Last week we delved superficially into how stock valuations are determined by the market. To summarize, the higher the earnings and/or projected earnings, the more desirable the stock would be, thus increasing its price. Earnings do not necessarily need to be returned directly to shareholders for the stock to move higher. If management can undertake a project (i.e. acquisition, capital investment, etc.) that could accelerate future free cash flows, then it would make sense to do this versus issuing a dividend. We will often see companies with no dividend at all opting to reinvest free cash flows internally to goose revenues. This is the distinction between what some investors refer to as “Growth” versus “Value” stocks, a distinction I do not like because it assumes all board capital allocation discissions fall on one side of the spectrum or the other. Traditionally, a growth company would reinvest most of its earnings internally while a value company would return excess capital through a dividend payable to shareholders. The truth is that all companies operate under the same premise: maximize return to shareholders through optimal capital allocation. Sometimes this means issuing a dividend and sometimes this means reinvesting in a growth initiative.
This is an important point to understand because it highlights the main axiom for investing in stocks, one that many investors have forgotten: invest for the earnings. A popular saying goes “buy low, sell high”, but this implies you should know the future. How else would you know what “low” and “high” are, relatively speaking? It suggests that the only way to make money in stocks is to time the buy and the sale, which is a gamble without perfect information. Rather, I suggest investors buy realistic earnings projections at a reasonable price. A more exciting way to put it is, “buy low, cash flow”. The first question I pose today is are the leading constituents of the S&P 500 today reasonably priced given their respective expected future cash flows? I posit that the answer is no, definitely not. We looked at the top six holdings last week which represent 23% of the index, none of which maintain a price to earnings ratio anywhere close to the 25-year average of the index. In fact, all were above 20x with most being above 30x earnings. Logically, the next question should be why are these valuations so frothy with an unhealthy amount of uncertainty on the horizon?
“buy low, cash flow”
I believe the reason for the inflation in valuations associated with the largest components of the S&P 500 is because of the sheer volume of passive inflows into the various index funds that mirror it. While I do not have the time to dedicate to a research project that would definitively prove my hunch, I do offer some anecdotal evidence to support my thesis. According to Morningstar’s Direct Asset Flows research, over $345B went into passively managed US Equity index funds in 2022, during a bear market which makes this an impressive statistic. The lion’s share of these inflows went into funds mirroring the S&P 500. These funds are generally not equally weighted which means that the largest components benefit the most simply because of their size, not because they offer the greatest potential for future earnings. Investors across the nation have been instructed to mind our pennies and only buy cheap index funds, and boy, have we listened.
I maintain an agnostic approach when it comes to passive versus active investing because I believe that the style of investing is far less important than your dedication to the strategy. Therefore, the right investment style for you is the one you are most likely to stick with. The message behind index investing is compelling: fees are on the only controllable variable and most active stock pickers cannot beat the index. This message resonates with people. I do argue that reasonably priced managers using a GAARP selection process tend to defy the later argument, but that’s beside the point. Nonetheless, this eventually creates an issue. What happens to price discovery when everyone is pursuing index strategies? We get valuations that make no sense and I believe we are beginning to see this effect.
There’s a lot of hope priced into the largest US stocks given the headwinds we’re facing in the market. It becomes increasingly difficult for companies to exponentially grow earnings as they get larger. The most likely explanation for the “hope premium” is that we have too many lemming dollars flowing passively into the market without giving valuation its proper due. The irony in all of this is that this situation could persist indefinitely, or at least until the masses realize through some catalyst that these concentrated constituents are simply overvalued, which could trigger a mass exodus. Maybe in a world where deficits do not matter, day trading is an actual career option and investing in stock funds is equated to “saving”, my opinion is too old fashioned. I don’t advise waiting to find out though. As two-time winner of Morningstar Manager of the Year, David Giroux, puts it in his book Capital Allocation, “Firms that pay out a reasonable amount of earnings in the form of dividends tend to outperform the market while exhibiting lower-than-average volatility.” After a decade of stellar performance, now may be a good time to put a little more thought into your portfolio construction than “buy the index”.
Above: S&P 500 cap weighted index (blue) vs equal weighted index (green)
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