Capital Markets: Observations & Insights
Productivity Pick-Up - Winter 2018
Capital Markets: Observations and Insights Productivity Pick-Up Winter 2018
Productivity Pick-Up
Productivity. We all want more of it — to be able to do more in less time because we can’t find more hours in the day. The economy also craves productivity. While it does produce slightly more labor hours each year, the more important determinant of economic growth is output per labor hour or productivity. Last quarter we wrote about our belief that business spending would improve and lead the economy forward. Indeed it has and we think this is only the beginning. The recently completed U.S. tax reform bill only strengthens our conviction in this thesis. But it is the impact of stronger business spending on which we focus in this presentation. Investment is a key driver of productivity, which in turn dictates long-run economic growth. Therefore, we are hopeful that the surge in business spending that we anticipate will boost the long-run potential growth of the U.S. economy.
Then we can all stop hoping for more hours in the day.
Daniel C. Chung, CFA Chief Executive Officer Chief Investment Officer
Brad Neuman, CFA Senior Vice President Client Investment Strategist
Page 1
Key Observations
• Business spending is set to accelerate and outpace the broader economy, given strong earnings growth, tax reform, solid business confidence, and accommodative financial and lending conditions • Increasing corporate investment should help drive a resurgence in productivity growth, which is the key to stronger, sustainable long-term economic growth • Leading indicators suggest the economy will continue to expand and corporate profits will continue to rise
Table of Contents
Productivity Pick-Up
Pages 3-6
Performance
Pages 7-14
Fundamentals
Pages 15-22
Valuation
Pages 23-27
Page 2
Productivity Drives Potential GDP Productivity Pick-Up
• Economic output = labor hours x output per hour (i.e., productivity)
• Therefore, to increase long-run economic growth, we have to increase productivity growth
…And Recently Both Have Trended Lower
Productivity Drives Potential GDP…
Potential GDP
Productivity
Potential GDP
Productivity
18,000
120
4%
16,000
Productivity Index (2009=100)
100
14,000
3%
12,000
80
10,000
60
2%
8,000
6,000 $ Billions
40
1%
4,000
20
2,000
0
0
0%
Year-Over-Year Change (5-Year Average)
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: FactSet using CBO potential GDP data and U.S. Bureau of Labor Statistics productivity data as well as Alger estimates for 4Q17.
Page 3
Productivity Pick-Up
Productivity Growth Dependent on Business Spending
• Stronger business spending should drive innovation as businesses have more cash to deploy to research and development and capital expenditures
• Historically, increases in business spending lead to higher productivity
Business Spending vs. Labor Productivity (1988-2016)
R 2 = 0.64
10.0
= Year
8.0
6.0
Higher business spending leads to higher productivity
4.0
2.0
0.0
% Increase in Business Spending
-2.0
0.0
1.0
2.0
3.0
4.0
5.0
% Increase in Productivity
Source: Bureau of Labor Statistics. Business spending is capital intensity (capital services per hour worked and advanced one year), and labor productivity is output per labor hour.
Page 4
Recipe for an Increase in Business Spending Productivity Pick-Up
• Profit growth
• Tax reform—lower statutory rates, foreign profit repatriation, accelerated depreciation
• Higher business confidence—driven in part by lower regulation and certainty on taxes
• Banks’ increased willingness to make commercial loans
• Accommodative financial conditions—interest rates and spreads
S&P 500 EPS
Business Spending
20%
15%
An acceleration in earnings growth should help drive a double-digit increase in business spending
Forecasted
10%
5%
0%
Year-Over-Year Change
-5%
2011
2012
2013
2014
2015
2016
2017E
2018E
Source: FactSet. Business spending is U.S. private fixed nonresidential investment with an estimate for 4Q17 as well as 2018, the latter based on a regression with S&P 500 EPS. S&P 500 EPS 2017 estimate based on consensus and 2018 is Alger estimate.
Page 5
Higher Investment to Lead to Higher Productivity Productivity Pick-Up
• A surge in business spending on assets (e.g., plants, property, equipment, IT, etc.) should drive higher productivity
Business Assets
Productivity
5%
4%
3%
2%
Forecasted
1%
(3 Year Average)
Year-over-Year Change
0%
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
Source: FactSet, Bureau of Economic Analysis and Alger estimates. Business assets is U.S. real private nonresidential capital stock, which is advanced two years. Productivity is U.S. output per labor hour. Estimates are based on regression with real private capital stock.
