Earnings growth is becoming a priority
Montgomery Investment Management
Over the years I have often sat alongside guests on a TV or radio panel and heard them conclude the easy gains have been made. For the first time in many years I agree.
In recent years investors have made substantial gains from equities but a close look at the driving force behind those gains is likely to reveal investors won because the tide was rising. Sure, many companies grew their earnings too but there were a huge number of companies whose share prices went parabolic despite the absence of earnings. A rising tide does indeed lift all boats, but don't mistake a rising tide for genius, or so the axiom goes.
Since 1979, without exception, every period of inflation and or rising interest rates, was accompanied by a contraction in price to earnings (PE) ratios. And using data back to the 1980s, we find the decline in the earnings multiple is greatest when interest rates move up from lower starting levels, just as we are witnessing now. For the last four decades, whenever inflation or interest rates have risen, the multiple of earnings investors have been willing to pay for a share in a company has declined. In every one of the seven phases when US 2-Year Treasury yields rose between 1980 and today, the US S&P500 12-month forward PE Ratio declined.
In other words, if Jerome Powell and his team at the US Federal Reserve continue on the path articulated in our blog post The End of Zero, investors can kiss goodbye the easy wins resulting from shares simply becoming more popular, and that rising popularity being reflected in ever expanding PE multiples.
I will go so far as to suggest we are, right now, in a period of adjustments to a regime of lower PEs. Plenty of investors haven't yet worked that out and this can be seen in the steep gains for almost all equities amid the hope and talk of peace in Ukraine.
Fundamentally however, rates are rising. And while I think rates will rise by less than the most bearish forecasts, the impact on PEs is already underway.
Investors should now be looking at the quality of their portfolios and seek at least some exposure to high quality growth.
If a company, with earnings of $10 per share, sees its PE of 35 times fall to 25 times, the share price will decline 28 per cent, from $350 down to $250. Plenty of high-quality growth companies have experienced this, and worse. And that represents a new opportunity.
In an environment of high short-term inflation expectations history tells us not to expect expanding PEs. If the best we can hope for is PEs remain static, the way to generate capital growth will be from earnings growth.
If the PE ratio for our hypothetical company stays at 25 times earnings, the share price will return to $350 provided earnings grow 40 per cent to $14 per share (E$14 x PE25 = Px$350).
The work investors need to undertake now is to uncover those companies able to grow. One place to look is among those companies enjoying structural or megatrend tailwinds. And if among those companies you also find a capital light and highly profitable business with net cash on the balance sheet, more power to you.
Avoid capital intensive, low growth, mature, cyclical, geared businesses, or those with lumpy contract-type revenues, and those exposed to discretionary spending (unless they are on a store roll-out tear) and those companies playing in the revolving door of capital - paying out cash, they need later, as dividends today and subsequently raising dilutive capital to replace it.
In the next period investors will be wise owning businesses selling products and services with inelastic demand and the recipients of non-discretionary spending. Think of Microsoft - nobody is going to cut their subscription to Microsoft Office just because Jerome Powell said interest rates are going up, or because Putin decides to invade Ukraine.
Inelastic services like Microsoft Office are entrenched in the daily systems of hundreds of millions of businesses and individuals. That durability provides Microsoft low cyclicality, higher profitability, stable, recurring and growing cash flows and little or no need for debt.
Another company that comes to mind is held in the Polen Capital Global Growth Fund; Adobe. Adobe's Digital Media products enjoy a near monopoly and are "industry standard". Adobe creates and markets software for creative professionals and hobbyists. Its digital media segment supplies 70 per cent of revenue and 90 per cent of it is recurring. Meanwhile its SaaS based digital marketing solutions for enterprises produces 24 per cent of revenue, while Print & Publishing is two percent.
In 2011 Adobe commenced a transition to annual subscription-based sales, forever altering the company from a "boom, bust" product cycle business to a predictable, subscription-based model.
Unsurprisingly the company generates a return on invested capital of 33 per cent, a return on equity of 43 per cent, has US$1.1 billion of net cash on its balance sheet, produced earnings growth in 2021 of 23.6 per cent, free cash flow growth of 29 per cent and an operating margin of 45 per cent. They are numbers most businesses owners would be envious of.
But when Adobe recently announced it was ceasing new sales to Russia and not collecting on subscriptions there, the share plunged nearly 10 per cent. Great!
Since its share price highs last year, the shares have declined 37 per cent. Sure, the rate of growth that saw revenue of US1.6 billion in 2004 rise to US$15.8 billion in 2021 may slow but this is a structural growth story, a very high-quality company and remember, shares prices generally track earnings if the PE remains constant.
And finally, let us say interest rate rises have the desired effect of reducing inflation. Well, what follows is disinflation and in a disinflationary environment, when the economy is still growing, PEs expand again. That would be icing on the cake for investors who heed the suggestion to invest in quality growth after share prices have been slammed by contracting PEs.
Author: Roger Montgomery, Chairman and Chief Investment Officer
Funds operated by this manager:
Montgomery (Private) Fund, Montgomery Small Companies Fund, The Montgomery Fund