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Security selection has always been an important part of our investment process, along with a focus on quality.

Jul 2019
Julianna Donovan

Despite the slowing economy, U.S. stock indices advanced at the fastest rate for the first six months of the year since 1997, ending June near record levels.

The S&P 500 Index of large U.S. companies returned 18.5% for the year through June, including dividends, while the NASDAQ increased 21.3%. Investors looked beyond rising trade tension with China, military threats from Iran and other geopolitical problems to drive stocks higher.

As posed above, “why are stock prices rising when the economy is slowing down?”

Ultimately, two things matter most to equity investors. The first is earnings expectations, and the second is the multiple at which stocks can be purchased relative to those expected earnings. Let’s break it down further:

2018 was an excellent year for corporate profits, with S&P 500 Earnings Per Share (EPS) growing 22%.

Total EPS growth for the first quarter of 2019 was 4.0% – a rather lackluster figure – and while second quarter earnings are still being tallied, we expect EPS growth in the mid-single digits.

The other key measure is valuation.

The last quarter of 2018 proved to be an especially difficult one for stock prices and so the S&P 500 Index began 2019 priced at an undemanding multiple of 14x expected forward earnings. As the year progressed, investors drove stock prices up while earnings expectations for 2019 fell, leading to a 17x forward earnings multiple as of June 30. Roughly 90% of the market return through June can be attributed to investors’ willingness to pay more for future earnings. Valuations still look reasonable to us, given the very low returns we highlighted above on cash and bonds. For an investor with a time horizon of at least a few years (and preferably longer), stocks offer the highest potential return, in our opinion. And while stocks are not as inexpensive as they were at the beginning of the year, the current multiple of 17x is in line with the past twenty-five-year historical average of 16.2x.

So what do we expect going forward?

We remain optimistic about the long-term return potential for stocks, but given the exceptionally strong returns from stocks so far this year we see modest potential upside in the near-term. We expect earnings to grow at a mid to high single digit rate in the next few quarters and do not expect valuations to expand very much from current levels. Security selection has always been an important part of our investment process, along with a focus on quality. We believe this emphasis is especially important now, and are approaching our investment research and selection process with the same rigor as usual.

As in years past, a busy second quarter conference and annual meeting schedule allowed us to meet with or see
the managements of many of our model portfolio companies. Importantly, we do not see large imbalances in the market that characterized prior peaks in 2000 and 2007 amid the technology and housing bubbles. The stock market peaked at an earnings multiple of 27.2x in March of 2000 (based on earnings that never materialized) while the 10-year Treasury bond yielded over 6%. In 2007, the market peaked at 15.7x earnings while the 10-year bond yielded 4.7%. In the current environment, with the 10-year Treasury bond yielding 2% and falling expectations for short-term interest rates and cash, equities still offer reasonable returns for those willing to tolerate some price volatility and stay the course for a longer time horizon.

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