There are several ways in which we approach measuring the attractiveness of individual companies as investment opportunities including analyzing a company’s valuation, momentum and quality characteristics, Earnings Quality as well as management’s ability to create wealth for its shareholders. In order to communicate with our clients the overall attractiveness of an entire sector or index, we often aggregate data based on specific metrics in order to communicate with our clients where investment opportunities are most prevalent.
Along with aggregations of data that analyze the valuation attractiveness, market multiples such as Market Value/Invested Capital, and Economic Margins of an entire index, we also analyze imbedded sales growth expectations of companies in an index. We utilize the imbedded expectations to determine whether or not expectations for revenue growth for an individual company or an entire sector or index are likely to be met/exceeded or extremely lofty and unlikely to be reached based on the historical sales growth a company or group of companies has achieved historically.
We view the implied sales growth as the “hurdle rate” to get an idea of whether a company or index is able to deliver the growth necessary to provide an adequate return for its investors. When implied sales expectations are high (high hurdle rate) for a company or index relative to what it has delivered historically, it becomes difficult to deliver the growth required for investors to obtain a satisfactory return on their investment. On the contrary, when expectations are low (low hurdle rate) a company has a much easier time meeting the growth requirements to deliver adequate returns to its investors. In many circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued.
Aggregating this data for an entire sector or index is one way in which we determine the overall attractiveness of the “market” (S&P 500 index for this discussion) and one way that we communicate with our clients where investment opportunities are present. The chart below displays the current and historical implied sales growth expectations embedded in the market price for the S&P 500 index (industrial firms - excludes Financials and Utilities) and we compare those expectations to the sales growth these stocks have delivered over the past five years. The main point to draw from this chart is simple – the market has priced the median S&P 500 industrial company to grow its sales at around 10% over the next five years, while over the past five years these companies have grown at just over 7%. From this vantage point it looks as though the S&P 500 industrial firms are currently slightly overvalued. The index is currently within normal historical range (between +/- 1.5 std dev.) although it is approaching a bubble level valuation. Although the index does look slightly overvalued, we continue to believe that attractive investment opportunities are still available within the S&P 500 index and that exposure to the large cap segment of the market (S&P 500) should not be reduced.