Page 6
Sector Disparities Performance
• In 2017, the technology sector vastly outperformed other sectors of the market both in the U.S. and globally, driven by strong fundamentals • U.S. tax reform and rising interest rates influenced 4Q17 performance with relatively high tax rate sectors outperforming those with lower tax rates or bond-like characteristics
4Q17 Returns (%)
2017 Returns (%)
50
U.S.
World
U.S.
World
10
40
8
30
6
4
20
2
10
0
0
-2
-10
Energy
Utilities
Energy
Utilities
Telecom
Materials
Telecom
Materials
Financials
Industrials
Financials
Industrials
Technology
Real Estate
Health Care
Technology
Real Estate
Health Care
Consumer Staples
Consumer Staples
Consumer Discretionary
Consumer Discretionary
Source: FactSet as of 12/31/17. U.S. represented by S&P 500 and World is represented by MSCI All Country World Index in local currency.
Page 7
Scale Rewarded Performance
• Large cap stocks with low volatility did best in 2017, while dividend yield, which had benefitted in recent years from lower rates, underperformed • Tax reform drove 4Q17 performance; many domestic stocks that have low revenue multiples and high tax rates outperformed
2017 Excess Return (%)
4Q17 Excess Return (%)
2.6
1.7
1.5 1.4
0.7
1.1 1.0
-0.3 -0.4 -0.4
-0.3
-0.9 -1.0
-0.7
-1.4
-1.2
-1.6 -1.8
-1.9
-2.2
-3.5
-4.0
Market Cap
Book / Price
EPS Growth
Market Cap
Debt / Equity
Book / Price
EPS Growth
Debt / Equity
Price Volatility
Dividend Yield
Price Volatility
Trading Activity
Dividend Yield
Earnings / Price
Revenue / Price
Trading Activity
Earnings / Price
Revenue / Price
Relative Strength
Relative Strength
Earnings Variability
Earnings Variability
Source: FactSet as of 12/31/17 using Northfield defined quantitative factors for the Northfield broad U.S. market database.
Page 8
Performance
Prices and Fundamentals Converge
• Stock prices and fundamentals converged in 2017 after having previously diverged
• Growth stock fundamentals continue to imply outperformance
Growth Relative to Value
Stock Prices
Fundamentals
Convergence
110
105
Disconnect
100
95
90
Jul-16
Jul-17
Oct-16
Apr-17
Oct-17
Jun-16
Jan-17
Jun-17
Feb-17
Mar-17
Nov-16
Dec-16
Nov-17
Dec-17
Aug-16
Sep-16
Aug-17
Sep-17
May-17
Source: FactSet as of 12/31/2017. S&P 500 Growth and Value Indices used to represent Growth and Value stocks. Fundamentals are LTM EPS.
Page 9
The Earnings Growth Resurgence Is Boosting Performance Performance
Total Return = Dividend Yield + EPS Growth +/- P/E Change
MSCI All Country World Index ex-USA
S&P 500
Dividend
EPS Growth*
P/E Change
Dividend
EPS Growth*
P/E Change
35%
25%
30%
20%
25%
15%
20%
10%
15%
5%
10%
0%
5%
EPS Growth Acceleration
-5%
0%
EPS Growth Acceleration
-10%
-5%
-15%
-10%
-15%
-20%
Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17
Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17
12- Month Total Return:
12- Month Total Return:
2%
16%
32%
14%
1%
12%
22%
-12%
17%
21%
7%
2%
7%
19%
Source: FactSet as of 12/31/17. *Based on consensus estimates of next 12-month EPS. Actual earnings per share might be materially different than shown. MSCI ACWI ex-US performance based on local currency.
Page 10
Performance
Bull Market Is Aging Well
• Bull markets have been getting longer over time
‒ Factors prolonging economic expansions include: increased fiscal and monetary intervention, structural changes in the economy, and technological advances, such as improved inventory management
‒ The current bull market is 3.5 years younger than the 1990s bull market
14
2010-Current Average: ?? Years
12
1980-2010 Average: 7.2 Years
10
1950-1980 Average: 4.3 Years
Current Bull Market (ongoing)
8
1930-1950 Average: 1.7 Years
6
4
Duration of Bull Market (Years)
2
0
1932
1943
1954
1965
1976
1987
1998
2009
2020
Year that Bull Market Ended
Source: FactSet and Goldman Sachs as of 12/31/17. Bull markets over six months in duration since 1930.
