Global Equity Valuations Offer Investors Food for Thought
September 8, 2017
Investment Director, Equities
- Analysis of four valuation multiples shows that global equity valuations are universally higher than they were in the spring of 2007 and higher than their 20-year averages.
- The returns generated from these high equity prices have been lower than historical averages.
- Investors can position their portfolios for a potential equity market correction by staying invested in global equities, having a variety of investment strategies and working with portfolio managers who can protect against the downside.
Global equity markets have been on an upward trajectory for several years, and investors have enjoyed mostly double-digit annual compounded returns, almost continuously, since 2011. Even over the past five years, well after the recovery from the global financial crisis, the MSCI World has averaged 13.1% per annum in local market terms, or 16.9% in Canadian-dollar (CAD) terms. To put those numbers in perspective, in those five years world equity markets generated about 140% more returns (2.4x) than was generated in the previous 25 years.
|Category||25 Years ending June 30, 2012||5 Years ending June 30, 2017||+/-||Premium|
|MSCI World Index (Net) CAD||4.8%||16.9%||11.5%||252.1%|
|MSCI EAFE Index (Net) CAD||3.2%||14.1%||10.6%||340.6%|
|S&P 500 TR CAD||7.7%||20.3%||11.7%||163.6%|
|S&P/TSX Composite TR||7.5%||8.7%||1.1%||16.0%|
|MSCI World Index (Net) LCL||5.3%||13.1%||7.4%||147.2%|
|MSCI EAFE Index (Net) LCL||3.1%||12.5%||9.1%||303.2%|
|S&P 500 TR USD||8.6%||14.6%||5.5%||69.8%|
Since hitting the bottom for CAD investors early in 2008, global equity markets have gone on to produce returns of more than 225% to investors. This was called the “trade of the century”, and those investors who took advantage did very well. So well, in fact, that some investors are now left wondering if equity markets have risen too far. This article evaluates where global equity markets are from a valuation perspective and what that could mean for investors.
While returns might give an indication of where value is deteriorating they are not a good gauge of whether markets present attractive value, since returns depend on the starting point. Investors putting capital to work when prices were depressed at the bottom of the global financial crisis would have understandably high returns over several years while the economy regained its footing. Equally, prices of stocks are not a good indicator of the value offered by stock markets; value depends on the businesses being purchased and their cash flow. Instead, we used some common market valuation multiples to get a sense of the prices being paid in relation to the earnings being generated to represent the current investment opportunities. These multiples include:
- Price to Earnings Ratio (PE)
- Price to Cash Flow (PCF)
- Price to Sales (P/Sales)
- Enterprise Value to EBITDA (EV/EBITDA)
We used trailing 12-month financial statement data to eliminate any biases created by enthusiastic analyst predictions. Basically, we just evaluated the current prices being demanded compared to the current cash or earnings being generated in the businesses. Each of the chosen metrics is known to investors and each one has strengths and weaknesses in assessing value for companies. We evaluated these multiples as a group to try to triangulate market value around them.
The first challenge reached in assessing value was the need for a benchmark. We wanted to assess whether markets present good value opportunities relative to something. Again, for simplicity, we made only two comparisons: the current multiples relative to their 20-year averages and also relative to 2007 market peaks.
Across the multiples we can see that valuations are universally higher than they were back in the spring of 2007 and higher than their 20-year averages. The metrics are measured at a premium between 13% and 24% over the peak of the financial crisis, and 5% to 35% over long-run averages. Taking a simple average of these together, global equity markets are trading at price multiples 18% higher than in the global financial crisis, and 21% higher than their individual 20-year averages.
|Category||PE - LTM||PCF - LTM||P/Sales - LTM||EV/EBITDA - LTM||Average|
|Current Premium to GFC Peak||23.8%||13.2%||16.8%||17.2%||17.8%|
|Current Premium to 20Y Avg||5.0%||24.0%||35.0%||20.0%||20.8%|
To answer the question on whether markets have gone too far, we have to examine the relationship between valuation multiples and forward-market returns. Thankfully, this is fairly straightforward on a historical basis. By comparing the market valuation metrics against the forward returns for the same market we can observe the relationship pretty clearly.
First, we focused on three-year returns for markets compared with the four multiples for analysis. Below you will find scatter plots that show each pricing metric along the horizontal axis, the forward three-year return along the vertical axis, and an orange line in the middle representing the trend line between those two numbers, or the average of that relationship.
In this set of three-year returns the results are unambiguous. For each case the higher the multiple the lower the three-year forward return has been in the market, and vice versa. This result may seem intuitive: the higher the price we pay for investments, the lower the eventual return we get on them, given that return is just the value received minus the value paid. Over three years the results are all statistically significant and the relationships are strongest among Price to Sales and EV/EBITDA multiples.
