Adapting to the new, more nuanced position for markets

Over the past 18 months, our commentaries have often reflected on markets either falling dramatically or staging a remarkable revival. Now the position looks less clear-cut and increasingly nuanced.

In our view, there are several reasons to remain optimistic, even after the strong and sustained recovery from last year’s Covid-induced crash. First, vaccination programmes are helping the global economy to fully re-open. Second, we’re investors in many companies that have benefited from Covid’s acceleration of trends that were already working in their favour. Third, central banks and governments remain firmly committed to huge stimulus programmes. For such reasons, the business cycle continues to look positive for equities.

The prospect of persistent inflation

Yet there are equally valid reasons for adopting an increasingly cautious approach. For example, inflation is currently running well ahead of targeted rates, which is increasing speculation about interest rate rises. Despite central bankers’ reassurances, we’re expecting inflation to persist at levels above both central bank targets and society’s expectations for longer than investors are assuming.

Other concerns include Covid-19’s highly transmissible ‘delta variant’ and the disappointingly low vaccination rates in several countries, especially (and remarkably) Japan.

Less surprisingly, some stock valuations now look stretched after markets’ long and strong bull run, so a ‘correction’ (in other words, a 10% fall) seems likely or even overdue.

“At this point in the cycle, it is essential to identify and control shorter-term investment risks while nurturing longer term growth.”
Philip Smeaton, Chief Investment Officer

Squaring the circle for investors

We’ve reached a point where the outlook is complex, with equally valid reasons for optimism and concern. In our view, the solution is to balance the risks. Stretched valuations heighten the risk that companies disappoint and fail to measure up to expectations. This risk is managed by selecting business in which our analysts have conviction and ensuring we do not overpay. With rising inflation, we continue to focus on property, infrastructure, and companies with real pricing power. Finally, with a correction increasingly likely, our modest underweight in equities means that any buying opportunities can be exploited.

In one key respect, however, our approach remains unchanged. In common with bear and bull markets, we believe it is essential to back high-quality companies with sound business models and strong earnings growth potential. Despite what the next six months may bring, they have the highest probability of delivering the long-term growth that can meet investors’ financial goals.

Investment View: Looking back and planning ahead – the importance of earnings growth

As indicated in the market outlook, some valuations now look stretched. But what factors can affect market valuations? And which insights from past experience remain relevant today? It’s time to take a closer look at long-term earnings growth.

It is always tempting to think of ‘the stock market’ and its performance, however this oversimplifies the opportunities that investors have. Instead of being one amorphous entity, investors are not restricted to purely investing in the stock market, rather we have the luxury of selecting from a market of stocks which contain a myriad of opportunities.

As we recover from 2020’s Covid-induced crash, it’s also a good time to reflect on how different markets have fared over the longer term and understand that the ability for companies to grow their businesses is an often overlooked, but key determinant of investment outcomes.

Four trends seem particularly striking. Firstly, it’s remarkable how total returns from the US market have diverged from those recorded in other countries and regions. The divergence began slowly but has accelerated during the past decade, with US companies’ overall performance moving ‘above and beyond’ that seen elsewhere.

Secondly, it’s noticeable that indexed earnings per share (EPS) – a measure of profitability – have followed a comparable trajectory, with the US increasingly outperforming Japan and emerging markets – leaving Europe and the UK even further behind. Indeed, virtual flatlining has been a common European and UK experience as companies have often struggled to increase earnings, which has impeded returns.

An analysis of different investment styles tells a similar story as, thirdly, a growth-based investment approach has far outperformed its value-based alternative while, finally, both EPS and total returns were considerably higher for US than world stocks.


EPS drives performance

There are many factors that explain this divergence, for example the relative prevalence of technology companies within the US and growth indices compared to a concentration of banks and resource extraction stocks in the European and value indices. However, these explanations provide little real insight other than highlighting the dangers of analysing market indices without understanding what businesses lie within.

The takeaway from this analysis is that, over longer timeframes, the delivery of EPS growth is a key driver of overall market (and portfolio) performance. Dividends tend to be relatively predictable, valuation changes can be headwinds or tailwinds, and earnings growth does a lot of the heavy lifting over time. This is one of the reasons we look for companies with the ability to grow most consistently. Nevertheless, it’s still extraordinary to see EPS growth by US companies averaging 5.3% per year since 2008, whereas the world figure, excluding the US, is minus 1.3%.

Building reliable portfolios

One way to build conviction that a business can grow earnings is to look at their past track record. When we compare the expected future earnings growth rate for our portfolio of companies to that achieved in the five-year period before the global economy was hit so hard by Covid-19, there is a high degree of correlation. This means that all we require our companies to achieve, is exactly what they have achieved in the past. Combined with a detailed assessment of each company’s outlook and valuation, we can manage some of the key risks facing investors and create the conditions which allow the passage of time to compound wealth.

Phil Smeaton
Chief Investment Officer


The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable but are not guaranteed as to accuracy or completeness by Sanlam. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.

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