Curmi & Partners

The valuation conundrum

By Robert Ducker

The longest bull market in history (128 months) ended abruptly last February as the uncertainty brought about by COVID-19 dominated investor sentiment. Despite the long duration and strength, the last bull market has been generally unloved by investors. It has been characterised by concerns around several issues including lacklustre global economic growth, soft inflation, the sovereign debt crisis in Europe, rising political risk (Brexit, US/China) and  weak corporate earnings growth (especially in Europe) amongst others.

A constant debate amongst investors post the global financial crisis has been equity market valuation levels. Many investors have missed out on the rally because of valuation concerns. Equities screen as expensive on traditional valuation metrics like current Price-Earnings ratio (“PE”), forward PE, dividend yield, Enterprise Value (“EV”) over EBITDA and Price to Book since 2005. The current PE, forward PE and Price to Book are all in the 100th percentile, with the EV/ EBITDA at the 91th percentile, the Shiller PE at the 89th, and dividend yield at the 87% (inverse calculation: that is how low it is compared to history). Based solely on these metrics, it has been difficult to make a case for equity upside, especially against the uncertain macro and political backdrop.

On the other hand, bullish investors have ignored rising valuation levels, arguing that higher valuations are justified in periods of record low interest rates and inflation expectations. Such investors point to the gap between forward earnings yield (the inverse of the forward PE ratio) and the yield offered by a risk-free asset (10-year German Bund for example) as an argument that upside remains in the equity market.  The current gap, at 6.7%, is among the highest in history suggesting equities are currently undervalued. Notwithstanding, the raw comparison between earnings yield and bond yield is not perfect. Firstly, the model assumes that equities are correctly value if the earnings yield is equal to the bond yield, meaning that the higher risk of investing in equities (the equity risk premium) is ignored. Secondly, despite using a forward earnings yield, the subsequent earnings growth is ignored.

Looking away from the above methodologies, we believe that the following factors need to be taken into consideration when discussing equity valuations in the current environment:

Growth expectations: Macro-economic growth has been weakening for the past years, with the long-term growth rate in the US falling to c.1.7%, from around 2% over the past five years. The implication here is that earnings growth should slow in line with expected macro-economic growth, apart from the significant impact on equity valuations from a lower terminal growth rate. Corporate profits in Europe have been growing at a slower rate compared to the US (in line with economic performance), mainly because of a lower exposure to the technology sector in Europe when compared to the US. The recent EU recovery fund could be a catalyst for EU corporate growth. However, we believe that the region’s corporate growth outlook is clouded by the potential for higher corporate tax rate (-ve for corporate profits) to fund the recent fiscal stimulus which was announced post COVID-19 to support the region’s economy.

Inflation expectations: Equity is a real asset due to the positive correlation exhibited between corporate profits, economic growth and inflation. Therefore, as expectations for economic growth and inflation change, so will expectations on profit growth, dividends and investor return expectations. The biggest risk for an investor holding a 10 year German Bund (i.e. risk free asset) is generally inflation. Sovereign bonds pay a fixed nominal return and therefore offer very limited protection to investors for inflation. On the other hand, corporate earnings generally rise with inflation. Obviously, the opposite is also true, in that falling inflation is generally a positive for fixed income instruments and negative for equities. Cash flows and dividends should fall in line with inflation leading to a lower valuation. Therefore, a big risk for European equities is the potential for deflation in the region. The current inflation rate is nowhere near the European Central Bank (“ECB”)’s target rate and deflation remains a key risk.

Against such a backdrop, companies that have been able to grow earnings at a faster rate than the global economy have been handsomely rewarded by investors since the global financial crisis. In Europe, we see then EU recovery plan as a potential catalyst for the region if implemented efficiently, whilst the Green Deal could provide the region with a competitive advantage (similar to Tech in the US).


The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.