Jan 2020: Valuation Expansion

by | Jan 4, 2020 | Market Updates

Here’s what we’re about to tell you: 

The market – nearly every part of it – ripped higher in 2019. It was an awesome year.

Here’s the more important thing we’re going to tell you: Valuation expansion drove nearly all of it, 92% to be precise.   

We’re going to explain this and its importance to our portfolios moving forward, through the almost unexplainable last 12 months of none other than… Apple stock. 

First, a crucial concept.  Where investment returns can come from:

  1. Yield – Dividends and interest.  Easy to quantify and directly related to the fundamental make up of companies you own.
  2. Growth – Earnings growth.  Harder to quantify, but directly related to the fundamental make of companies you own.
  3. Valuation Change – The hardest to quantify, and directly related to the EXPECTATIONS of the companies you own…not the fundamental make up.   

We operate our portfolios and investment structure around a yield + growth framework – this is important.  To read more, see our update from July linked here. 

Now to the fun part – Apple stock – (Ticker: AAPL): 

For the record, this is not a buy or sell call on AAPL, we think it’s an incredible business 

The largest company in the world returned investors 89% for 2019!  Apple alone was responsible for nearly 10% of the S&P 500’s 31% return on the year.  

Percentages are one thing, now think about that in dollar amounts. Apple closed 2018 with a market cap (overall company value) of $693 Billion. It closed 2019 with a market cap over $1.35 Trillion – yes, that’s trillion with a “T”.   

Forrest has a trillion reasons to thank Lieutenant Dan for putting that Bubba Gump money to good use in that “fruit company”: https://www.youtube.com/watch?v=SNa4EMUWnAc 

The driver of those returns, to propel a company by over $600 Billion in market cap, has to be some incredible developments and growth at Apple, right?  Wrong.   

Data below is from FactSet and refers to trailing 1-year numbers at the end of Apple’s fiscal year, which is in September:  

  • Sales growth must have been amazingActually, it was negative, down 2.20%.  
  • If it wasn’t top line growth, surely it was earnings. Actually, they were negative, down 7.20% 
  • EBIT, EBITDA, and Free Cash Flow all had negative growth rates, the only positive growth rate was in the dividend 

There seems to be a disconnect.  How could Apple’s stock price go up, and go up that much, with things at the company level appearing stagnant? The answer is applicable to the market as a whole and impacting our portfolio positioning more so than ever.     

Returns last year were generated more from things that have little to do with underlying fundamentals. As a reference, earnings growth has been the primary driver of stock returns since 2009, accounting for 67% of the S&P’s return vs only 8% in 2019. Why? 

We won’t pretend to know the full answer, but here’s our guess:  Look at an investor’s opportunity set: stocks or bonds. 

Currently, the forward earnings yield of the S&P 500 sits at 5.3%. That’s simply the aggregate earnings of the S&P 500 relative to its price, meaning 5 cents of every dollar in the index translates to net income. Consider Apple’s earnings yield to make this point clear: 

Apple’s current earnings yield in real time as of January 6, 2020: 


The current yield on the 10-year Treasury bond, a symbol of security being backed by our government, sits at 1.79%. That means the S&P 500 has earnings yield 3.51% higher than a 10-year Treasury bond’s yield. Here’s the kicker, not only do stocks have a much higher yield relative to treasuries, they also give us, as investors, potential for growth. 

We believe valuation change’s contribution to return has more to do with the opportunity set investors are stuck with than anything else. 2019 saw three rate cuts by the Federal Reserve and the equity market rose after each. As long as stocks look more attractive than bonds, valuations can continue to rise and further disconnect from fundamentals.  

Here’s the good news: 

The economy is rocking along. Economic health appears healthy enough. In addition, valuations are expensive in stocks, just not all that expensive when compared to bonds. We’re working through a more in-depth piece on the markets as a whole, follow the updates here. 

Here’s what this has to do with our portfolios: 

The structure of our Yield + Growth framework lends itself to understanding trade-offs and probabilities. While the past is important, its relevance pales in comparison to what could happen. We need to be comfortable with the trades offs in our asset allocation decisions around the risk we take, and those we don’t.  

Our portfolios are positioned towards return drivers that we can better understand, yield and growth. We depend less on valuations’ continual upward march.  If they continue to expand, we and our investors will welcome rising prices with open armsit’s icing on the cake. 

It’s not the upside that worries us in an environment where returns are dependent on expectations continuing to rise. It’s the elevated exposure to drawdown risk if a political or economic development changes the direction of those expectations.  

That’s the tradeoff that comes with returns driven by Fed decisions and trade wars easing, and not from basic fundamental improvements. It’s that exact risk we aim to guard against in our portfolios. More details on what that looks like here: https://impact-series.com/fact-sheets/ 

As always, thank you for your trust and please don’t hesitate to reach out with any questions.

Your Team at Aptus


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