American hawks are wrong that Europe, including Britain, isn’t trying to raise defence spending as a percentage of output. There’s hardly a region in the world doing more to lower its GDP.
I’ve written before about how focusing on ratios leads to muddled thinking. This is especially true when numerators and denominators have nothing to do with each other — guns and growth, say.
Even when they are not independent, as is often the case in finance, it is still wise to unpack a ratio to see what is driving it up or down. It may be moving in the right direction for the wrong reason, or vice versa.
Take one of the best numbers to follow when analysing a company: its capex-to-sales ratio. Share prices can receive a boost in the short run if bosses cut back on investing in their business. Further out, however, revenues will suffer.
Then again, a rise may be coming from a dip in the top line. A steady ratio could be masking a drop in both variables. It isn’t hard to work things out, of course. My point simply being that a long-run chart of capex-to-sales in isolation doesn’t tell you the whole picture.
Likewise with price/earnings ratios, where the numerator is a stock or index price and the denominator net earnings, either historic or forward-looking. Hence, if the ratio suddenly drops, have shares tumbled or profits soared?
Either way, the valuation is potentially more attractive. But it’s a pretty useful thing to know whether the reason a stock is suddenly cheaper is due to panic selling or an earnings upgrade.
Certainly, so-called growth investors prefer the latter and might deign to give the shares the once-over themselves. Value investors, meanwhile, are less concerned about why they sold off in the first place.
I’m rambling on about this because the way prices and earnings moved within global stock markets before, during and after the Iran war drove much of my investment decision-making over those volatile months.
And with the wild daily swings in AI shares in the past two weeks or so, I thought it sensible to review where these simplest of valuation metrics have ended up for regional equity markets.
For example, the forward PE ratio of the S&P 500 index was hovering around 22 times at the beginning of the year before dipping to 19.6 times in late March, when I decided to own US shares again.
Today the multiple is just under 22 times, where it has been for the past couple of months. And because we know that over the period US equities have been on a tear, we also know that earnings must have kept pace.
This is a good thing — and definitely better than a steady ratio with the numerator and denominator both falling. But some longer-run context is also necessary. The 10-year average forward PE ratio for the S&P 500 is about 20 times.
So we’re a couple of turns above that now — which is to say that prices are about a tenth too high if historical valuations are anything to go by. Alternatively, net profits are undercooked by the same amount.
A basic analysis, I’ll grant you. But PE ratios are so flawed that I wouldn’t be comfortable asking them to do much more. One of their biggest faults is that earnings are measured differently across companies, sectors and regions. Nor are capital structures considered — that is, how leveraged businesses are.
In other words, the only thing you should really compare a stock’s PE ratio with is itself. The same with indices. Even then you have to be careful, because profits in any one year can be volatile. (Hence why Robert Shiller’s cyclically adjusted ratio uses average earnings over a decade.)
Still, if the US seems a tad high versus history using bog-standard PE ratios, it’s not the only one. Japan’s Topix index, which has been cheap for as long as I can remember, is also back above its 15-year mean of 16 times — having fallen from 20 to 17 due to Iran.
That’s one of the reasons (worries about the yen being the other) that I only have a 10 per cent exposure, compared with the whopping 40 per cent of my portfolio for most of last year.
Conversely, the forward PE ratio for my Asian fund remains below its five-year average, having been ravaged in March — and not in the fun way. The ratio had the biggest contraction when the Strait of Hormuz was first closed.
Yet, despite the region’s higher dependence on Middle Eastern oil and gas, earnings have risen by a tenth since then, which also explains why Asian PE ratios still look cheap — the denominator has done the heavy lifting.
It’s the same profits story for Latin America, the only region I own with an aggregate PE ratio in single figures. Unfortunately, a resurgent dollar hasn’t helped the numerator, despite LatAm lovers saying that the effect on earnings is much reduced these days. (They have been promising this for decades).
All good then? Sadly, no. My 30 per cent weighting in the UK isn’t following the script above. Yes, we had a nice drop to 13 times in the PE ratio in March. The trouble is the long-run average is 12 times and there has been bugger-all earnings growth.
Thus, my largest exposure is the least compelling based on this kind of analysis. Are there mitigating factors? Well, the pound may not be keen on the UK’s new prime minister. That would boost overseas earnings for FTSE 100 companies.
Apart from that, it seems to me that emerging markets are the better place to be right now. Or is it time to get over my loathing of Europe? More on the latter in my next column.
The author is a former portfolio manager. Email: [email protected]
