The Cure for Baldness
By Neel Kashkari
September 18, 2012
American society is becoming increasingly politically polarized. Indeed, a June Pew Research Center survey found that while philosophical divisions between groups based on race, education, income, religion and gender have remained largely flat since 1987, the division based on political differences has almost doubled during that same time and has ramped dramatically since 2009.
But it also creates challenges for individual publishers: Getting noticed among the thousands of others competing for mindshare is becoming harder. This is complicated further by the use of text messages and social media services such as Twitter to disseminate information, which limit the articulation of viewpoints to very brief messages. It is difficult to distill complex ideas into a 140-character tweet.
- Earnings may grow
- Valuations may increase
- Companies may pay dividends
Considering each of these individually:
Earnings growth – more specifically earnings per share growth. If earnings don’t grow, but just stay flat, then this term of the equity return equation would be zero. Where do corporate earnings come from? They come from economic activity. Earnings growth for the market as a whole ultimately comes from economic growth. If an economy stops growing, corporate earnings also might not grow, but they could still be positive.Some market commentators have remarked that there is no correlation between stock returns and GDP growth, and they therefore conclude that they are unrelated. Figure 3 illustrates the low apparent correlation between global equity returns and GDP growth.Remember, however, that our professors in statistics classes usually went out of their way to teach us that “correlation does not equal causation.” In other words: Just because two things look related does not mean one necessarily caused the other. Similarly, a lack of apparent correlation does not necessarily mean a lackof causation. Many other factors could also be at play that cause direct correlations to appear to break down.So how do corporate profits relate to the growth of an economy? The income approach to measuring economic activity helps demonstrate the important linkage between economic activity and corporate profits (note: I use National Income here rather than GDP because it more directly illustrates the fundamental linkage between corporate profits and economic activity):National Income = Labor Income + Corporate Profits + Rental Income + Interest IncomeObviously in a global economy this relationship is more complex. For example, large U.S. multinationals have been growing their earnings faster than the U.S. economy by selling products and services globally and tapping into higher growth markets. And indeed some industries are countercyclical. But the basic relationship between economic activity and corporate profits has to be correct. There is a linkage even if not strongly correlated in the short term.The denominator of earnings-per-share (EPS), or share count, complicates the issue. Share issuances hurt EPS growth by diluting earnings. Conversely, share buybacks help. Some commentators have noted that increased share issuance has been a key driver that has broken down the correlation between economic growth and equity returns. Unfortunately those breakdowns usually mean equity returns have been lower than economic growth would have suggested because firms have issued shares more quickly, diluting existing stockholders. Exports and share issuance and buybacks may complicate the direct relationship between economic activity and corporate profits, but the fundamental linkage between the two is irrefutable.Note that corporate profits have increased over the past several decades in part because corporate taxes as a share of GDP have fallen over time and the share of National Income that has accrued to labor has also fallen. Going back to the equation that defines National Income: If National Income grows modestly and Labor Income grows even more slowly, it is likely that Corporate Income will grow more quickly to balance the equation. We believe that there will be an easing of these tailwinds that have helped drive corporate profit growth so quickly over the past few decades. There are limits to how low corporate taxes and labor’s share of National Income can go. If we are right, that suggests future equity returns, driven by corporate profit growth, are unlikely to be as strong as in the past.
- Valuations – P/E multiples can expand. As fear decreases and confidence increases investors are often willing to pay more for the same dollar of earnings. Hence even if earnings are flat stocks still have the potential to generate positive returns by people paying more for the same earnings. There are many measurements of earnings – last twelve months, forward twelve months, cyclically adjusted. Each has advantages and disadvantages. Overall valuations of stocks seem reasonable at today’s level in a historical context with a developed market P/E of 14 times and emerging markets at 12 times (measured by the S&P 500 and the MSCI Emerging Market index, respectively). We aren’t forecasting strong P/E expansion from here, though if left tail risks are reduced, it is certainly possible.
- Dividends. Even if an economy were to stop growing, corporate profits were to stop growing and P/Es were to remain flat, stocks still have the potential to generate a positive return by paying dividends. Hence economic growth is not a hard ceiling on stock returns, but again the overall linkage between economic activity and corporate profits and dividends is clear. Economies that grow more quickly fuel corporate earnings that can then grow more quickly. Corporations that experience sustained growth and strong cash generation are more likely to pay and increase their dividends. In past decades when economic growth has been slower, dividends have been a larger share of equity returns than capital appreciation. Figure 6 shows equity returns by decade, broken out by capital appreciation and dividends. One can see in the slow growth 1970s dividends were a larger share of total equity returns. Given our New Normal outlook of continued sluggish economic growth, we believe investors should focus on companies with a strong ability to pay and grow their dividends.
- Active management becomes increasingly important. If we believed the equity market would provide very strong growth, then we’d believe the cheapest passive exposure to stocks would likely be enough. Unfortunately we don’t think that’s the case, so alpha generation or selecting stocks that can outperform the market as a whole, is essential to meeting overall return objectives.
- Look to companies that can grow faster than the market as a whole. Where a company is headquartered is not nearly as important as where it does business. The best way for a company to overcome the constraints of a slow domestic economy is to sell into higher growth economies. Sometimes companies headquartered in higher growth economies are best positioned to capitalize on them. Sometimes large multinationals are better equipped to take advantage of those growing markets. We believe investors should consider an unconstrained approach that allows investors to concentrate in the best companies, wherever they may be domiciled. In addition, some companies are able to out-compete entrenched players and take market share.
- Don’t overpay for companies. Look to well-run companies that sell into higher growth markets, but of course it doesn’t make sense to pay too high a price for them. We believe focusing on quality is a smart investment strategy, especially in a low growth environment with ever-present macro risks. But we believe a prudent investment approach should be anchored in a rigorous valuation framework. Sometimes buying a somewhat lower quality company at a steep discount makes more sense than overpaying for the highest quality company.
- Actively manage downside risk. This is a constant refrain of my colleagues and me at PIMCO. In the next six months there are several major policy drivers that each individually could overwhelm market fundamentals: the ECB’s actions to stabilize the eurozone, the U.S. Presidential election and the U.S. Fiscal Cliff. While we believe policymakers are well-intentioned and our base case scenario avoids left tails in the near future, political factors could constrain policymakers. We believe hedging against extreme downside risks is prudent, even if it means giving up a little on the upside.
And yet the same hyperbolic polarization that we are seeing in our politics continues to extend to other subjects important to our lives. You may be wondering what the title of this piece, “The Cure for Baldness” has to do with equity investing. I must confess: nothing at all. I wanted a headline that would capture attention, and I know I have a lot of company among the fellow follically challenged in the investment industry.
Hyperbolic polarization during a Presidential election cycle shouldn’t be unexpected, and since we each only get one vote, for one candidate or the other, it really is all or nothing. Fortunately investing isn’t all or nothing. We can allocate to individual companies that we believe are positioned to grow faster than the market and those that we believe will be more resilient against market shocks. Given how hard people work over many years to save for their future and for their families, we believe it is worthwhile to take time to craft an investment strategy that can withstand a range of market outcomes. Reports of the death of smart investing have been greatly exaggerated (and the cure for baldness is right around the corner).