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Buy Economically Sensitive for a Sensitive Economy

By Justin McNichols, CFA

Where are the superior risk/rewards in this sensitive economy?

Many investments have more than doubled since their pandemic lows.  However, the U.S. equities market is in an interesting position as we enter the fourth quarter.  Due to the sizable disruptions caused by the Delta variant and ongoing global supply chain issues, global markets have become more sensitive to incremental news on these topics.  Markets have whipsawed as investors attempt to gauge whether the economy will continue to reopen and improve or be stunted by lingering headwinds.  The “sheltered in place” cohort, such as Peloton and Zoom, have quietly corrected by 50% or more from highs earlier in the year.  Many of these companies continue to be extremely overvalued with difficult earnings comparisons and peaking growth.  The infamous “meme” stocks like Gamestop and AMC have corrected 50% as their hype and investor interest has faded.  New SPAC issuance has cratered, along with the interest in SPACs, and unfortunately for investors, the SPAC prices as well.  Finally, the crypto area simply cannot be properly valued, and in most cases likely have no value.  With these speculative investments slowly imploding, where are the superior risk/reward investments found at this point in the economic and pandemic cycle?


As described above, one of the issues with today’s capital markets is the generally high, and extremely wide-ranging valuations.  While the S&P 500 trades at approximately 20 times next-12-month earnings, a reasonable valuation relative to the present level of interest rates, many other investment choices are trading at “infinity” valuations since they either do not generate revenue or consistently operate at a loss.  Crypto, Memes, and SPACs fall under this category.


In examining other investment choices outside of the S&P 500 and the “infinities”, many investors have gravitated toward areas with higher earnings growth such as the Nasdaq (QQQ), large capitalization growth stocks (IWF), and the internet sector (XWEB).  These areas with faster earnings growth have been bid higher consistently over the years due to the record low level of interest rates.  Simply stated, when an investor calculates the present value of future earnings, a discount rate based on today’s interest rate is used.  The lower the interest rate, the higher the present value of future earnings, and the higher the price (and generally valuation) of the stock.  However, if interest rates are no longer a major tailwind, and could be higher in the future, the present value of earnings is lower.  When valuations are 27 times forward earnings for the Nasdaq, 30 times for the Russell 1000® Growth Index, and 63 times for the internet sector, you could easily argue these areas are a poor risk/reward unless interest rates are flat to down and earnings continue to grow at a strong pace.   


The less expensive parts of the Russell 1000® Growth Index, like “the FANMAG six” have valuation issues of their own (Facebook, Amazon, Netflix, Microsoft, Apple, and Google).  In 2020, a strong argument could be made to overweight parts of the FANMAG six due to reasonable valuations, and strong expected earnings growth.  These companies were beneficiaries of the pandemic as their earnings were stable and growing, while the work-from-home and sheltered-in-place phenomenon bolstered their earnings through more screen time and at-home shopping, whether it was for work or pleasure.

However, as we approach 2022, it is clear that some of the strong earnings growth initially expected in 2022 was pulled into 2021 and 2020.  The result is more difficult earnings comparisons in 2022 versus 2021.  As shown in the table below, while valuations are only modestly higher than the S&P 500, the earnings growth rates will likely slow.  In dividing the 2022 P/E by the expected growth rate, (called a PEG ratio), it is clear that FANMAG is no longer inexpensive versus the S&P 500 on a P/E-to-growth rate basis.  Presently Facebook and Google are the closest to the overall S&P 500.


Are there areas outside of the S&P 500 that possess a superior risk/reward?  To reiterate our stance from earlier in 2021, we assign a higher probability of foreign equities outperforming U.S. equities assuming a 3-5 year horizon.  First, from a valuation standpoint, while the Emerging Market Index trades at a 12 P/E on 2022 estimated earnings, Germany (EWG) trades at 13x, Japan (EWJ) trades at 14x, and Europe (VGK) as a whole trades at 15x; the U.S. S&P 500 trades at 20x (a 33%-66% premium to these examples).  With a similar longer-term earnings growth profile, along with a higher dividend yield and improved balance sheets, the rest of the world has a superior longer-term risk/return profile versus the U.S.  The following chart shows the record valuation discount foreign equities sport versus the U.S. equities.  Foreign equities trade at a 30% discount to the U.S., which is the most extreme discount in decades.


 A common argument in 2021 has been whether to overweight growth stocks or value stocks.  But which is a better risk/reward?  We believe the answer is neither.  While “value” stocks can be less expensive, their earnings are volatile and could soon peak.  Meanwhile most “growth” stocks now trade at excessive valuations with potentially peaking earnings growth and difficult earnings comparisons ahead.  The outperformers of late 2021 through 2022 could be the economically sensitive companies.  These are companies that have experienced a delay in their earnings rebound, stunted by the Delta variant, supply chain disruptions, or both.  A number of these companies in the leisure, gaming, travel, airline, and materials areas could experience high future earnings growth coupled with reasonable valuations.  As an example, by assembling an equal weighted basket of these companies like Vulcan Materials (VMC), Freeport-McMoran (FCX), (TCOM), Bookings Holdings (BKNG), Alaska Airlines (ALK), Planet Fitness (PLNT), and Caesars (CZR), this group is estimated to deliver over 80% earnings growth while trading at a 33x P/E on 2022 earnings – a P/E-to-growth rate of less than 0.50.  These companies can have lower correlations to interest rates, inflation, and currency as well.

Although certain types of investments, sectors, and industries are trading at excessive valuations, especially considering their future earnings growth (or no earnings growth), we believe stronger risk/rewards can be found in foreign equities and select economically sensitive companies.  Buy economically sensitive for a sensitive economy, as earnings, interest rates, and inflation normalize. 

Justin McNichols, CFA

Justin is the Chief Investment Officer for OPCM, and has over 25 years of experience. Justin is a member of the OPCM Investment Management Team, and became a principal of the firm in 2000. Justin is a member of CFA Society San Francisco and CFA Institute. Justin received a Bachelor of Arts degree in Economics in three years and a M.B.A. in Finance from the University of California at Irvine. Additionally, he is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.