by Joseph Pecoraro
In recent years, the market has been pushed by mega cap names that trade at high price-to earnings ratios. The price-to-earnings ratio (P/E ratio) is the ratio used to value a company and provide a relative comparison to its historical ratio or other companies. The calculation for the P/E ratio is: current share price divided by earnings per share. The higher the P/E ratio, the more expensive the company is.
Currently the S&P 500 index is trading at a forward P/E ratio of 19.07X. Compared to the 25-year average of 16.28X. However, as we noted in our January 25, 2020 commentary by removing just six of the mega cap tech stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft) from the capital weighted index the S&P 500 is trading at 15.25X.
While the stock market is reaching a new high, 494 stocks in the S&P 500 are trading at below average price to earnings mutiples. Furthermore if you take into consideration where interest rates and CPI currently are, the market should be trading at over 19.10X.
Certainly, there are some expensive stocks and sectors but to say that the entire market is expensive would be historically incorrect. Our GARP investment discipline (Growth At a Reasonable Price) is finding value.
It is important for clients to understand that even with the market at all-time highs, our portfolio managers are able to find and purchase securities that might not be at peak valuation. When you compare our private account portfolios to the broader market at the end of 2019, you’ll find that our portfolios traded at a discount of nearly 20% to the S&P 500 Index.
Source: Advisors Capital Management: P/E ratios as of 12/31/2019. ACM Private account composites
This should be comforting to clients knowing that their diversified ACM portfolios are not “closet indexing” or chasing momentum stocks. But rather finding value at this late stage of the economic expansion.
To illustrate the types of companies selected for our portfolios we can look to Zebra Technologies (ZBRA). ACM has been invested in Zebra Technologies for over 2 years in our growth strategy. Zebra provides the barcode scanners and technology for Amazon to use in their warehouses, so as Amazon grows, so does Zebra. This provides our clients with Amazon exposure without having to buy what we feel is an expensive stock that is vulnerable to a recession or higher interest rates. The forward P/E ratio for Amazon is 69.35X and Zebra’s is 17.99X through the end of January 2020. (source: Finviz.com).
We view Zebra as the Remora fish that attaches itself to the great white shark. And of course, Amazon is the disruptive predator of the sea. The Remora eats the pieces of the shark’s dinner as they pass through the gills, cleans the shark and is smaller enabling it to hang on for the ride.
Zebra like the Remora is cheaper (leaner) than Amazon on a valuation basis but its stock performance over the past two years has actually outpaced Amazon. You can see by the chart below that for the trailing 24 months ending February 15, 2020 that Zebra has outperformed Amazon.
Source: Yahoo Finance
When rising interest rates or a slowdown in the economy become a concern, high P/E stocks will typically react negatively as we witnessed during the December 2018 correction. At that time Amazon corrected sharply while Zebra maintained value and has since outpaced the white shark while maintaining lower valuations.
Zebra has picked up another big fish customer in the United States Postal Service but is not immune to its own company specific vulnerabilities. As with any growth stock in our GARP discipline we can balance these risks with cheaper valuations and a reasonable portfolio allocation.
Searching for value investments doesn’t mean we don’t have conviction or belief in the expensive stocks in the market. We will buy a more expensive stock if the cost is justified. But if we can find the Remora fish it’s a lot easier just to hang on for the ride.