This blog will take you through a general understanding of what market and industry fundamentals are looking like right now in our Covid-19 impacted economy.
Image from Seeking Alpha
Wait, what are ‘fundamentals’?
Fundamentals are the primary characteristics and financial data that help us to understand the health of an asset or an economy. In ‘fundamentals’ there are both macroeconomic and microeconomic perspectives. Macroeconomic factors are larger scale and tell us about the overall economy, not just a specific asset. An important macroeconomic consideration for us to look at right now is ‘supply and demand’, because coronavirus pushed our global economy into ‘supply and demand shock’. Coronavirus supply and demand shock could cause manufacturing companies, (high-street) retail and food service businesses to have liquidity issues. Once we analyse these industries specifically, however, we enter into microeconomic analysis. Microeconomic fundamentals look at activities within these smaller segments of the economy. Such as, indeed, how supply and demand shock might impact the food service industry specifically. Thanks to Christina Majaski and Gordon Scott for this explanation on Investopedia (linked at end).
So, let’s take a look at what fundamentals can tell us about US markets at the moment.
For this piece, we were influenced by a recent Bloomberg What Goes Up podcast interviewing Katie Koch, co-head of fundamental equity at Goldman Sachs AM. We have for quite a while in the Covid-19-hit global markets seen a gap between growth and value. Growth and value investing, as mentioned in our other blog (linked below), is essentially as follows: value investing looks for under-priced or glamorous stocks to pick up at a discount, whereas growth investing looks for companies that will outperform their peers (through, e.g. being a disruptor). For more on this, check out Madison Darbyshire’s Financial Times article ‘Value and Growth investments gap at 25 year high’ from way back in June (linked at end). It is not new information that coronavirus saw the US market take a huge drawdown, but we have recently seen – in the U.S. certainly – a pretty tremendous recovery. Yes, the U.S. market is flat on the year, and this economic slowdown means that growth investing is becoming less and less fruitful. Koch reminds us, though, that there is stuff happening and that active managers can find great value... if they hunt for it.
Firstly, we need to know what the investment environment is like. Not only is there this growth / value gap, but suggestions that the market is expensive.
What does it mean for the market to be ‘expensive’?
Let’s take some guidance from Ken Little – writing for TheBalance.com – who explains this concept well (full article linked below). Essentially, each stock has its price-to-earnings ratio, or P/E. The P/E tells us how much investors are willing to pay (a.k.a. the stock price) for the earnings a company produces. To work out the P/E, we find the earnings per share (EPS), and divide the current price per share by this EPS. So, if a share has a $2 EPS and a share price of $20, then it has a P/E of 10. Importantly, this tells us that investors are willing to pay 10x earnings per share for the stock. This information is most useful when compared with other companies in the industry. For example, if other companies have a P/E of 10 but the company you are looking to invest in has a P/E of 5, then it is a cheaper stock. Vice versa if analysing a more expensive stock. So, is the whole market more expensive right now? Well, it isn't that simple. Let’s not forget that lower interest rates – like those we are seeing with Covid-19 – push investors away from bonds and towards stocks, and this higher demand drives up the P/E ratio. If you’d like to take a look at the S&P 500 PE ratio – an index seen as representative of the whole stock market – you can track it here: https://www.multpl.com/s-p-500-pe-ratio. A reminder that we are in the middle of earnings season, so data is coming in. Also note that, from a fiscal perspective, Koch emphasises that the market continues to need monetary and fiscal support to hold at the current levels. So, if stimulus stops then a whole new analysis will be required.
Koch tells us that we need to look at valuations in other low inflation periods; she found that in low inflation regimes, today’s valuations are actually just above median. Remember, we are in a recession and seeing depressed earnings because of this, which is also driving up the P/E ratio. So, it’s more complicated than ‘the marker is expensive, look at the P/E ratio’. We need to understand the factors driving this ratio, like depressed earnings and low inflation, before we say that the market is expensive. Of course, as is always the case in market analysis, we cannot just look at one factor. Koch talks about the implied equities risk premium sitting at 3.8% in contrast with the negative risk premium in tech (bubble) stocks. In the interest of keeping readers engaged, I won’t go into this in detail. Very essentially, the equities risk premium is the return that compensates investors for taking on the higher risk of equity investing. It is the difference between the estimated real return on stocks and the estimated real return on safe bonds – so, as Investopedia says, take the expected return on stocks, the expected return on risk-free bonds, and the subtracted difference is the equity risk premium (Investopedia linked at the end). The fact that it’s negative in the tech bubble tells us that investors are not being rewarded for taking on the risk of investing in tech stocks (because they are in such demand due to immensely positive / stabilising earnings reports so far, most likely).
