Equity Market Valuations: We Haven’t Been Here Before
“…. valuing the market has nothing to do with where it’s going to go next week or next month or next year, a line of thought we never get into. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.” - Warren Buffett
As the equity bull market has entered its ninth year, market participants have voiced concerns over elevated valuation levels. John Hussman has been one of the more prominent who have sounded the warning bells about low expected returns and elevated risks embedded in equity valuations. In his recent note, Hussman stated that few investors recognize that one of the reasons why valuation multiples were so rich in 2000 is that profit margins were actually below historical norms at the time. The benefit of normalizing the embedded profit margin comes not just from muting margins that are above historical norms, but also from normalizing margins in periods where they are below historical norms.
In the chart below, Hussman plotted the margin-adjusted cyclically adjusted price to earnings ratio (CAPE) on an inverted log scale along with actual subsequent S&P 500 nominal average total returns over the subsequent 12-year period. There are two points that are worth noting about this chart. Firstly, the fit between observed valuation levels and subsequent long-term returns is tight, suggesting that the valuation model employed is robust. Secondly, valuations based on this metric are in the same territory as the 1929 high and the tech bubble, zones that resulted in poor subsequent investment returns.
Source: Weekly Market Comment, John P. Hussman, Hussman Funds, October 2, 2017
At our firm, we are focused on a much smaller sub-set of businesses; that of high-quality businesses with durable competitive advantages. Accordingly, our concerns around market valuations are largely related to the valuation of this sub-set of businesses. Our target sub-set performed well over the last few years with a significant portion of that performance driven by the broader equity bull market. The important question that we face at this juncture is whether the sub-set of high-quality businesses is as overvalued as the broader markets and whether that is likely to bode ill for our future investment returns.
To effectively answer that question, we built a bottom-up model of the companies in our investment universe; the Global Moats Index. Our analysis covers 120 unique companies over the last 16 years with 110 of these companies being a part of our investment universe currently. In the discussion below, we take a deep dive into the profitability of these businesses as a group, levels of leverage employed, business reinvestments and share buybacks, and business valuations.