My interest in equities has not abated. When I first wrote this column in mid-January 2016, equities were swooning, the S&P 500 was down almost 8% from the start of the year, and prognosticators of every stripe were forecasting dark days for both the US economy and for global stock markets. Fast forward three months and the storm clouds have lifted, the S&P 500 is now up 1.4% (almost 2% with dividends reinvested) for the year. Emerging markets have rallied even more sharply: they were down over 10% in mid-January, and are now up over 4% year to date.
Exhibit 1: After a difficult first six weeks in 2016, the S&P 500 index is now (as of 04/04/16) up 1.4% on a total return basis in 2016 year-to-date.
Source: Bloomberg, as at 4 April 2016.
High frequency economic data seems more robust too: the Philadelphia Fed’s Aruoba-Diebold-Scotti business conditions index, which hit a short term low of -0.207 on February 22, has recovered to -0.1 (0 denotes an average level of expansion), suggesting that the economy, while expanding slightly slower than average, is nowhere near contracting. By way of comparison, the index dropped below -4 in early 2009, very close to its all-time low of -4.52 in December 1974.
With this renewed vigour as backdrop, what do equity investors have to concern themselves with? In my last column, I pointed out that anaemic earnings growth in Europe and earnings dilution in emerging markets (EM) were key concerns, and given the number of questions I received about earnings dilution and its implications for prospective equity returns, I felt a deeper dive into this murky topic was warranted.
Macro economists concern themselves with aggregate corporate earnings, but to equity investors, per-share earnings matter more. A share of stock represents a claim against a company’s residual income, or the income after all senior claimants have been paid, and if a company issues new shares, the slice of the residual income that accrues to each share declines proportionately. It can be shown that corporate profitability (as measured by return on equity, or ROE), per-share earnings growth (denoted g) and dividend payout ratio (denoted p) are linked by the following equation:
G = ROE x (1-p)
A company that does not wish to dilute existing shareholders must be sufficiently profitable to allow it to finance the investments it needs to support its growth from its earnings, and to still have some profit left over for dividends. But if a company is insufficiently profitable, and cannot make the required investments even after eliminating its dividend, it has no option but to raise additional capital in the capital markets, diluting its existing shareholders and lowering its rate of per-share earnings growth. Exhibit 1 shows that since 1925, the per-share earnings of the S&P 500 have grown more slowly than GDP by 1.2% per annum (the gap in growth bottomed out in 1991), faster than inflation by about 2% per annum, and approximately in line with per-share revenues (though we have data on per-share revenues only going back to 1946). Rob Arnott and William Bernstein were perhaps the first to point this out in an article that appeared in the Financial Analysts Journal in 2004, but the effect seems surprisingly poorly known and understood even today.
Exhibit 1: The evolution of earnings relative to consumer prices, GDP and revenues in the US
Source: S&P, BEA, as at 4 April 2016.
We have much less data on emerging markets, but MSCI data shows that EM GDP (measured in USD) is over 5 times as large as it was in 1994, while the per-share earnings of the MSCI Emerging Markets index have less than tripled, suggesting earnings dilution of over 3% per annum over this period. We believe this issue will finally resolve itself when companies serving emerging markets focus not on gaining market share at any cost, but on earning their cost of capital, and on financing their expansion internally. And to repeat what I said in January, emerging market stocks are selling at attractive valuations even after their recent surge, and will likely be included in a well- diversified institutional portfolio.
This article was written on 4 April 2016 in New York City.