Why lofty corporate profits question current market valuations

Valuation is the ultimate arbiter of the return on investment from any portfolio pick. No matter how strong the narrative, paying too much can lead to losses, while paying a lowly valuation can provide downside protection and the basis for positive long-term returns, once an asset’s true charms come to be better appreciated.

The tricky bit is which valuation metrics to use. There is no one right answer when it comes to individual stocks or for that matter entire indices and countries. Investors will be used to the nitty-gritty of stock analysis and the disciplines of price/earnings, price-to-book and dividend yield ratios, and possibly even the ruthless mathematics of a discounted cashflow (DCF) model.

These techniques are harder to apply to an entire index or country but there is another way. Market capitalisation to GDP – the aggregate value of all quoted companies relative to a country’s economic output - can be a useful rule of thumb to decide whether a market is expensive or not. And it’s very interesting right now with regards to the US and UK in particular, since both look toppy relative to their own history, unless corporate earnings prove destined to remain at what are also historically high levels.

This latter subject is tackled by a lengthy analysis from consultants McKinsey entitled The new global competition for corporate profits and released this month. The research concludes that prior tailwinds could now become headwinds for company earnings on a worldwide basis and that trend company profit growth is going to slow considerably over the next decade.

Equity market bulls will counter that McKinsey’s report is in no way guaranteed to be right and that a major market fall is certain even if they are. But this intriguing document – which can be found here - suggests there is no room for complacency. As this column has noted before, major market accidents, let alone the sort of common-or-garden correction seen during the summer, tend to occur when

• markets are expensive relative to historic norms
• interest rates start to rise
• corporate earnings begin to disappoint (and/or a recession begins)

Whether you think this conjunction of events is coming to pass or not will remain a matter of personal opinion (and also for the heads of the Federal Reserve and Bank of England to decide) but one valuation measure suggests some degree of caution is warranted.

Big figure

The key charts are these two: they show the UK and then the US stock markets’ valuations as a percentage of GDP

UK market cap equates to 124% of GDP, near historic highs

Source: Thomson Reuters Datastream, ONS

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

US market cap equates to 128% of GDP, right at historic highs

Source: Thomson Reuters Datastream.

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The only real good news for the UK is it stands below the 133% peak seen in 2000. The US, on this one metric, looks similarly exposed, relative to its own history. American stock’ combined valuation, based on the Wilshire 5000 index, previously peaked at 112% and 104% in 2000 and 2007 respectively.

However, it is possible to justify these apparently lofty valuations because British firms are highly profitable, compared to previous levels and the same applies to their American counterparts.

UK corporate income equates to 5.9% of GDP, against a post-1988 average of 4.9%.

Source: Thomson Reuters Datastream, ONS

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

In the USA, corporate profits now represent 12.4% of GDP, compared to a post-1950 average of 5.0%.

Source: Thomson Reuters Datastream, ONS

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Combining the charts for the UK and US does suggest there is a relationship between valuation and corporate profitability, as you would expect, even if the past is by no  means a guarantee for the future.

Long-run corporate profitability does seem to correlate with valuation ...

Source: Thomson Reuters Datastream, ONS

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

.... in both the UK and US

Source: Thomson Reuters Datastream, ONS

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Think about the future

This is where the intriguing analysis from consultants McKinsey comes in. They assert that on a global basis corporate profits had surged from 7.8% of GDP in 1980 to 9.8% by 2013 helped by

• Lower corporate tax rates
• The availability of cheaper labour in emerging economies
• Strong demand from emerging economies in particular

McKinsey now fears those helpful factors will become hindrances:

• Corporate tax rates may start to rise – this makes sense in an era of austerity when many politicians and members of the public are calling for the economic pie to be shared in a different way
• Labour may become more expensive, as minimum or Living Wages rise in Developed and Emerging economies alike
• Emerging economies develop their own industries which look to establish a position on the global stage

As an added complication, the internet continues to act as a huge deflationary force, with the rise of price comparison sites just one facet of this

The net result is McKinsey believes global corporate profits as a percentage of worldwide GDP will drop in the coming decade, out to 2025, even if the total profit pool rises.

This chart shows corporate income in trillions of dollars and as a portion of GDP. Note how the bulk of the last 30 years’ gains disappear and that the implication is the compound annual growth rate in profits slide from 4% to just 1.8% a year.

McKinsey fears global profit growth could slow in the coming decade

Source: McKinsey

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Wait and see

The McKinsey analysis makes sense in some ways. History shows that very few firms manage to make above-normal returns for long: either the competition catches up with them, the customers revolt and demand lower prices or the regulator/politicians intervene.

Legendary investor Warren Buffett touched upon this subject a 1999 Fortune article, noting:

"In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn't going to happen."

Again, both Buffett and McKinsey could be wrong. And if they are right, other factors will exert an influence too, notably interest rates – one topic this column intends to cover soon is how the dividend yield offered by UK equities outstrips the yield available on 10-year Gilts by an unusually lofty margin. This well provide support to share prices.

But the McKinsey analysis does mean investors need to be at least aware of US and UK stock market valuations, because if there is any profit disappointment there could be trouble ahead.

As a final point, McKinsey does look at which specific industries could thrive and which could fall by the wayside in the environment outlined by the report. The consultants look toward idea-intensive industries as potential winners, those where intellectual property is a potential differentiator, and capital-intensive, labour-intensive manufacturing areas as potential losers.

Russ Mould

AJ Bell Investment Director