27 May 2021
Are returns from US stocks doomed to lag those from their global counterparts as economies reopen and as industrial production surges? Artemis’ CIO, Matt Beesley, and head of US equities, Cormac Weldon, answer this and other key challenges for US equities:
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Matt Beesley: The first chart shows us that US equities have a tendency to underperform whenever leading indicators of global economic activity, such as manufacturing PMIs, have pointed to expansion.
US equities underperform when global PMIs rise
Source: Credit Suisse as at 6 April 2021
US companies have low operational leverage
Source: Credit Suisse as at 15 April 2021
Meanwhile, the second chart suggests that companies in the US generally have lower operational leverage than those in other regions.
So, having been more resilient than European and emerging markets over the past year as the pandemic ravaged growth, are returns from US stocks doomed to lag those from their global counterparts as economies reopen and as industrial production surges?
Cormac Weldon: Like most observers, I’m optimistic about the prospects for both the US and global economies. But I’m also aware that the pace of those recoveries will vary. The US has a clear lead in vaccinations compared to many European economies – and to most emerging markets.
Thanks to that, the American economy seems likely to recover sooner and faster. The IMF forecasts that the US will outgrow the world’s other major economic blocks over the coming year. So although operating leverage is undoubtedly important for earnings, the edge that companies in some other markets have in operational leverage could be more than offset by the faster growth in the US economy.
The second point I should make is this: we run high-conviction portfolios, investing in companies rather than in the overall characteristics of an index. Our portfolios are underweight in bond proxies, such as REITs and consumer staples, whose earnings probably won’t be particularly responsive to the global recovery.
Set against that, we have overweights in US domestic earners and in cyclical stocks such as industrials and financials, whose earnings will respond as restrictions are lifted and activity in the US economy snaps back.
Matt Beesley: The net debt of US listed companies relative to their Ebitda, a good proxy for their free cashflows, is as high as it has been for 30 years.
With the next move in interest rates more likely to be higher than lower, and with bond yields moving up, does this pose a challenge to indebted companies, particularly given that so many have used borrowing to fund share buybacks?
Share buybacks have accounted for a third of growth in earnings per share that US companies have delivered since 2010. Might this be a hard trick to repeat as bond yields move higher?
Net debt to EBITDA is high in the US
Source: Credit Suisse as at 6 April 2021
Cormac Weldon: Over the longer term, it is valid to question the rising levels of debt in the US corporate sector. Yet we are slightly more relaxed about leverage than we were in 2018-19, when we were careful to be underweight in the most highly geared companies, favouring ‘quality’ stocks with strong balance sheets instead. Conditions today, however, are rather different.
In the shorter term, rapid growth in Ebitda will lower the debt-to-earnings ratio. As we saw in the latest US quarterly earnings season, rapid growth in sales is translating directly into healthy growth in corporate earnings: top-line growth is coming in at around 6% while earnings growth this year is running at 30%.
Consensus estimates, meanwhile, are for earnings to grow by another 13% next year. So the ability of US companies to service their debts will actually improve in the short-to-medium term.
To reiterate, however: we are stockpickers, looking at debt on a company-by-company basis rather than across the US market as a whole. Do some companies have uncomfortably high levels of debt? Absolutely. And we avoid them. Others, however, could probably stand to use a little more leverage to enhance returns to their shareholders.
Matt Beesley: Information technology stocks now represent 27% of the S&P 500, with communication services companies such as Alphabet and Netflix accounting for another 11%. So more than a third of the US market might reasonably be described as being ‘tech’ – and that’s before we include Amazon, which sits in the consumer discretionary sector.
These companies are long-duration assets – investments whose valuations are predicated on their future (rather than current) cashflows. These future cashflows are subject to a discount rate that will rise with bond yields, thereby lowering their present-day value. Does this make the US market particularly vulnerable as expectations for interest rates move higher?
Cormac Weldon: The proportion of the US market accounted-for by technology stocks has clearly increased over the last 20 years. But we see that as a blessing, not a curse.
The weighting of tech stocks has risen because the importance of these companies to the global economy – and to the daily lives of all of us – has been transformed.
As US equity managers, we can invest in these transformative businesses – but we are not obliged to. Although the US market probably has more than its fair share of the world’s best technology stocks, it is so diverse that whatever style of investment you favour, you will find an abundance of options. Whatever type of company you prefer, you will find it.
