White Swans

Nearly everyone you speak to predicts the European debt issues will have calamitous economic consequences. In an investment sense (as opposed to economic) the best case scenario is often predicted as the market going nowhere for up to 10 years.

While not wishing to dismiss the seriousness of debt issues emanating from southern Europe there seems to be a single focus of attention on this issue and disregard for any positive data. 

Southern Europe is not the sum of global economic activity and there are areas where growth is strong or strengthening. Certainly corporate results in the US would indicate things are improving and growth continues in emerging economies.

Our approach is to look principally at the operations of the companies that we are invested in and try not to make too many predictions regarding broad economic developments - the track record of economic prediction is not good and we are not going to improve it.

The disconnect between press commentary and the health of corporations seems to be growing. On one hand there is a view of impending doom resulting from sovereign debt issues and bank liquidity problems. On the other hand there is a picture of corporate earnings growth.

In a wide range of industries companies are producing extremely strong operating results or at least a solid performance; earnings are growing. Balance sheets are extremely strong (with a few obvious exceptions, but that is normal at any time), and in many cases there is excess capital held - this is particularly the case in the US.

For perspective, we have reproduced a graph we shared several months ago showing the growth of earnings for S&P500 earnings over the last 65 years. What it shows is surprisingly steady growth in corporate earnings, punctuated by some sharp but relatively short corrections.

This is counter intuitive because it is a somewhat different picture to the far less consistent returns from the equity market. The value the market places on earnings is not consistent, thereby creating opportunities at times.

Thus while the S&P500 is pretty much where it was 10 years ago, corporate earnings have doubled - effectively Price to Earnings ratios have halved. If you take the view that the last 65 years looks like a consistent pattern then you might conclude that equities look a little cheap.

Another way of looking at equity market valuations is the premium (in terms of earnings return) that the market demands for investment in equities over low risk investments. The current level is extremely high by historical standards. As the graph below shows in the US (S&P500) it is close to the dark days of 2009 and substantially above the level that existed in the bear markets of the late 1980’s, early 1990’s and after the tech bubble burst in 2000.

For the Australian market (ASX) the measure has been far more volatile but is still at the level of previous bear markets. What tends to happen in these circumstances is one gets a period of very high equity returns (contrary to the current consensus view) as the equity risk premium returns to more normal levels.

The point we want to make is that as a result of all the pessimism, valuations seem pretty attractive if you discount the appearance of Black Swans*. If the market was to do nothing in terms of capital growth the dividends that are currently being paid would more than justify the Australian equity market as an attractive investment.

*As someone quipped Black Swans refer to totally unexpected events and the current issues seem to be conventional wisdom - a very white swan.

Hugh MacNally, December 2011

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