Profits warning - US equities arguably offer even less value than they appear to


Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

Over the last six months or so, in articles such as Peak districtDizzy heights and The nature of things, we have expressed concern about valuations in certain parts of the US market and yet, as other commentators look ahead to the new year with their customary high hopes, you may find yourself wondering whether things really are that bad. Well from a value perspective – pun intended - they could be even worse.

Let’s first set the scene with the chart below, which is of a kind that will be familiar to regular visitors to The Value Perspective. It shows the total real returns investors have received over the subsequent decade after buying into the US market on particular valuations – as measured by the Graham & Dodd price/earnings (P/E) ratio.

Chart from Gerard Minack of Minack Advisors –November 2013
Past performance is not a guide to future performance and may not be repeated.

Rather than referring to a single year’s profit number, this longer-term P/E ratio uses an average of 10 years profits to try and smooth out the inevitable peaks and troughs of the economic cycle.  As you can see, based on history, investors deciding to buy US equities at this point would on current valuations be looking at a total real return of 2% over the next 10 years.

That sort of number is not the reason people usually like to get involved with equities and yet, as we said at the start, it is possible the picture could be bleaker still. We would point out we are going to have to speculate a little now, but we believe it will be a worthwhile exercise.

Take a look at the chart below, which shows the profits of US listed companies as a share of the country’s GDP over the last quarter of a century or so. What you can see is that, for a significant proportion of the last 10 years US profits as a share of GDP have been well above long-term average levels - and this has potential implications for the Graham & Dodd PE analysis shown above.

Chart data from Gerard Minack of Minack Advisors – published by him on 8th December 2013
Past performance is not a guide to future performance and may not be repeated.

As a result, the average for the last 10 years (the top line) is a lot higher than the longer-term average (the bottom line). Now, it may just be that that the current 10-year average represents a sort of ‘new normal’, as it were. If this is the case then the level of corporate profits generated over the last ten years is a more or less fair reflection of average corporate profitability going forward and investors should expect the 2% total return suggested by the Graham & Dodd chart above.

But if the 10-year average does not represent a ‘new normal’ – if the longer-term average remains the ‘correct’ one – that means our Graham & Dodd PE is being distorted by the fact that the last 10 years’ profits have been abnormally high. It would then follow that if we adjust for this the US market is really trading on an even higher multiple of ‘normal’ earnings than we thought – which suggests that future stock market returns from US equities will be worse than we thought too.

Here on The Value Perspective, we yield to nobody in our respect for the Graham & Dodd P/E and a ten year time frame is normally enough to iron cyclical ups and downs. But no system is infallible and there’s no rule written in stone that says a decade is always long enough to capture financial phenomena. If the last 10 years aren’t an aberration, investors could reasonably look forward – if that is the right phrase – to that 2% return, although this isn’t guaranteed. But if profits really are well above their longer-term average – as our second chart implies – that can only magnify the valuation headwinds faced by US equities.


Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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