David Nelson

David Nelson

The past decade has been brutal on value investors. If we simply look at the broad S&P1500 Growth and S&P1500 Value indexes, growth stocks have nearly doubled the returns of value stocks. Some see this as irrational, but the truth is this outperformance has largely been justified by earnings growth.

Lately though, over the last 6-12 months as the economy has started recovering from the pandemic, we have seen value stocks outperforming growth stocks pretty consistently. Many see this as a short-term reversal in an ongoing trend. Maybe it is just that value stocks fell further and then got a bigger bump as things recovered. They might argue that tech will continue to dominate as more so-called old-school industries get disrupted.

While we don’t know what the future looks like, we do know that fundamentals matter. Lately the fundamentals have been painting a picture that show it might be possible for the outperformance of value stocks to continue. To gain some insight into this it is worth understanding how earnings and valuations work together to explain stock price movements.

When we look in the rearview mirror and see what a stock or group of stocks has returned for a given period of time, we can deconstruct that return into three basic components. There is a little math involved, but it helps in understanding these dynamics.

The first part of the return comes from the cash flow of an investment, or its yield. That makes sense as whatever else happens, cash received will always factor into your investment performance. When analyzing stocks, we generally take this to be the earnings yield. Even though not all earnings are paid out to investors, the amounts not paid out get reinvested into the business.

The next component of the return is the growth of cash flows (i.e., earnings growth for stocks). This is also pretty intuitive. If my investment pays more after owning it a year than it did initially, that increased cash flow improves returns.

The last component of the return is the change in valuation. This component, unlike the others, is not cut and dry. Cash flows are easy to measure, but valuation change represents the gain or loss in excess of the underlying cash flow growth and are subject to the whims of investors.

Let’s put this together in a simple example (this does not represent any real investment): I purchase something for $10,000 that pays me $500 each year, which would be a 5% yield. The next year cash flows improve, and it now pays $550. This change represents a 10% growth in cash flows. Because of the attractive growth, someone is willing to buy the investment for $12,000. The original valuation of my investment was 20 times cash flow ($10,000 divided by $500). The new valuation of my investment is 21.8 times cash flow ($12,000 divided by $550). This represents a 9% increase in valuation and brings my total return to 24% (5% yield, 10% growth, and 9% valuation increase).

Growth companies and tech in particular have benefited from both strong earnings growth during the pandemic as well as valuation increases (investors paying more for the cash flows). However, with the boom in earnings they have seen, continuing to grow these year over year is a tall order.

On the other hand, many cyclical stocks have seen their earnings fall, in some cases a great deal over the last year. As the economy gets back to normal even modest earnings from those companies could result in large year-over-year growth.

So, while the rally we have seen in cyclical stocks may initially have been in response to their prices falling further and having cheaper valuations, going forward it looks like there could be a lot of runway for returns to be driven by earnings growth. Standard & Poor’s data show analyst earnings expectations over the next two years call for much higher earnings growth in value focused sectors than in growth focused sectors. Of course, investor sentiment could still cause valuation changes to be the dominant force on returns, whether that is for good or for bad. Always mind your risks.

Sources: All earnings and index level data from Standard & Poor’s. Calculations by NelsonCorp Wealth Management.

Disclosure:  Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including loss of principal.  Indices mentioned are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. Examples are hypothetical and for illustrative purposes only. The rates of return do not represent any actual investment and cannot be guaranteed.

David Nelson is the president and CEO of NelsonCorp Wealth Management.

David M. Nelson is the president and CEO of NelsonCorp Wealth Management.

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