The importance of earnings growth

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

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

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.