high calorie product producers. Because these drugs effectively reduce obesity-related illnesses, many companies in the healthcare space also suffered a similar experience.

Embecta is one example, out of many, of a good company that has sold off. The company operates in the diabetes space and manufactures syringes and other products to effectively deliver insulin to patients. We think the shadow of doubt over diabetes technology, because of the disruptive impact of GLP-1 drugs, is overstated and has created an attractive entry point.

It is important to understand the difference between knowing the price of the market (which is trading at, or near, all-time highs) and understanding valuations.

New market peaks need not be accompanied by fear. It is valuation and future earnings prospects that matter, not price. Over the last 50 years, the MSCI World Index has traded at all-time highs 33% of the time (using month end data), and 58% of the time the month-end close price levels were at a new all-time high or within 5% of the last all-time high. New market highs alone have historically not been a signal of weaker returns to come, because high returns are often clustered together. In figure 6, we show that the returns earned from investing on any given day versus an all-time high are not that different over the longer term. More importantly, even investing at market peaks has beaten investing in cash.

Figure 6: MSCI World Index average annualised returns after investing at certain points over the last 50 years

Source: FactSet, 30 May 2024

Only monkeys pick bottoms, don’t be a monkey!

Trying to time the market can also be extremely costly. As shown in figure 7, Ned Davis Research has calculated that missing just a few days in the market can completely erase gains. Figure 8 shows, the risk of losing money in equities reduces as time horizons extend.

Investors trying to maximize returns by frequently moving in and out of equity investments should remember that to be successful at market timing, they must be correct twice: first when they decide to sell, at or close to the peak; and secondly, when they decide to re-enter the market, just before or at the bottom. Many researchers have found this to be a nearly impossible task to consistently master. As shown in figure 8, even if investors avoided the worst of a downturn, if they also missed the top 20 days, returns could have been a monumental 73% lower. The conclusion is that the length of time you remain invested is more important to long-term returns than getting the timing right.

Figure 7: S&P 500 average annual total returns from 1994 to 2023

Source: Ned Davis Research, Morningstar, and Hartford Funds

Figure 8: Probability of negative returns, based on S&P 500 total returns: 1929-June 2024

Source: BofA Global Research

Over the next decade, it will be tough to mirror the exceptional performance we’ve seen in global developed markets over the last few years, at an index level. 

Today’s fears about how much higher equity markets can go are not without foundation, if you compare the current MSCI World Index’s PE multiple to the longer-term average. However, the good news is that if you exclude the mega-cap stocks, you will see a different picture. There are smart options available for fundamental stock pickers, willing to take the road less travelled. Selectivity is the key. The ride will not be without bumps and it is not worth trying to predict the direction of the market over the short term. However, it is essential to be prepared for different scenarios.