Inflation and interest rates go up, while ratings on stocks come down. How many times have we said that a stock is now selling at its lowest rating in 40 years? And then it goes lower.
This is the first bear market since 1973 which has been driven by a re-rating. Not an earnings collapse, not spontaneous illiquidity and not waves of bankruptcies. Our fund has had an average price-to-earnings ratio (P/E) of 15x trailing earnings since 2010. Now it is at 6.4x, with the same sort of stocks. Funnily enough, we also appear in the top quartile for financial strength (source: Morningstar). How is this even possible?
After 40 years of declining interest rates and rising P/Es, it has been a shock to consider stocks on a generic rather than specific basis. For all those extolling the wonders of an inventive new company, it must be disappointing to learn the wondrousness really doesn’t matter anymore.
If P/Es are going down, the safer place is lower P/E stocks as the re-rating arithmetic hurts them less. The additional trick is to head for shorter time horizons, or durations, because then we bag those earnings quicker. For 40 years the play was to go longer. By the late 1990s we started focusing on earnings before interest, taxes, depreciation and amortisation (EBITDA), rather than earnings per share (EPS).
When Amazon came along, we stopped caring about earnings at all. The rewards for holding shares were kicked ever further into the future until finally even revenues were a distant prospect for Tesla as it boomed to a trillion-dollar valuation in 2021. This was all a long way from 1976 when Chancellor Denis Healey reminded us that the only value of a stock was the discounted sum of its prospective dividends.
As we reverse back towards greater uncertainty and greater rates of discounting, we can either gently remember EBITDA or cut to the chase and look at the flood of short-duration earnings that can now repay an entire market cap in just a few years.
We may, given our fear of recession, seek strong stocks which can get round the U-bend and still be with us on the other side. We can also see this in stocks with short durations because the rapid payout of a cash gusher will overwhelm indebtedness on the way. The company can be strong despite prior errant overspend.
Where are the gushers? Does this have to be all about energy and fertiliser, which stand at a junction of war and politics, making reinvesting their vast profits problematic even if they did seek to defer rewarding the shareholders?
Surprisingly, they’re in many other cyclical places. By all means hold energy on 4x cashflow, pledging to give it all to shareholders through buybacks and dividends, but also consider the booming consumer stocks on 4x earnings. They don’t have to keep it up for long before we get the investment back there as well.
By bringing in short duration, we can get quality and low P/E. This triangulation is working and we are getting valuations we haven’t seen for years. How low can it all go? The 1974 low for BP was 2.5x trailing and a 14% yield, which means energy today is great value relative to technology if that’s where we’re going.
If you think this analogy with the 1970s and 40-year cycles is simplistic and wrong, and if you think that demographics and technology will soon return us to the deflationary trail, you may wish to ignore this article.
However, for us to come unstuck with P/Es at this level and four-year paybacks, consider how much peace and decorum must be reinstated, how severe a recession will be required to smash consumer spending and commodity prices, and how transient inflation needs to be to restore confidence in longer duration. Triangulating in that short duration does seem for us to be the lower risk set-up, and since the November top, it has certainly been working.