So, what does this mean in the context of finding value in the market right now? Well, of course, investing in tech is attractive. However, Koch explains that if you are selective then you can look for returns to equity across most industries. The market isn't that unhealthy and it is not that expensive either. She tells us that the coronavirus environment has created a lot of differentiation between business models, and to find value it helps to embrace active management. So, which business models are going to win and which are going to lose?
Koch explains in the context of the coronavirus-impacted retail and restaurant industry. She compares two companies in this industry – Domino's (NYSE: DPZ) and Darden Restaurants (NYSE: DRI). She explains that Domino's is very much an online and technology-based business that sells a food product (75% of sales are digital), whereas Darden Restaurants is a food product business with a dine-in experience base. These are two very different models, both in food & dining, with Domino's reporting a strong coronavirus coping strategy and Darden reporting sales down 47% (and stocks reacting negatively). Koch says it is important to distinguish, and to look to products in demand in quarantine with e-commerce strategising, as e-commerce has been said to have made a 10-year jump in a matter of months. Product categories to look out for are: computing (working from home); appliances (eating from home) and tablets (entertaining from home). There is bifurcation between winning and losing business models – active managers should get behind the right business models and the right valuations in order to find opportunities.
The U.S. market stays afloat
As background, What Goes Up reminds us that the NASDAQ 100 has had its largest share of positive trading days ever. Movement is happening in capital markets, and that movement is positive, too. There is a-typical behaviour for a recession ongoing at the moment. What Goes Up looks at the U.S. housing market: in a typical economic downturn people hold off on buying homes. In this recession, and in the low mortgage rate environment (and exodus from big cities), homebuilders have been doing well in the U.S.. Homebuilding applications are up 15%, in fact, and the median price listing of homes is up 7%. Not only this, but there is spill-over here with home renovation-type companies doing well, too, because people are decorating the homes that they are spending more time in. There is activity in this recession, and there is money out there. Those hit the hardest by coronavirus economic downturn have been pretty industry-specific. This is not good news for tourism or service-based economies, of course. We will take a look at this (and the U.K.) in another blog post.
Ok, let’s take a closer look at tech.
So, a little bit of analysis from me here. It looks like the 1990s tech bubble collapse can be partly attributable to pretty blind investment in the industry (the aptly named ‘dotcom’ boom, where a company just needed ‘dot com’ in the name to warrant rocketing share value). So, listening to Koch and the attitudes across investing in all industries at the moment, we are seeing a much more individual (i.e. individual company analysis) approach to buying up stocks. We are seeing far more scrutiny than we saw in the 1990s in a booming industry, which suggests that the bubble is far more robust this time around. Koch explains the positives: FAANG have the cleanest balance sheets ($260bn net cash), lower leverage, better liquidity and good visibility. Near term growth is 15%, versus 8% for the median S&P 500 company. FAANG stocks are driven not just by long term growth expectations, but by strong realised profitability and markers of quality also. This does not suggest anything like the crash we saw in the 1990s, even if there is a tech bubble.
And there is some spill over, because a technological edge or strategy is also bearing fruit in industries that should be suffering in coronavirus environment. Take what we are seeing with companies like Domino's, who are able to succeed with 75% online sales where others, who at first appear to be a similar business type, are struggling. Koch reminds us, though, that tech has always been generally quite cyclical, and not to invest in the industry without any diversification. Investors would be wise to diversify beyond the top tech companies dominating the market right now – currently, a pretty staggering 22% of tech investment is in the top 1% of the names. If we look at turnover historically in the tech eco-system, Koch highlights that, in the last 23 years, the largest tech company by market cap has changed 8 times. If we look back a decade ago, it was Intel, IBM, Oracle and after 10 years of FAANG dominance, the next 10 years really could look different.
How can this diversification be achieved? Well, in the U.S. and UK, recent news has seen some pretty worrying uncertainty over govt regulatory action, which makes M&A made more difficult. Koch recommends trying to find future leaders, and this probably requires looking to emerging markets that haven’t been saturated yet. In EMs, there is still room for growth in internet, mobile phones and 'splinternet' and as another bonus, local companies can apply and benefit from the successful business models of dominating U.S companies. Koch provides some recommendations of companies that Goldman AM has looked at, but if you’d like to see those then you’ll have to subscribe to Bloomberg and check out the podcast yourself (linked at end). Reminder: It is not in any way recommended that you take investment advice from this blog.
Overall, there are many reasons to be positive about tech stocks, but reasons to be concerned about the tech bubble. The U.S. economy is staying pretty well alive, particularly in Tech, which is genuinely showing not only great success but solid earnings and, most importantly, robustness. Koch advises active managers to allocate capital in search of new emerging tech leaders both outside and inside western markets and, I have to say, if I had the capital then I’d be doing just that.
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