Mega-cap equities still priced to outperform bonds

Author: Alastair George

A decade after the severe market downturn of 2009 there remains a minority but vocal view within the investment community that the global expansion since the financial crisis has been built on poor foundations. The economic edifice is said to be at risk of crumbling, once the ineffectiveness of monetary policy in continuing the expansion has been demonstrated. Empirically, the steady declines in global government bond yields and absence of inflationary pressure in this cycle prevents this thesis being dismissed out of hand. However, this also deflects attention from an important source of returns for investors. It appears the largest global companies continue to operate in a benign environment, with strong profitability and growth expectations which, if fulfilled, suggest a wide performance advantage over very low government bond yields over the medium-term.

Oft-repeated mantras in investment are in many cases an enemy of considered judgement. One particular mantra in this cycle has been idea that equities are overvalued and were it not for central bank support markets would surely collapse, along with corporate profits. It has been an expensive view to put into practice from an opportunity cost perspective as not only have markets continued to rise during an exceptionally long US economic expansion but the largest companies within the corporate sector globally have delivered double-digit returns on equity and significant profits growth over the same period.

Furthermore, central banks have demonstrated little appetite for stepping back from market and economic intervention preferring a policy of reacting proactively to any perceived or actual slowdown in growth. Nevertheless, at times during this cycle we have been cautious on equities. We sensed opportunities to lower equity allocations ahead of times of risk aversion – such as 2015/16 or earlier this year – but it has been essential for portfolio performance to regain equity exposure before sentiment turns. Most recently, since September there has been a significant rally in global risk assets as investors once again give central banks the benefit of the doubt as policy is eased during 2019.

The US stock market in particular has defied all pessimistic prognoses, being at the epicentre of “bad” reasons for going up (Fed QE) and “good” reasons for rising, such as the incredible growth of corporate profits and the lucrative maturation of the US technology sector. Wage growth has remained muted, easing pressure on profit margins while demand has recovered. Industry consolidation and the natural quasi-monopolies prevalent in “Big Tech” business models have supported profit margins. There has also not been any evidence of mean reversion in profitability to date. Furthermore, the determined re-investment of strong operating cashflows into maintaining and enhancing US and China’s technology franchises has thus far been highly value accretive.

Exhibit 1: Profits forecast downgrades have been prevalent for most of 2019

Given the global nature of the very largest businesses, dropping the traditional division of the corporate sector along national lines makes sense if we wish to assess just the very largest of the world’s organisations by market value. For example, within a group of the largest 600 companies worldwide we find that profits growth for 2020 of close to 10% exceeds the median profits growth forecast for developed markets of just 8%. Furthermore, a free cash flow yield of 4% which is stated after-tax and after growth capex does not appear overly demanding from a valuation perspective in the context of sub-2% 10y bond yields in all major developed market regions at the present time.

Taken as group, the world’s largest 600 companies are expected to generate a median return on equity of 16%, a level which has been consistently recorded over the past 5 years. This group has also demonstrated greater earnings forecast resilience, as 2019 forecasts amongst this group of companies have dropped by only 6% over the prior 12 months, compared to 11% for developed markets as a whole.

Given the above-average corporate performance of this group, we do not believe a median P/E ratio of 17x appears especially demanding. The price to book multiple of 2.5x seems justified to a large degree by the 16% expected ROE. In addition, the largest companies offer the greatest level of liquidity and in general better corporate governance than smaller peers. The benefits of scale global franchises should be clear – yet these stocks do not appear to be valued at a premium at this point.

We continue to believe that despite the unresolved political risks of Brexit and US/China trade, politicians are stumbling towards conclusions which lower uncertainty and risk premia. The greatest risk of the dominance of these political narratives in the media is in our view the distraction of investors from the strength of corporate profitability and profits growth among the largest global companies. While populist movements may eventually impact profitability, the power of the largest companies to shape their own environment should equally not in our view be underestimated.

In the context of very low government bond yields, we believe the total expected return on this large-cap cohort of the stock market which represents 2/3rds of global market value is sufficient reason to remain at least neutral on the outlook for global equities for the medium term. To become more positive for the short-term we would prefer to see some stability in profits forecasts for the markets as a whole, given the recent strong performance of equities. However, for the medium-term even given the extraordinary length of this business cycle equity investors who have the capacity to take the attendant risks may in our view outperform bond investors over the medium-term given starting valuations, the quality of the business franchises of the leading global firms and in particular very low yields current yields of government bonds.

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