Markets to move sideways for many years - Allan Gray
Mahesh Cooper*|
19 October 2009
Earnings unlikely to match the price investors are prepared to pay.
The significant rise in global stock markets over the last 12 months has
resulted in many questions around whether a bull market is beginning and the
recession is behind us. The fact that, over the last year, developed markets are
up 24% in US dollars and emerging markets up over 60% in US dollars may lead to
this conclusion.
Despite the considerable gains by stock markets around the world, most markets
are still some 30% off their highs experienced in late 2007/early 2008. During
this period, companies around the world experienced a collapse in earnings due
to a combination of factors including falling consumer spending, commodity
prices and asset prices.
The recent rise in stock markets appears to imply a strong recovery in earnings
is ahead. The big question is whether these earnings will materialise and if
they do, to what extent?
If one looks at the technology bubble in 1999, investors were prepared to bid up
prices of IT stocks to extraordinarily high levels despite these companies
making little or no profits. This was based in anticipation of future earnings
as a result of expected growth in demand for information technology. The
correction that followed is well documented, with many IT stock prices falling
over 80% when earnings simply failed to materialise and business models were
proven to be unsustainable.
Looking back at those companies that did actually survive the tech bubble, like
Microsoft, it's clear that the scope to grow their earnings was there but the
price that investors were prepared to pay in 1999 was just too high. Microsoft
was trading at a PE of 70 in 1999. This meant that post the crash many of
these IT stock prices went nowhere for close to six years despite the subsequent
growth in earnings.
For example, the current PE of Microsoft is now around 14x and reflects the
company's earnings growth without resulting in share price appreciation, as the
good news had been priced into the stock well in advance.
This brings us to the current environment and the extent to which people are
presently pricing in earnings growth of the average company. Ideally you don't
want invest when good news is already reflected in the share price. It would be
even more foolish to overpay for potential good news that might not materialise.
It is important to look at the long term, sustainable earning prospects of a
company when assessing what its intrinsic value is while not overpaying for this
potential future earnings stream.
With the current low levels of companies' earnings relative to their share
prices, investors are obviously pricing in a distinct level of earnings growth
going forward. Investors often tend to think of stock markets as either rising
in anticipation of improving prospects and earnings, or falling, when they
expect a poor near-term outlook for company profits.
Given the recent sharp rise in stock market prices, we would not be surprised to
see company earnings taking much longer to meet the levels that are being
inferred by current share prices.
*Mahesh Cooper is head of Orbis Servicing in South Africa and a director of
Allan Gray.