Financial Questions for Bill Richardson Part 21
Good Morning. North American stock markets have been very strong since 2020 COVID reaction. The S&P 500 is up over 100% since March 2020. With that magnitude of move, is it logical to assume that the market is overvalued?
Numbers can be easily manipulated. Yes, the S&P 500 is up over 100% since its lows in March but it is up a more reasonable 33% since just before the index dropped, so that significantly alters the question, but it is a good question, regardless.
To address this, I’m going to break this question into three questions. A wrinkle on the “3 Questions for Bill” format.
Question 1: What is “the market” to which you refer?
In the question above, we have used the S&P 500, which is a standard benchmark. As Canadians, we often look at the TSX 60 or Composite index. There are hundreds of benchmarks, so which is the best to follow?
For this discussion, let’s look at the S&P 500. It is an index made up of 500 of the largest companies in the USA. Companies on this index range from small companies like Alaska Air ($5 billion market value) to Apple ($2.6 trillion) and the average of $83 billion. (Note: small companies in the US would be considered large companies in Canada. Royal Bank, Canada’s second largest company has a market value of $150B and would rank just outside of the top 50 companies in the S&P 500). On this list, there are some great and some mediocre or struggling companies. To its credit, 458 companies made money and only 42 lost money in the past year.
Sixty-four percent of the companies fall into the 8 to 10 fundamental score range which we consider to be investment grade, but this means that thirty-six percent are below that and fail a fairly large number of our fundamental tests.
So, what does this have to do with the market being potentially overvalued? It answers an important question: “What is the market?” Is an index of 500 companies, where 36% are below investment grade, what we should be tracking? In our view, you should be looking at a basket of companies that would be suitable for your personal portfolio.
If, however, you are buying or own the S&P 500 or the TSX 60 Index, then the question should be “Are those indices overvalue?” You are better focusing on stocks you own or the quality of companies that you own.
Question 2: What factors do you look at to identify whether stocks are undervalued, properly valued or overvalued?
To answer this, I’m going to look at companies that meet our investment criteria. That is, let’s look at companies that have a fundamental score of 8, 9 or 10 and larger, more mature companies with a market value of more than $10B.
There are a number of factors that can be used to look at valuation. The most widely used is the “Price/Earnings multiple”. The PE multiple is the price investors are currently willing to pay for the earnings or earnings growth of a company.
It is calculated by simply taking the price of a stock and dividing it by the earnings per share of the company. If the PE Ratio is high, you might say that the stock is expensive or vice versa. By comparing it to previous periods, like the average PE Ratio for the past 5-years, you have a tool to assess its valuation.
Companies with strong earnings growth should trade at higher PE multiples than companies with weak earnings growth, so as earnings growth has been strong, PE multiples should have increased.
In looking at “investment grade” companies, the average PE has ranged between 20 times earnings and 70 times earnings since 2000 with the median in the 45 range. The PE for this group of stocks is currently 33, so I would say that stocks in this basket have reasonable valuations – not at all overvalued.
Question 3: If stocks have reasonable valuations, why have stocks risen so much over the past year or so?
In 2009, the average earnings per share (EPS) of our investment grade basket was 78 cents per share. At the lowest level in 2020, the average earnings per share was about 6.50 per share on June 30th. One year later (June 30, 2021), the average EPS was at its highest level at 9.60. Over the past year earnings per share have risen by almost 50% and the S&P 500 is up 41% including dividends paid.
We focus on trying to identify companies with a history of strong, consistent and predictable earnings growth that is expected to continue and that we can buy at reasonable prices. Earnings are reported quarterly and we have recently had most companies report and growth remains strong. With the average PR multiple at reasonable levels, this group of companies should continue to perform until earnings growth slows. At this time, we see no slowing of earnings growth and expect these companies to continue to perform well.
Until next time, have a great day!