A REFRESHER ON VALUATION
When it comes to making an investment, there are several factors that will influence whether the outcome is successful. One of those factors, which is built directly into our investment process at Matco, is value. Value is one of our nine key investment factors. In its simplest form, the intent of the stock market is to invest a dollar, which provides you with a claim on the earnings of the company you have invested in. So, when we say value, what we are referring to is how many dollars an investor must invest into a company (or the stock market as a whole) to have a claim on one dollar of earnings. If we use real estate as an analogy, real estate investors often equate value with the price of a property in terms of dollars per square foot. A real estate market will often have a range that it trades within from a dollar per square foot perspective. If a real estate investor can capture a property at the lower end of the valuation spectrum, lower cost per square foot, historically speaking there is a better chance there will be a solid return on that investment (all else equal). Admittedly, we are oversimplifying but the stock market is similar. Rather than trading in dollar per square foot terms, it trades in dollar per earnings terms.
WHERE DOES THE STOCK MARKET'S VALUATION STAND TODAY?
When looking back over the last 15 years, on average an investor would have had to invest 20 dollars into the stock market to have a claim on 1 dollar of earnings (Price-to-earnings of 20). However, the number does fluctuate, and the long-term range is roughly between a 10 price-to-earnings ratio on the low end and a 30 price-to-earnings ratio on the high end. Remember, lower is better. Today, the Canadian equity market is trading at a 27 price-to-earnings ratio, while the U.S. equity market is trading at a 31 price-to-earnings ratio. So, from a historical perspective, the stock markets in Canada and in the U.S. are requiring investors to provide more dollars into the market for each dollar of earnings they have a claim on. More simply, the market is expensive.
WHAT IMPACT SHOULD VALUATION HAVE ON AN INVESTOR'S RETURN EXPECTATION?
As previously mentioned, investing in a less expensive market improves the probability of a solid return, whereas investing in a more expensive market reduces the probability of a solid return. Is this fact or a flimsy assumption? If we look at data going back to 1954, the relationship between valuation and the return of the investment 12 months into the future seems rather apparent. As shown within the chart below, as the market becomes more expensive, the 12-month forward price return is lower. However, when the market becomes less expensive, the 12-month forward price return improves. The market’s valuation today is shown by the “Current” plot point. Keep in mind, although it is indicating a negative return over the coming twelve months, it is important to remember that valuation is not the only factor that will impact the outcome. The below is simply intended to highlight the relationship between value and outcome.
DOES THIS IMPACT ALL PORTFOLIOS THE SAME?
As portfolio managers, we carefully select the companies we invest in. Because we utilize value as one of our key factors, this ensures we are not overpaying for the companies we invest in. Speaking more specifically, although the Canadian stock market is trading at a 27 price-to-earnings ratio, our Canadian Equity Income strategy has a valuation of 15 price-to-earnings. Overall, we are paying far less for our companies than what is being offered in the market as a whole. Similarly, although the U.S. stock market is trading at a 31 price-to-earnings ratio, our U.S. equity strategy has a valuation of 15 price-to-earnings.
In both instances, by design, we are ensuring that we are investing our clients’ money at more reasonable valuations, and therefore lowering the valuation risk exposure within their portfolios. As stated directly within our investment philosophy: Our goal is to provide clients with resilient long-term investment returns without exposure to unnecessary risk. Investing our portfolios at lower overall valuations removes some unnecessary risk for investors.
Trevor Galon, CFA
Chief Investment Officer
Founded in 2006 to manage and service seven family offices, today Matco offers the benefits of our extensive investment management experience to individual investors, foundations, endowments, condominium corporations, trusts, corporations and not-for-profit organizations.
Our mission is to simplify the investment world for our clients by understanding their needs and providing exceptional investment solutions that preserve and grow capital.