Page 11
Performance
Has Active Relative Performance Troughed?
• While there are secular pressures affecting U.S. active management, cyclical factors tend to be much more powerful in the short term. Examples include: ‒ small cap performance
‒ overall market performance ‒ non-U.S. stock performance ‒ interest rates/bond-like equities
Active Relative Performance Is Cyclical
2017 saw the best large cap active management performance in eight years
100%
80%
60%
40%
20% % of Fund Assets Outperforming
0%
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
Source: Nomura/Instinet, Joseph Mezrich and FactSet through 12/31/17. Fund performance is trailing five-year data. Sidebar data based on active performance from Bank of America Merrill Lynch U.S. Equity and U.S. Quant Strategy using Lipper data
Page 12
Small Caps Due for a Comeback Performance
• Small caps dramatically underperformed large caps in 2017 in stark contrast to their historic outperformance
• Taken together, these data points may imply small caps are poised for a comeback
Small Cap Performance Relative to Large Cap Performance
400
253
Small caps underperformed large caps last year in contrast to their long term outperformance
193
200
20
0
-200
-400
-600
-800 Basis Points (Annualized)
(860)
-1,000
1 yr
5 yr
10 yr
20 yr
Source: FactSet as of 12/31/17 using S&P Small Cap and Large Cap indices.
Page 13
Performance
Structural Issues Driving Growth vs. Value
• Growth stocks have dramatically outperformed (+31%) Value stocks over the past decade
• The culprit for value investors has been the very weak performance of buying low P/B stocks, while P/E strategies have fared much better • Book value may no longer be as relevant given changing business models, e.g., R&D is not capitalized in book value
110
P/E
100
P/B, not P/E, has driven Value underperformance
90
80
P/B Russell 1000 Value / Growth
70
60
Total Return Index
50
40
2007
2009
2011
2013
2015
2017
Source: FactSet as of 12/31/17. Price-to-earnings and price-to-book returns are based on the E/P and B/P Northfield factors for the Northfield broad U.S. market database.
Page 14
Leading Cycle Indicators Are Benign Fundamentals
• Every major recession in the past 75 years has been preceded by substantial Fed Funds rate tightening or inflation acceleration, or both • We believe the Fed can be patient given forces weighing on inflation, including innovation (price transparency), labor dynamics (retirees), and globalization
Recession
Fed Funds Effective Rate
Inflation
20
Today, short-term interest rates and inflation are both less than 2%
18
16
14
12
10
8 Percentage
6
4
2
0
-2
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
Source: FactSet as of December 2017. Inflation represented by PCE Price Index ex-food and energy (year over year).
Page 15
Fed Tightening Unlikely to Derail Equities Yet Fundamentals
• The stock market has actually historically risen with the Federal Funds rate • Only after rates have stopped rising are equities likely to have peaked
• With the Fed still trying to normalize rates, equities may have room to run
Fed Not Done, So Stocks Not Done? (Current Hiking Period)
Stock Market Declines After Peak in Fed Funds (Average of ’99/’00 & ’04/’05 Periods)
Cumulative Hike
S&P 500
Cumulative Hike
S&P 500
2.5
114
2.5
150
112
2.0
Forecasted
140
2.0
110
S&P 500 (Indexed to 100)
S&P 500 (Indexed to 100)
108
130
1.5
1.5
106
120
1.0
104
1.0
110
102
Cumulative Rate Hike (Percentage Points)
0.5
Cumulative Rate Hike (Percentage Points)
0.5
100
100
0.0
98
0.0
90
0
2
4
6
8
10
12
14
16
18
0
5
10
15
20
25
30
35
Months Since First Hike
Months Since First Hike
Source: FactSet. Estimated future Fed rate hikes based on “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents,” December 2017.