Along with tech, it has a large, well-capitalised financial sector. It has industrial companies whose fortunes rest on domestic US demand and there are industrial companies leveraged to the global recovery.
Regarding duration, we do need to be aware of the extent to which a company’s share price today is a function of abnormally low interest rates.
We are conscious that inflation and interest rates might rise and so are avoiding long-duration ‘concept’ stocks, whose valuations today rest on hopes for profits to be made in a far-off future.
But even within the technology sector, it is relatively easily to position ourselves for the eventuality that long-duration assets are de-rated. The earnings of companies such as Facebook and Alphabet, which fluctuate with spending on advertising, are actually far more cyclical than their reputation as ‘secular growth’ names might lead you to believe.
Instead, we think the real threat that a rise in the discount rate poses is not to companies that have high growth in revenues and earnings and which are moving towards profitability. Instead, we believe the real risks are to companies with lower growth – to so-called ‘bond proxies’. These will struggle in an environment of higher rates.
Matt Beesley: Although it has rallied a little over the last few weeks, the dollar appears to be in a downtrend. The open-ended support being offered by the Fed and the huge stimulus measures being implemented by the Biden administration both seem to point towards a weaker currency.
At the very least, that must make overseas equities more attractive to US investors. And might this also pose a particular challenge to cyclical companies in the US, who are selling into a domestic market but who must source raw materials and other inputs from overseas, meaning their input costs are rising?
Cormac Weldon: We’re happy to acknowledge that a continued weakening in the dollar would be positive for the relative prospects for cyclical growth outside the US.
But again, as active managers, we can position our portfolios to respond to that challenge.
And remember that many of the raw materials, feedstock and components that are used in products sold in the US are priced in dollars anyway, so that reduces the risk of currency moves.
US Dollar Index
Source: Bloomberg as at 6 April 2021. Data rebased to 100.
An associated point: we’re sceptical of the arguments deployed by those who are ‘perma bears’ towards the dollar. It is the world’s reserve currency and our view is it will remain so. To us, the long-lived disparities in purchasing power parity merely speak to the strength of the dollar’s position in the global financial system. We believe the fundamental bid for US assets – and so for the dollar – will remain in place.
Matt Beesley: Relative to other markets, the US is not the region in which earnings are expected to grow most quickly – yet it still has the highest forward p/e multiple.
Furthermore, the US market’s current forward p/e of 23x is significantly higher than the long-term median of around 15x. Isn’t the US market simply too expensive in relative and absolute terms?
Regional forward P/E vs. earnings growth
Source: JP Morgan as at 16 April 2021.
Cormac Weldon: It’s hard to disagree with the idea that the US looks expensive relative both to its peers and to its own history. We would accept that returns from US stocks from this point are more likely to be driven by earnings growth than by a re-rating; the re-rating has already happened.
And, to reiterate, we think earnings growth in US stocks from here is likely to be powerful – and more powerful than this chart suggests: we look for 30% earnings growth this year and another 13% next year.
So I’m inclined to view broad market valuations as descriptive rather than predictive. Investors worldwide are engaged in a constant battle to find and exploit valuation anomalies across global markets on a stock level.
The higher multiple awarded to the US market on aggregate is the product of investors’ rational deliberations, analysis and millions of decisions on a stock level. US equities offer higher returns on equity, better growth prospects – so it is natural that they trade on higher multiples. Or, put more simply: you get what you pay for.
To find out more about the Artemis US Select Fund and Artemis US Smaller Companies Funds and their positioning visit the fund page at www.artemisfunds.com.
THIS INFORMATION IS FOR INVESTMENT PROFESSIONALS ONLY. IT IS NOT FOR USE WITH OR BY PRIVATE INVESTORS.
Artemis US Select Fund
The fund is a sub-fund of Artemis Investment Funds ICVC. For further information, visit www.artemisfunds.com/oeic. Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice. Issued by Artemis Fund Managers Ltd which is authorised and regulated by the Financial Conduct Authority.
Artemis US Smaller Companies Fund
The fund is a sub-fund of Artemis Investment Funds ICVC. For further information, visit www.artemisfunds.com/oeic. Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice. Issued by Artemis Fund Managers Ltd which is authorised and
