Fundamentals and Price, Five Years

Too much time is spent talking about price. Fundamentals are ultimately what drive equity prices higher over time. To say this another way, a company’s stock price can’t continue to rise unless it continues to be successful. The famous quote by Warren Buffett is, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” He also said, “Price is what you pay; value is what you get.” I prefer the second phrase.

I wanted to spend some time breaking down what this means and what it’s looked like over the past five years. Where have prices gone relative to earnings globally and in each country, sector and industry? Where was it heading into Covid vs today? Where have there been multiple expansions not supported by earnings, and even worse, where has there been no earnings growth?

All figures quoted below are based on the past five years.

EPS – earnings per share
Five years ago, the small-cap index Russell 2000 had a PE of 19.1. Today the PE is 19.6, so the multiple has stayed the same. At the same time, the value of that index has increased by 50%.

You buy a share of a company because you ultimately want a share of its earnings, and the value of that company must be based on the present value of future cash flows. One way to return that value is for the company to buy back shares, decreasing the overall supply of shares and increasing the proportion of the earnings represented by your shares. Buybacks increase EPS. Another way to increase earnings is to reinvest profits into the company to generate more opportunities, resulting in overall earnings growth.

EPS, earnings per share, for the Russell 2000 has increased 50% over the past five years, explaining all of the returns for shareholders over that period.

World

The most comprehensive ETF is VT, the Vanguard World Market Cap Weighted ETF, with roughly 9,700 companies including the S&P 500.
Over the past five years:

• VT (World) price increased by +53%. Half of that was due to multiple expansion of the PE from 15.2 to 17.7 and the other half was EPS increasing from $4.85 to $6.38.
• VXUS (World Excluding US) increased by +19.5%, with the PE increasing from 13 to 13.3 and EPS grew from $3.9 to $4.5. Most of the modest return came from a 15% increase in the EPS.
  It’s no surprise that global earnings growth has been muted for five years with the US as the one exception. This has been thoroughly covered in the news.

Country Specific

• SPY (S&P 500) increased by +85.22%. Half of that is explained by the PE increasing from 17.3 to 21.6 and the other half is credited to EPS increasing from $16.9 to $25.
• QQQ (Nasdaq) increased an outstanding +144.21%. The PE increased from 21.9 to 26.2 and EPS grew from $8.55 to $17.4. Historically the Nasdaq hit its dot com peak in March 2000, with a PE of 52 and an EPS of $1.77. The bottom was October 2002 with the price down -83%, the PE down -60% to 20.7 and EPS down -50% to $0.82. I mention this because the Nasdaq was the original tech index 25 years ago and it still is considered a tech index today, but today its earnings are globally dominant and its PE is not all that different today from the bottom of the dot com crash.
• VWO (Emerging Markets) from five years ago increased just +7%. The PE increased 12.1 to 13.2 but the EPS still dropped -2% from $3.35 to $3.29. If you’re wondering why the emerging markets stocks haven’t been doing well, it’s because of the lack of earnings growth.
• EWJ (Japan) and VGK (Europe) performed about the same with an average price increase of 28%, PE increase of +4% and an EPS increase of +22.8%.
• EWC (Canada) increased +36% with a PE increase of 10% and EPS from $2.07 to $2.57.
• EWW (Mexico) and EWZ (Brazil) had some of the worst multiple compression with PEs falling from the 12’s to the 7’s. Mexico managed to still eek out a 35% return thanks to a +125% increase in earnings. Brazil’s return is still negative due to lack of earnings growth with the EPS basically unchanged at +10%.

Sectors and Industries
For the US, here are some notable stats among the 11 sectors and 20 industries:

