Quality compounders

The importance of earnings growth

While global equities have rallied this year, the market has become increasingly concentrated. Investors have been pursuing themes and chasing shares with momentum, resulting in large stocks being the biggest gainers. We believe the market will begin focusing less on the ‘story’ component of investment cases, shifting attention back to companies’ earnings streams. After all, earnings are the key long-term driver of shareholder returns.

11 Jun 2024

5 minutes

Clyde Rossouw

This year began with an environment that looked positive for global growth. Investors pinned their hopes on three tailwinds likely to bolster equity markets in 2024: earnings, a more supportive interest rate environment and strong thematic drivers, largely focused on artificial intelligence and its impact on the investment landscape. This isn’t exactly how things have panned out.

It is no longer clear that we have unreserved interest rate support, given the market has revised its outlook for rates. The liquidity environment has become less favourable, with rates potentially higher for longer, which impacts the earnings picture. We have also seen signs of the market tempering its exuberance over AI. Investors have become more selective, which is starting to be reflected in the performance of some stocks.

Unpacking performance

If one looks below the surface and unpacks performance across different parts of the market, it is clear that large companies have delivered the bulk of the market’s returns. But when adjusted for market cap on an equal-weighted basis, the performance picture is very different. The average technology stock, for example, has only delivered a marginally positive return, much less than the reported 12%. The broader market, as measured by the MSCI All Country World Index (ACWI), was up only 2% in the first quarter. A very different story to the 8% headline figure.

Most of the returns have been driven by large stocks and those that have significant price momentum. We would caution that just because something has gone up in the short term doesn't mean that the market is necessarily right. Chasing themes can work very well, until it doesn't. The market has become increasingly concentrated, with the top seven stocks in the ACWI now comprising nearly a fifth of the total market cap.

The combined value of these stocks was $1.5 trillion 10 years ago. Today, they account for roughly $13 trillion in market cap, with almost all these stocks surpassing $1.5 trillion individually. As far as mega cap rallies go, they have been practically unparalleled in their outperformance. They have strung together a series of market-beating performances over the last 10 years, with 2022 being the single year in which they didn’t beat the index. The more investors have chased that story, the stronger the share price performance has been. We argue that this can't last forever without an underlying earnings evolution.

Earnings drive returns

Earnings growth is the primary driver of returns over time. If companies outgrow the market over time, share prices should follow. More recently, however, markets have been driven by multiple expansion – in other words, they’ve become more expensive. Companies have been rewarded for a future yet to materialise. On average, the valuation of stocks has risen faster than their fundamental value in this highly distorted market. As Figure 1 illustrates, nearly two-thirds of the MSCI ACWI’s total return of 22% has been driven by a rerating (multiple expansion) over the past 12 months. While earnings per share growth has been a solid 6% for the ACWI, it speaks to the point that the market has been more excited about themes than the actual earnings delivery.

Over the longer term, the narrative flips. Multiple expansion is a modest driver of returns, and it is earnings that accounts for the bulk of the market’s performance. This is encouraging. The Quality metrics that we pride ourselves on – which have been distinctly out of favour over the past year – remain the core drivers of stock market performance. Fundamentals are more important than short-term momentum. This has been our thinking since inception in 2007, and we haven’t ever deviated away from this philosophy.

Figure 1: Earnings growth is the primary driver of long-term shareholder returns

Figure 1: Earnings growth is the primary driver of long-term shareholder returns

Past performance is not a reliable indicator of future results, losses may be made.

Source: Ninety One, FactSet, Bloomberg, 31 March 2024, based to 100 at April 2007. Weighting based on a pooled vehicle within the strategy and is not available at the composite level. EPS based on blended 12-month forward earnings. Multiple based on 12-month forward P/E. Performance is derived from portfolio constituents through time and is based on the weighted average aggregation of EPS growth, rating change and dividend yield; hence, it does not take account of fees and trading costs and will differ from reported strategy performance.

Encouragingly, Global Franchise has historically delivered twice the earnings growth of the market since inception, across a range of environments. In more challenging times, such as COVID, these earnings have demonstrated resilience. Earnings are the engine of a decent business. For us, what’s important is that the engine is clearly not faltering, and even though growth and momentum may have driven the market on a short-term basis, the key underpin of long-term value creation remains intact.

Figure 2: Global Franchise’s earnings have compounded at twice the rate of the market, demonstrating resilience when it matters most
Forward earnings growth

Figure 2: Compounding of earnings

Past performance is not a reliable indicator of future results, losses may be made.

Source: Ninety One, Bloomberg, 31 March 2024, based to 100 at March 2019. Weighting based on a pooled vehicle within the strategy and is not available at the composite level. Compounded annual growth rate (CAGR) of earnings based on blended 12-month forward earnings.

Closing thoughts

Recent dynamics in the market have strongly favoured momentum, growth and cyclicality, proving to be a headwind for purist quality exposure. Yet fundamentals remain robust, with earnings growth intact. Proven earnings resilience is likely to become more important in a stretched near-term market with an increasingly uncertain outlook. Decent fundamentals have been the bedrock of returns over time, and not the story. We believe it’s only a matter of time before the market returns to this historical norm.

General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.

Specific risks: Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Derivatives: The use of derivatives is not intended to increase the overall level of risk. However, the use of derivatives may still lead to large changes in value and includes the potential for large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Style Bias: The use of a specific investment style or philosophy can result in particular portfolio characteristics that are different to more broadly-invested portfolios. These differences may mean that, in certain market conditions, the value of the portfolio may decrease while more broadly-invested portfolios might grow.

Authored by

Clyde Rossouw
Quality - latest insights

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