Since our last report titled "Time to Embrace Qatari Equities" published at the end of September 2013, Qatari Equities are up around 12% and a natural inclination might be to question if stocks are now expensive. We delve into this question in detail in this report, but in a nutshell our view is: Stocks are still not expensive, and although potential future returns may be lower in absolute terms, their attractiveness relative to bonds continues to stand out.
When investors ask if stocks are expensive or not, they are often comparing current prices and valuations with historical prices and valuations. Simplistic valuation metrics on their own can be very misleading for two reasons (1) a structural change in underlying factors ranging from interest rates and inflation to GDP growth, and (2) using reported earnings rather than "trend earnings".
US interest rates have never been this low historically except for a short period during World War II (see Chart 1).
With bond yields at historic lows, it should come as no surprise that earnings yields have tumbled as well (see Chart 2). PE ratios (mathematically the inverse of earnings yield) have consequently risen, with investors asking if this is the "new normal". The question equity investors should really be asking is whether the low interest rate environment is here to stay.
One mistake often made when looking at stock valuations is to compare stock prices to current year earnings, referred to as the "PE ratio". The limitation of this approach is that current earnings frequently fails to reflect
"trend earnings", due to a variety of cyclical and secular reasons. For example, during the 2008 crisis, stock prices declined but so did reported earnings (particularly bank earnings), so PE ratios did not reveal how attractive stocks had become. Only after earnings recovered from crisis low did stocks start to look cheap, but by that time stocks were already up significantly.
To overcome this common mistake, we instead look at earnings yield using trend earnings, rather than the current year earnings. This helps us eliminate temporary volatilities in earnings so it acts as a better guide for measuring a stock's attractiveness. However even this is not enough either as this still does not factor in either future profit outlook or future interest rates.
Computing the present value of future earnings (also referred to as Discounted Cash Flow) is the only fundamentally complete approach for valuing stocks. However making the right assumptions is as important as the valuation method. For example using past bond yields as the risk free rate may be good for explaining current valuations, but they will not help in predicting future valuations. Equally using past or current earnings does not help in predicting future stock returns.
In our approach to selecting stocks, we first thoroughly analyze companies as if we are the owners of the businesses not just stocks. Then once we are convinced we understand the future prospects of the company, we look at long-term macro variables to predict future growth rates, inflation and interest rates. Understanding company earnings is important but sometimes not enough in stock selection.
Investors' key aim is to always maximize future returns given a set of assets to choose from. Presently as interest rates are at an all-time low and stock valuations are not as cheap, it should come as no surprise that future returns from all asset classes are expected to be lower as well. However we find equities attractive relative to fixed income for those investors that can invest with a longer horizon. While equity investors should expect to experience volatility, we feel fixed income investors are also likely to see more of it than in the past as secular trends in interest rates are no longer apparent.
Stock selection in our view will become even more important in the current low return environment where investors will be looking for true alpha to get a boost over low market returns. For example in the past when equity market returns were on average 10-15%, a fund delivering an additional 2-3% may not have been that visible; however when market returns are around 5-7%, than these additional returns will become more visible and valuable. The case for stock selection is particularly strengthened by the chart below which shows a significant decline in correlation of returns among stocks.
In managing our clients' equity portfolios, we analyze and forecast macro variables as well as other asset class returns. These can be used as key inputs in their asset allocation decisions. When making asset allocation decisions, it is very important to assess risks, returns and correlations of all available asset classes.
A vital distinction that many investors miss is between market volatility and the risk of permanent loss of value. Investors who have the ability to invest longer term without short term liquidity requirements can structure their portfolios with a sharp focus on the latter, and treat the former as an opportunity.
We are all very conscious of short term (annual) returns, but the ability and fortitude to hold onto high conviction positions during market corrections can boost long term returns significantly.
In closing we are reminded of a quote from the world's most successful long-term investor Warren Buffet "The biggest risk in investing is not knowing what you are investing in".