• XLK (US Tech) has had the best sector price performance at 165%. The PE multiple expansion is interestingly not as healthy as the QQQs, with a +40% increase in PE from 20 to 27.7 and a very strong EPS increase of +91% from $3.95 to $7.57. While the tech sector’s PE is high, it’s not anywhere near the dotcom QQQ PE peak of 52. Fortunately, the returns have been supported by very strong earnings growth. Anyone who has been reading this blog for many years knows our stance on this. We’ve been heavily focused on tech as the dominant driver of returns and have been invested accordingly. This isn’t a novel idea because it’s also been the primary driver of returns for the past twenty years. The exponential equity growth has been supported by tremendous growth in fundamentals. Today the difference in returns is too dramatic to ignore and this has basically become consensus, with multiple FANG valuations measured in the trillions.
• XLE (Energy) is deeply unpopular due to climate initiatives. This is reflected in the persistently lower PEs down from 14.9 to 13.1. The notable element is the +75% increase in EPS from $4.05 to $7.08. The earnings increase is reflected in the price which is up +53.68% due entirely to earnings growth. It has the 2nd highest EPS growth of any sector (excluding Communications which includes Google and Meta which used to be in the tech index, and I don’t feel they are reflective of the comm sector). XLE has the lowest PE of the 11 sectors and many energy investors call this their advantage, which from an earnings and entry point perspective it is an advantage.
• IBB (Biotech) has had a really tough time with a -68% collapse of the EPS from $1.71 to $0.53. The ETF price is still up 40% but that’s reflective of the PE increasing from 61 to 274. In other words, it’s not driven by earnings. Biotech represents a nearly unlimited horizon of future human and health potential. Hopefully this marks the bottom of what’s been an incredibly challenging period.
• SMH (Semiconductor) are the obvious winners but they are not alone!! This is where I think the details start to get more interesting. First the numbers on semis:
  • SMH semiconductors are the heart of AI and have had all of the attention. The price is up +305% over the past 5 years with the PE up +47% from 17.3 to 25.6 and EPS up a whopping +174% from $3.27 to $8.96. I called out some of the potentially best performing AI assets NVDA, TSM and AMSL in my five trends that will shape the next five years article. ChatGPT came out two years later in Nov 2022 and kicked this trend into warp speed. Here’s what I wrote in Sept 2020:
    “Artificial intelligence to GPUs to semiconductors to EUV machines. Why is it important? Driverless cars, automatic fraud detection, improved search results, marketing analytics, HR analytics, more sophisticated video games, superior weather predictions, etc. require us to continue to push the boundaries of artificial intelligence and machine learning. That computing relies on the public cloud, state of the art software, and sophisticated GPUs (graphical processing units). The supply chain that makes AI possible includes some of the world’s best innovators. NVidia produces GPUs with semiconductors from TSMC built with breakthrough EUV machines by ASML. There are many ways to invest in the future of AI. The total addressable market for next-gen artificial intelligence is still in its formation stage.”
• OIH (Oil Services) and XOP (Oil & Gas) have had similar experiences as their sector ETF XLE. Multiples have compressed, weighing on returns. OIH’s EPS rose +317% from $5.54 to $23.17, but the PE fell -70% from 46.8 to 14.3, keeping the performance compressed at just +27.67%. XOP’s EPS rose +103.7% from $6.72 to $13.69, but the PE fell from 13.8 to 10.6, also compressing the return to just +56.47%. Same comments as before, the energy investors own highly profitable assets at low multiples, which is an advantage.
• IAK (Insurance) has been a steady business. The large insurance companies are run by actuaries who statistically position themselves to always win. They have had virtually no multiple change with the PE increasing from 11.8 to 12.3 and EPS increased 66.09% resulting in a +73.12% gain. In the game of life, they are the house.
• TAN (Solar) has done OK but vastly underperformed many people’s hopes and expectations at +34%. The attribution is roughly split with a +14% increase in the multiple from 17.7 PE to 20.2 and EPS from $1.71 to $2.02. While solar represents energy, the metrics could not be more different from the profitability increases in oil and gas.
• PHO (Water) and XME (Metals & Mining) have had above average performance mostly thanks to earnings growth. I’m less familiar with the details of these sectors but people have been discussing water as an investment thesis since I graduated from high school. As critical as water is for sustaining life and metals and minings for everything we do and use, there have to be other regulatory factors involved that I have yet to dive into. MOO (Agriculture) has not done as well as water in both earnings and price, for what it’s worth. I didn’t write the numbers in but the EPS growth is in the 90%’s and price return is slightly higher while multiples haven’t moved much.
• ITB (Housing) I left for last because I find it the most interesting sector. We have a persistent housing shortage in the US and the EPS for ITB has grown at nearly the same rate as the semiconductor industry $3.22 to $8.58 with little PE growth from 12.1 to 14.1, representing a +166% earnings gain and a +210% price return. I think the core question here is will the earnings growth in the housing construction industry continue as long as the housing shortage persists? Given that this has the highest earnings growth, comparable only to semiconductors and 2nd to the oil and gas anomalies, this is an area to keep an eye on and a longer term thesis to consider. I may cover this more in a future article.

This has been a longer and more technical review than normal. Many years ago, we highlighted US tech as the dominant opportunity and fortunately that’s been largely correct. While I believe the AI trend continues to push earnings growth forward, the higher the PEs rise, the less safety there is in the theme overall. Fortunately the earnings growth has supported this trend up through to today. The strong majority of international markets have had a very tough time generating positive earnings growth. I’m not sure when that changes but the trend has not been friendly.

We’ve been writing about private markets for the last few years because it’s clear that the diversification value is there in ways the public markets can’t provide. As markets continue to concentrate more on mega-cap FANG stocks, the need to diversify elsewhere increases.