As a value investor, you must be asking yourself how best to go about investing in a time of 20+ P/Es.
With over 90% of companies in the S&P500 reporting their 3rd quarter earnings, US corporate profits seem strong.
- According to FactSet, about 80% reported better than expected earnings per share, and about 75% posted revenues that beat estimates.
- For the S&P500 as a whole, earnings grew 39% as compared to the 3rd quarter of 2020.
While this is the 3rd largest earnings growth rate since 2010, the number appears large as a result of a recovery from a COVID impaired 2020. The stock market has responded to the earnings bounce off of depressed 2020 levels. The S&P500 is up just over 26%.
S&P500 Trades at a Lofty P/E
Even with the strong earnings surge, the S&P500 trades at a lofty forward 12-month P/E of 21. The 5-year average forward price-to-earnings ratio for the index is 18.4.
When valuations are well-above average, investors need to be careful. There is much less of a margin of safety and disappointments can lead to significant price declines.
Of course, earnings reports are backward-looking. The stock market looks ahead.
Financial and Healthcare Stocks Report Greatest Earnings Increases
The sectors where FactSet is reporting the greatest increases in earnings estimates since September 30 are financial stocks followed by healthcare.
Overall, analysts expect year-over-year profit growth to moderate from the 39% rate in the 3rd quarter to about 21% in the 4th quarter. This is still solid growth. Not surprisingly the year-over-year growth comparisons are expected to continue to slow as the 2021 economy was better than in 2020.
At present, analysts are calling for profit growth estimates in 1Q22 of 6%.
>> Interesting to note, analysts see revenue growth for S&P500 companies slowing at a much lesser rate than profits. The reason is inflation cost pressures. Of the companies reporting 3rd quarter figures, 285 mentioned “inflation”.
How Can the Market Sustain a 20+ P/E?
As we head into 2022, the big question for investors will be how can the market sustain a 20+ P/E in the face of slowing growth comparisons and inflation pressures which dampen profit margins and may cause the Fed to raise interest rates?
Two Ways for the Market to Support Current Valuations
I suggest that there are two ways the market can continue to support the current valuation.
1 – Growth Moderates Less Than Estimated
One would be that growth moderates less than estimated. This could happen if COVID subsides and/or becomes more manageable through greater vaccination and the development of therapeutics. An increase in productivity would help the profit picture, as well. This could happen as corporations reap the benefits of “work anywhere” technology.
2 – Inflation Moderates
The other way to maintain the market’s P/E would be for inflation to moderate which would help margins and keep the Fed from raising rates too much. For this to happen, supply bottlenecks would need to be resolved, and some increase in the supply of key commodities like oil.
Find Companies that Can Maintain Profit Margins & Growth
It’s not impossible to see valuations maintained in 2022 but it is unlikely to be an easy accomplishment. Investors need careful stock selection to find companies that can maintain profit margins and growth.
Growth for Value Investors Isn’t Always Comfortable
Growth appears to be the driver that investors are fixated on. As a value investor at heart, this reality is not always comfortable. Growth has a tantamount requirement which is more growth. Without more, the stocks can not maintain their valuations.
Example – PayPal
- PayPal is a platform and a platform needs users.
- Pinterest has over 400 million active users.
- If PayPal can get those on Pinterest to use its services, it unlocks a pool of growth.
After its stock declined on the rumor, PayPal did not go forward with a buyout offer. I’m not sure we’ve heard the last of this story.
Apple and the Auto Industry
Large mega-cap companies need to expand in ways that “move the needle” to keep growing in a way that satisfies investors. This means these super-big companies need to move into large industries and/or find large pools of users.
There is revived talk of Apple getting into the auto industry. I think it is likely we will see mega-cap e-commerce/internet/tech companies move into big areas like education and healthcare. M&A in 2022 may look very different.
Most Important for Investing in Times of 20+ P/Es: Careful Stock Selection
As we mentioned above, it’s important for investors to embrace careful stock selection to find companies that can maintain profit margins and growth.
For additional perspective, you may find these resources helpful:
Let us know if you have questions about evaluating stocks given growth, inflation, and a value mindset.
Thanks for reading!
Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.