Page 16
Fundamentals
Leading Indicators Suggest Earnings Will Continue to Rise
• The Conference Board Leading Economic Index (LEI) typically leads earnings by 6-18 months and usually peaks one to two years prior to a recession • Given that the LEI is increasing solidly year over year and hit a record high in 4Q17, we believe the economy and earnings have room to run
130
Leading Economic Index indicates further EPS growth
$150
120
$130
18 Month Lead
S&P 500 EPS
110
$110
100
$90
90 Leading Economic Index
$70
80
$50
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: FactSet, Conference Board as of December 2017. Based on NTM EPS estimates.
Page 17
Fundamentals
Economic Outlook
Tailwinds
• Robust corporate profits
• Fiscal stimulus/tax reform
• Strong business and consumer confidence
• Solid U.S. consumer balance sheet
Headwinds
• Tightening monetary policy
• Rising U.S. labor costs
• China growth slowdown
• Geopolitical risk
Page 18
Smaller Capitalization Stocks Poised to Outperform Fundamentals
• Stronger fundamentals : Estimated small cap EPS growth for 2018 more than double large cap
• More levered to fiscal stimulus : Small caps are more U.S.-oriented and have higher operating leverage • Rising interest rates : Small caps have historically outperformed large caps in rising rate environments and vice versa in falling rate environments
• Attractive valuation : Small cap sales multiple discount implies opportunity
Earnings Per Share
Enterprise Value/Sales Russell 2000 / Russell 1000
0%
R2000
R1000
-5%
170
Historically Large Discount
-10%
160
Small Caps Growing Faster
-15%
150
-20%
140
-25%
130
-30%
120
-35%
110 EPS Indexed to 100
-40%
100
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2017
2018
2019
Source: FactSet as of December 2017. EPS for 2017-2019 are consensus estimates and actual earnings per share might be materially different than shown.
Page 19
Fundamentals
Innovative Companies Grow Earnings and Stock Prices Faster
• Innovation propels economic growth over time
‒ Studies have shown, and our research demonstrates, that the most innovative companies grow their sales, earnings, and stock prices faster*
Innovation Drives:
EPS Growth…
and
…Stock Prices
11%
500
Most Innovative
400
300
5%
200
Least Innovative
100
Est. EPS Growth 2007-2017
-
Most Innovative
Least Innovative
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Source: FactSet. Most/least innovative based on R&D percent of sales. Est EPS growth December 2007 - December 2017 measured after classification of S&P 1500 companies into innovation quintiles in December 2007. Most/least innovative stock performance based on S&P 1500 quintiles one month returns for same time period, normalized for market value. * Baruch Lev and Suresh Radhakrishnan, “The Stock Market Valuation of R&D Leaders.”
Page 20
Speed of Innovation Is Accelerating Fundamentals
• Innovations are penetrating U.S. markets at an even faster pace
‒ “Growth” stocks should benefit from innovation while “value” stocks that appear cheap may simply be victims of change
Years from Market Entry to 50% Penetration in the U.S.
The faster speed of innovation may be exacerbating the disparity between growth and value fundamentals
200
160
120
80
40
0
TV - 1936
PC - 1974
VCR - 1965
ATM - 1969
Stove - 1750
Radio - 1897
Roads - 1880
Internet - 1989
Dishwasher - 1924 Air Con. - 1933
Steam Ship - 1810 Railroad - 1830
Hospitals - 1776
Cable TV - 1950
Wash. Mach. - 1904 Air Travel - 1914
Telephone - 1880
Microwave - 1967
Newspaper - 1704
Credit Card - 1950
MP3 Player - 1998
Smartphone - 1996
Social Media - 2004
Electric Power - 1882
Secondary Schools - 1810
Source: Asymco.
Page 21
Fundamentals
The Growth Advantage
• Three variables drive P/E multiples: growth, returns, and risk
• As compared to the Russell 1000 Value, the Russell 1000 Growth has higher expected EPS growth, higher returns on equity, and lower risk in the form of better balance sheets
Stronger Growth
Higher Returns
Lower Risk
R1000G R1000V
R1000G R1000V
R1000G R1000V
14.4%
2.5x
24.6%
9.9%
1.3x
10.1%
Long-Term EPS Growth
Return on Equity
Net Debt / EBITDA
Source: FactSet as of December 2017. Growth represents consensus long-term analyst estimates, and actual future EPS growth rates might be materially different than the forecasts shown.
