Global equities have continued to rise strongly this year with YTD returns pencilled in at 13.47%*. Using the Enterprise Value/Cashflow (EV/CF) multiple, global equities have not been this highly valued since the dot-com boom in the early 2000s. Furthermore, as Chart 1 shows this is no longer just the case in the US, as European equities are now almost as highly valued.
CHART 1 : Valuation multiple (EV/CF) of US equities vERSUs Europe equities
*Source: MSCI World, Datastream, data as at 31.08.2017 and in USD. Equity indices quoted on the basis of net dividend reinvested.
Why do we use EV/CF as a valuation multiple as opposed to the more universal Price Earnings (PE) ratio? In short, because we think the reliance of PE on the income statement provides only one side of the story, and earnings are one of the easiest figures to massage through creative accounting, buybacks, and capital structure. In our view, using an enterprise-based and cash flow approach provides a fuller picture.
A 'two-speed' equity market
As Chart 2 shows, 'high growth' stocks have driven this year's equity rally, especially those in the technology space. Meanwhile, ‘steady growth (compounders)’ - what we call defensive stocks - have underperformed.
Chart 2: Relative performance of US steady growth vs. US high growth equities
2017 YTD
Source: MSCI World, Datastream, data as at 31.08.2017 and in USD. Equity indices quoted on the basis of net dividend reinvested.
Steady growth stocks are therefore trading at a widening discount to high growth. Indeed, Chart 3 shows that using our favoured EV/CF valuation multiple they are at a discount to high growth stocks in the US market not seen since the build-up to the dot-com boom.
Chart 3: valuation multiples (EV/CF) of high growth stocks versus steady growth stocks in the us
1997 to 2017
Source: MSCI World, Datastream, data as at 31.08.2017 and in USD. Equity indices quoted on the basis of net dividend reinvested.
Note: we define ‘steady growth’ and ‘high growth’ companies as those ranking in the 4th and 1st quartile respectively for ‘investment growth’. We use 5 year investment growth of a company as it is a good proxy for anticipated future revenue growth.
Long-term, steady growth, defensive equities beat high growth
While the current environment is perhaps more favourable for growth strategies, long-term track records show such an environment tends to be rather short-lived. As chart 4 shows, over the longer term it is the less glamourous, lower growth, defensive US stocks that have outperformed. A similar, actually more emphatic, trend is observable within global equities over this same period. This is because, more often than not, growth stories do not translate into sustainable shareholder returns.
CHART 4: long-term performance of high growth veRSUS STEADY growth US stocks
1987-2017 YTD
Source: MSCI World, Datastream, data as at 31.08.2017 and in USD. Equity indices quoted on the basis of net dividend reinvested.
We think this calls for great caution when investing in growth stocks, especially when valuations are not supportive.
Although the aggregate market is very expensive, we continue to find interesting opportunities in defensive steady-growth stocks in our portfolios. As stated above, these have the advantage of being less expensive and we believe should outperform over the long term.
To find out more about how we manage the Pictet Global Defensive Equities strategy, read below or get in touch with your Pictet salesperson.
Reda Jürg Messikh joined Pictet Asset Management in 2007 and is Head of Quantitative Research in the Quantitative Investments team. Prior to his current position, he was Deputy Head of Risk Control in the Product and Risk Management team until 2011. Before joining Pictet, he was a researcher at the Swiss Federal Institute of Technology (EPFL) in Lausanne and at EURANDOM in Eindhoven, The Netherlands. Reda Jürg graduated with an Engineering degree in Physics from EPFL. He also holds a PhD in Mathematics and a MSc in Stochastic Modeling from the University of Paris (Orsay).
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