Using the three-year returns as an outcome does cover some investor horizons, but most investors look to five years and beyond for equity market performance. In that frame the results are more resounding, with the relationship between each valuation metric and the forward five-year market return being more negative with more statistical certainty. That is, five-year results are even more convincing.
Within the five-year comparisons, Price/Sales and EV/EBITDA remain the strongest predictors of five-year forward returns. However, all of the comparisons are significant and have a more direct relationship than in the three-year cases. Each metric consistently pointed to a negative relationship between price and return.
Though we do not show it here, we extended the analysis to seven years and observed results similar to those in the five-year analysis, with even higher degrees of confidence and more direct negative relationships for all metrics.
What might happen next?
Returns have been high for a while and valuations are now elevated over 20-year averages. Multiples are approximately 18% higher than they were before the financial crisis in 2007, and the higher multiples get the lower the returns experienced by investors. So where do we go from here?
We know what markets have done when valuations have reached these levels before. First, we looked at our two metrics with the highest confidence, P/Sales and EV/EBITDA, to review historical relationships. The last time these two metrics were at their respective June, 2017 levels was in early 2001 and forward returns in the market were about -5.0% per year for three years or -2.8% per year for five years.
For a more systematic approach to estimation, using the same linear model above to describe the relationship between price and return, we can input today’s valuations and get a prediction of where returns may go based on historical relationships.
|Category||PE - LTM||PCF - LTM||P/Sales - LTM||EV/EBITDA - LTM||Average of Model Predictions|
|As at 6/30/2017||21.46%||10.87%||1.67%||11.74%||–|
|Model Predicted 3 Year Annualized Return||4.0%||-1.2%||-12.2%||-3.8%||-3.3%|
|Model Predicted 5 Year Annualized Return||3.0%||-2.5%||-9.7%||-3.2%||-3.1%|
The Price to Earnings metric predicts modest positive returns over three and five years, but three out of four metrics show negative returns going forward in those periods. Moreover, it is concerning that the two valuation metrics with the strongest negative relationships predict the lowest returns, with current P/Sales ratios in particular hinting at significantly negative returns over the next three to five years.
It is important to remind ourselves that these are statistical predictions from simple linear models, not comprehensive forecasts of market returns. These considerations are two-dimensional at best and do not pretend to include all of the complications and textures facing investors in today’s global equity investing climate. We did not consider the general level of interest rates, economic output or growth, investor sentiment, geopolitical risks, or the returns available in other assets. Our aim was to present simple equity value on offer in the market today in relation to its outcome history.
Consider these results food for thought to inform a strategy for a portfolio.
Stay in the game, protect against the downside
Words like “expensive” and “overvalued” have been avoided in this article because we looked at valuation metrics with few judgements. Our goal was to make an objective comparison against recent historical averages. It’s up to individual investors to determine for themselves if global equity markets are expensive or overvalued relative to the risks in the market.
We know that equity prices are generally higher than they have been in history, including before the global financial crisis in 2008, and that the returns generated from these levels have been lower than historical averages. For investors, current market conditions may create risks from emotional investing. They might buy when markets are high and sell when prices decline. Or, they might sit on the sidelines, worried about the onset of a bear market. Staying invested over the long haul can help investors manage their emotions. It can also help investors capture all market gains.
We do not pretend to know where global markets will go from here but do recommend investors stay invested in global equities. Timing market movements is difficult to do and can be costly if you get it wrong. Also, a portfolio manager with a track record of offering protection against the downside can help maintain growth potential in a portfolio.
Despite concerns over current valuations relative to the opportunities available in the global equity market, we remain aware that market prices can rise significantly from these levels before they fall back to (what we would consider to be) attractive levels. Central bank support of asset prices and stubbornly low returns available in other assets may conspire to keep markets at these valuation levels, or higher, and there is no way to know for sure when this will end.
The one thing we know for certain is that, despite any intervention or innovation thrown at them so far, equity markets self-correct in the fullness of time. But investors can position their portfolios against that eventuality. Staying invested over the long term, having a variety of investment strategies in your portfolio and investing with portfolio managers who have a proven track record of protecting against down markets can help your capital live to fight another day.
One example of such a strategy is the Mackenzie Ivy Foreign Equity Fund. By not overpaying and holding what the Ivy team believes to be high-quality, market-dominating companies, the Fund has a history of being able to capture growth on the way up in the cycle and limiting losses on the way down.
Since the Global Financial Crisis, global equity markets have been on a consistent rise. Listen to Daniel Arsenault, Investment Director of the Mackenzie Ivy Team explain to what extent they have risen, and what this might mean for investors.
- What Goes Up: Rising Equity Valuations and their Implications
Global equity valuations are above their 20-year averages. Daniel Arsenault, Investment Director with the Mackenzie Ivy Team discusses these valuations and what they means for investors.
September 12, 2017
For more information about the Mackenzie Ivy Foreign Equity Fund, speak to your financial advisor.