Page 22
The Great Rotation Valuation
• Moving from monetary stimulus and quantitative easing to fiscal stimulus and increased deficits should drive a Great Rotation from bonds to stocks • The magnitude of the rotation will be fueled by the valuation disparity between equities and bonds, which are expensive by comparison ‒ The earnings yield of equities is more than 300 bps greater than the yield of 10-year Treasury notes vs. 55 bps median over the past half-century prior to the Global Financial Crisis
Equity vs. Bond “Yields”
S&P 500 EPS Yield
Treasury Bond Yield
16
14
Stocks are attractively valued relative to bonds
12
10
8
6
>300 bps
4
2
0
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
Source: FactSet, Federal Reserve, and S&P, as of 12/31/17.
Page 23
Not All Sectors Are Expensive Valuation
• Growth-oriented sectors are reasonably valued compared to history, particularly given low levels of interest rates, in contrast to many other sectors
37%
Reasonably Valued
23%
21%
20%
20%
18%
9%
2%
1%
P/E Relative to 20-Year Median
Utilities
Materials
Financials
Industrials
Real Estate
Technology
Health Care
Cons. Staples
Cons. Discretionary
Source: FactSet, based on S&P 500 Index, 12/31/17. Note: energy and telecom are excluded; the former because of an extremely high P/E due to depressed earnings and the latter owing to a small number of constituents. Real estate is a new sector classification, so for the historical data shown above, an industry group category that has approximately 16 years of data was utilized.
Page 24
Growth Valuations Are Reasonable Valuation
• Despite their recent outperformance, Growth stocks remain attractively valued compared to Value stocks, relative to history and their respective growth rates
Russell 1000 Growth vs. Russell 1000 Value PEG Ratio (P/E Divided by Long-Term Growth Rate)
Russell 1000 Growth vs. Russell 1000 Value P/E
30% premium is low relative to history
1.7x
1.5x
Russell 1000 Value
Russell 1000 Growth
Source: FactSet, Bank of America as of 12/31/17.
Page 25
Valuation The Single Greatest Predictor of Future Stock Market Returns
• Current valuations suggest equities, particularly growth stocks, should materially outperform bonds over the coming decade • The full impact of tax reform implies lower P/Es and higher annualized returns than current estimates shown below
S&P 500 P/E vs. 10-Year Returns
Russell 1000 Growth P/E vs. 10-Year Returns
= month
= current
Tech bubble
25%
25%
R² = 0.79 (0.85 ex-tech bubble)
R² = 0.85
20%
20%
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
-10%
-10%
5
10
15
20
25
30
5
10
15
20
25
S&P 500 10-Year Annualized Return
Russell 1000G 10-Year Annualized Return
Russell 1000 Growth Price/Earnings
S&P 500 Price/Earnings
Source: FactSet. Monthly data through December 2017 and beginning in January 1986 (S&P 500) and December 1978 (Russell 1000 Growth). The tech bubble, represented by the 10- year returns beginning in April 1987-March 1990 and ending in April 1997- March 2000, skewed the regression by resulting in higher returns for given valuations than the historical relationship would imply.
Page 26
Addressing Interest Rate Risks—It’s Too Soon to Worry Valuation
• Potential Risk : higher bond yields lower equity valuations?
• Potential Solution : favor equities over bonds given that increasing interest rates have supported higher P/E multiples at low absolute levels
S&P 500 NTM P/E vs. 10-Yr Treasury Note Yield 1964-2017
25
Higher Rates Rising P/E
Higher Rates Falling P/E
= Month
20
15
P/E
10
5
-
5
10
15
10-Year Yield
Source: RBC Capital Markets and FactSet. Data through December 2017.
Page 27
Disclosure
The views expressed are the views of Fred Alger Management, Inc. as of December 2017. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only.
Risk Disclosures : Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political and economic developments.
The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The Russell 1000® Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small-capitalization companies with greater than average growth orientation. The Russell 2000 Value Index is an unmanaged index generally representative of the small-cap value segment of the U.S. equity universe and measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000® Growth Index is an unmanaged index designed to measure the performance of those Russell 3000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index is an unmanaged index generally representative of stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. The MSCI ACWI Index (gross) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, Inc. and actual client results might differ materially than the indices shown. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell ® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.
ALCAPPRESSPR-0118
Fred Alger Management, Inc. • 360 Park Avenue South, New York, NY 10010 • 800.992.3863 • www.alger.com
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