By Ben Peters, portfolio manager and Robert Strachan, analyst for the Evenlode Global Income fund
At an investment conference dinner last week, the conversation inevitably turned to the state of the global stock market and its recent performance. The global market is increasingly a US-centric one, with 71% of the benchmark MSCI World Index made up of companies listed in the States in dollar terms at the end of February. Within this, technology companies dominate, with Microsoft at the top of the chart, making up 4.6% of the index with a market cap of $2.9 trillion. In close second is Apple at $2.8 trillion, followed by artificial intelligence chipmaker NVIDIA at $1.9 trillion.
To underscore the heft of those at the top of the market cap charts, in less than a month since MSCI inked its February factsheet, NVIDIA has added about $400 billon of market value, now standing at $2.3 trillion in market cap. To put this in context, only 16 of the c.1,500 companies in the MSCI World Index are worth more than $400 billion. This has helped the market to quite a run, with the index up by +27% in sterling and +34% in dollars since December 2022. The question around the dinner table was: can this continue?
Beware of market mania
Some of the greatest downside risks in equity investing come from periods of mania where the value of shares becomes vastly overblown and detached from the earning power of individual companies. Given the nature of the companies currently driving the market, the late 1990s ‘dotcom’ bubble is a recurring comparator. However, the mere fact that companies in a certain sector have greatly increased in value, or happen to be very big, does not necessarily mean that the market is in a bubble scenario. We have a position in Microsoft, which has enjoyed handsome returns of late and has a vast market value. At 4.3% of our Global Income portfolio, this is a marginal ‘underweight’ to the company’s position in the MSCI World Index, but a large position nonetheless. We believe the valuation of Microsoft is acceptable given its prospects, but it is less of an opportunity than it was following the company’s share price decline in 2022, so we have reduced the position from 6% at its peak. So, a less attractive valuation than it has been, but in a bubble? Not by our estimation.
We value companies based on a long-term projection of the cash flows they might generate and use that as the basis of our decision making. However, a simple way of looking at the picture is to examine how a company’s price/earnings (P/E) multiple has evolved over time. All other things equal, a higher P/E multiple means a more expensive company. The five companies that saw their P/E multiple increase the most over the year to end-February enjoyed an expansion of six ‘turns’. While these are great businesses, their earnings potential has not expanded that much, hence our reduction in their position sizes.
We also hold companies that have not enjoyed the same positivity from the market. Each company has its own story to tell, but the five most negative P/E contractions averaged a fall of two ‘turns’. There has been generally muted performance from consumer goods and healthcare firms in the market, despite being expected to grow revenue and profitability as they generally did last year, explaining the contraction in the P/E multiple.
This is not to say there are no negatives to consider. Consumer goods and healthcare company Reckitt is a case in point. Fears around US litigation involving its infant nutrition business, Mead Johnson, resulted in a severe sell off in March. We believe the lost market value far outweighs the likely cost of settling the cases. However, such situations are very much the exception rather than the rule, as we saw last month that revenue, profit, cash flow and dividend growth have progressed as expected as companies reported their 2023 results and laid out their expectations for 2024.
Remaining mindful amid elevated valuations
While we cannot speak for every company, our view is that the market is not in a bubble and valuations are generally not crazy. However, we should remain mindful of further moves upward. Any such move could come from areas of the market that look better value. In this situation, the broad level of valuations may remain acceptable in risk/reward terms. However, if the returns come from piling more value on companies that have already seen their valuations increase significantly, then the balance may tip the other way.
Consider again the MSCI World Index return of +27% sterling since the end of 2022. The context for this was a weak market seen during the calendar year, so the market has had to make up some lost ground to reach current all-time highs. There are always details behind the market headlines, and whatever the next moves are, they will likely keep us discussing these details over dinner for some time to come.
