Stock markets have rallied this year. Outside the US, the rally has been driven almost entirely by investors getting less anxious: valuations have gone up, despite widespread disappointment among analysts. Most companies have missed earnings per share (EPS) and sales forecasts – although the US has had the additional kicker of tax reform boosting after-tax profits. 
This has made for an interesting set-up for investor and analyst views now, a little more than halfway through 2019. Stocks have gone up over the first seven months of the year, while expectations for EPS and sales have come down.
Most commentators seem nervous about the future. There is an acceptance the trade war is here to stay. Central bankers have shifted back to worrying about economic growth far more than inflation. Bond yields and interest rates have fallen. Expectations for sales growth have continued to drift lower, especially in the US.
However, the belief in the ability of corporate profit margins to rise appears undiminished. In every region, expectations for EPS growth run well ahead of sales growth. Only in emerging markets is the ratio less than two.
Beneath the averages, some stocks have moved more than others. Stocks with high growth expectations have continued to perform well, especially in the US. They have generally got more expensive, but they have also managed the rare feat of growing surprisingly – rather than disappointingly – fast, at a time when disappointments have generally dominated.
Riskier stocks – those that are more volatile or harder to predict – have also performed well. These stocks have achieved this despite generally missing forecasts. As a result, many are considerably more expensive than at the start of the year. Lower risk, or more defensive stocks, have also generally gone up, but valuations have, by and large, gone up less than ‘growth’ or ‘value’ stocks.
Meanwhile, by the looks of management behaviour, life is getting tougher. Profitability has generally been under pressure everywhere. Most businesses are still struggling to hit EPS and sales forecasts. Debt looks like it is rising everywhere except Japan. In Japan and emerging markets, cash flow is under pressure from unhelpful shifts in working capital – normally a sign of stress in the supply chain.
Our conclusion is simple. Stocks which have rallied on the hope of improving fundamentals, especially improving profit margins, look vulnerable. There seems to be an embedded assumption profit margins will relentlessly rise, when all current trends suggest they are more likely to fall.
Many of the stocks most exposed sit on valuations inflated this year by hopes of recovery. They may be ‘cheaper’ than faster-growing companies – which have more control over the path of margins – but they are a lot more expensive than they were at the start of 2019.
Dependable, slower growing, but more predictable, stocks have done ok this year, but have had to rely much less on rising valuations to achieve stock price rises.
As a result, we have wound back our exposure to what we call ‘investor bias’ stocks. These typically either sell on lower than average valuations or have experienced relatively poor price performance over the last year.
We have shifted into stocks with higher and more predictable growth. These companies have more control over margins, expectations look realistic and valuations have not moved much. This seems to be the opposite of current prevailing wisdom.
There seems to be this odd perception ‘value’ is the place to be at the moment and good quality, predictable, stocks are dangerously expensive. What is dangerous, in our view, is a belief that companies without much sales growth can grow EPS by improving profit margins over the next couple of years.
Jeremy Lang is partner and co-founder of Ardevora Asset Management. The views expressed above are his own and should not be taken as investment advice.