Recent focus on high price/earnings ratios often fails to recognise distortions in the value of individual companies.
Since the 1920s in the US and the 1960s in the UK, the price/earnings (P/E) ratio has been perhaps the most-quoted gauge of how accurately a company is valued on the stock market. The ratio measures a company’s current share price relative to its earnings per share – a high ratio implies the company may be overpriced.
In recent months, P/E ratios have been at historic highs on several leading global indices, including in the US, the UK and Japan. According to figures collated by the Wall Street Journal, the P/E ratios for the S&P 500 and NASDAQ are both close to 24 points1, while the P/E on the FTSE 100 is approaching 27, according to Bloomberg figures2. These stretched ratios imply that stocks are expensive by historic standards – over the long term, these ratios tend to sit somewhere between 10 and 20.
The most obvious reason for the surge is quantitative easing. Since the financial crisis began almost a decade ago, central banks around the world have rolled out more than $12 trillion in quantitative easing – more than four times the size of the UK economy3. This largesse is widely identified as one of the reasons behind the inflation of asset prices to historic highs, from bonds to property stocks. P/E ratios have risen as a result, creating a potential conundrum for investors.
“There is no escaping the fact that P/E multiples are high,” says Paul Boyne of Manulife Asset Management. “What I think is possibly more important, however, is that the US and Europe are more levered [or leveraged] today than they were going into the crisis, and that debt-adjusted multiples are essentially at 20-year highs. Japan is the exception to this.”
Boyne points to how QE has pushed up asset prices, while companies’ operating earnings have fallen, adding that company debt has mostly been used for buybacks and for mergers and acquisitions. Thus companies have received a boost from both QE and from increasing their self-ownership stakes, but potentially without the commensurate investment and growth that would make their share price growth sustainable. Yet for active managers, this kind of index environment offers an exceptional opportunity to differentiate themselves from broader market trends – not least when high P/E’s oblige passive index-tracking investors to sell.
“High leverage and high multiples are a dangerous combination,” says Boyne. “Having said that, we are still able to construct a concentrated portfolio focused on quality, income and valuation that we believe has absolute upside whilst trading at lower multiples than the market and with lower leverage.”
Not just P/E
This raises the question of whether P/E ratios can become unreliable guides, if simply taken in isolation.
At the index level, P/E ratios can certainly distort the picture. For example, the S&P 500 and FTSE 100 are both weighted for market capitalisation – different companies have different weightings within the index. Yet when P/E ratios are estimated for both these indices, no account is taken for these different weightings; instead, the earnings of all constituent companies are simply added up cumulatively.
Thus no allowance is made for the fact that a $500 million profit at Apple, which accounts for more than 3% of the S&P 500, is much more important to the S&P 500’s value than a $500 million profit for TripAdvisor, which accounts for less than 0.04% of the index. As a result, P/E’s for entire indices present a distorted picture.
Yet even if you move beyond the headline P/E ratio for an index as a whole, questions remain over the universal applicability of P/E ratios at company level too. If P/E ratios were always fully indicative of real value, then a simple computer formula could simply pick your stocks for you based on those numbers. In reality, P/E ratios can distort even an individual company’s investment profile.
“There are times when a high P/E can be deceptive in terms of the underlying value,” says Boyne. “One example is cyclical stocks, where due to the depressed nature of earnings – or even losses – at the trough of a cycle, the resultant P/E will present as high; but this is exactly when these stocks should be bought. Yet if you were simply thinking axiomatically, they should be sold on low P/E as earnings are then at their peak. “
Of course, this does not render the P/E ratio useless to investors buying and selling cyclical stocks, but it does point to the need for both broader and more in-depth analysis before making a decision. It is in this combination of analysis styles that active managers truly prove their worth – especially when so many stocks are overvalued due to QE.
Among the other ways in which P/E ratios distort reality is their failure to properly account for charges which, although they skew quarterly earnings reports, are often one-offs and do not necessarily reflect a company’s profitability.
“We own a company called Mondelez which is a good example of this,” says Boyne, referring to the American food & beverage conglomerate that was, until 2011, known as Kraft Foods. The manufacturer of Oreo Cookies, Cadbury’s chocolate and Trident gum, Mondelez has been undergoing an extended (and costly) restructuring process since 2014. At the end of October, its primary listing in the US traded at a P/E ratio in the mid-20s. A recent earnings statement showed that the company paid out $187 million in restructuring charges (i.e. costs relating to the reorganisation of its business) in the third quarter.
“Mondelez is in the process of materially improving its operating margins from less than 9.5% in 2010 to roughly 16% in 2016, putting it closer to those margins achieved by peers,” says Boyne. “This combination of low-but-improving margins, coupled with the erosive effect of the required restructuring charges necessary to effect change, further depresses its earnings per share – raising the P/E ratio – and can belie the underlying opportunity.”
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The opinions expressed are those of Manulife Asset Management, and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.
2 All figures are correct as on 22 November 2016