Thoughts on the Market: Winners and Losers

August 31, 2020

On August 18, the S&P 500 Index officially closed at a new all-time high, surpassing its pre-pandemic high set February 19, 2020. The impact of the COVID-19 pandemic has been dramatic and ongoing, and the world has been subsequently divided between the winners and losers. It is a fair argument that, thanks primarily to global central banks and governments flooding the world with liquidity and vaccine-related optimism, financial asset prices (stocks in particular but also bonds) have been the winners, while the real economy (where US unemployment continued claims still number over 15 million) has thus far been the loser. However, this ignores the dramatic disparities between winners and losers within the US equity market.

Since pre-pandemic 1/31/20, basically all of the roughly 9% rise in the S&P 500 Index has been driven by its top 5 constituents: AAPL, AMZN, FB, GOOG, MSFT (price +45% on average vs. +1% for everyone else in the S&P 500). If these companies are considered to be the winners, then why don’t we just load up on these stocks in client portfolios?

“Price is what you pay; value is what you get” – Warren Buffet

In the table below, we look at how EPS estimates for these five companies have changed since 1/31/20. We use 2021 calendar year estimates to look past direct pandemic effects on the current year (though using current year estimates tells the same story). We see that on average, EPS estimates have stayed roughly the same for these five companies (-2.0%), compared to a 17.1% decrease in CY2021 EPS estimates for everyone else in the S&P 500 Index. However, we also see that the price you are paying for those earnings has risen much more for the top five companies vs. everyone else (+47.7% vs. +21.8%), i.e. more than half of the 45% average price rise in the top five companies is explained by expanding relative CY2021 P/E valuation multiples rather than the earnings estimates themselves.

Table_1

The market is paying a much higher price per unit of CY2021 earnings for these five companies than it was pre-pandemic 1/31/20, relative to the rest of the S&P 500. They were all valued at a premium to the overall market on 1/31/20 and even more so now. In general, there are two main reasons why you should pay more for a company’s earnings with a relatively higher P/E multiple: (1) the company’s future EPS is expected to grow relatively faster long term, (2) the rate you discount the company’s cash flows back to the present is lower as the relative riskiness of the company has dropped.

By the end of 2021, it is expected that the worst of the pandemic-related recession will be over. Has the world permanently changed such that, relative to other companies on 1/31/20, these five companies will grow faster long-term post-2021 or their cash flows are less risky?

We believe the answer to that question is probably yes, as some companies and industries have been permanently impaired, but the extent is highly uncertain. While in retrospect, we wish we had loaded the boat on the winners in the depths of March, it is not at all clear that doing so now is a wise decision given current relative valuations. Therefore, we continue to believe that maintaining a diversified portfolio at the client’s chosen target risk level is the best recipe for long-term investment success. In fact, we believe maintaining diversification is even more important today as the market has become more concentrated in these few top companies. We have always incorporated firm quality into our stock selection process via our sustainable competitive advantages scores, but we will not ignore relative valuations.

Galvin, Gaustad & Stein (“GG&S”) is an SEC registered investment adviser located in Scottsdale, Arizona. GG&S and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers by those states in which GG&S maintains clients. GG&S may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. GG&S’s web site is limited to the dissemination of general information regarding its investment advisory services to United States residents residing in states where providing such information is not prohibited by applicable law. Accordingly, the publication of GG&S’s web site on the Internet should not be construed by any consumer and/or prospective client as GG&S’s solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation, over the Internet. Furthermore, the information resulting from the use of tools or other information on this Internet site should not be construed, in any manner whatsoever, as the receipt of, or a substitute for, personalized individual advice from GG&S. Any subsequent, direct communication by GG&S with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of GG&S, please contact the United States Securities and Exchange Commission on their web site at www.adviserinfo.sec.gov. A copy of GG&S’s current written disclosure statement discussing GG&S’s business operations, services, and fees is available from GG&S upon written request. GG&S does not make any representations as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to GG&S’s web site or incorporated herein, and takes no responsibility therefore. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

Certified Financial Planner Board of Standards Inc. (CFP Board) owns the certification marks CFP and CERTIFIED FINANCIAL PLANNER in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

CFA and Chartered Financial Analyst are registered trademarks owned by CFA Institute. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. GIPS® compliant performance information for GGS’s strategies is available upon request.

Past performance is no guarantee of future results and may have been impacted by market events and economic conditions that will not prevail in the future. This site/blog contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”)which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. As such, there is no guarantee that the views and opinions expressed in this letter will come to pass.

ACCESS TO THIS WEB SITE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND WITHOUT ANY WARRANTIES, EXPRESSED OR IMPLIED, REGARDING THE ACCURACY, COMPLETENESS, TIMELINESS, OR RESULTS OBTAINED FROM ANY INFORMATION POSTED ON THIS WEB SITE OR ANY THIRD PARTY WEB SITE LINKED TO THIS WEB SITE.

Relationship Summary (ADV Part 3)