By John Fox
We began the last decade with “irrational exuberance” for equities. Investors poured money into stocks and ignored other asset classes. This “herd behavior” caused the valuations of equities to become overly inflated. The latter part of the decade brimmed with financial distress and ended in a severe Bear Market.
However, since this new decade’s inception in 2010, there is a fresh outlook for equities. In fact, there are four fundamental reasons why we continue to be optimistic about stocks, especially now.
1. Valuations = At the beginning of the last decade, company valuations (estimates of their future earnings potential) were exaggerated due to illogical enthusiasm for technology stocks. For example, the S&P 500 Index traded at a P/E ratio of 29x. Comparatively, stocks began this decade at reasonable valuation levels, trading at a P/E ratio of 17x, and are more in-line with historical averages. What this means is that from these more realistic valuations, investors have a greater potential for appreciation.
2. Free Cash Flow = Financial strength is one of our core investment guidelines. We like companies that have little or no debt and plenty of free cash flow (measure of cash generated after accounting for capital expenditures). During the past recession, American corporations tightened their belts and became more efficient;as a result many are much stronger – especially those that went into the downturn with ironclad financials. Businesses that generate cash can create value for shareholders. This includes: paying dividends, buying back stock, expanding their operations, and making acquisitions. We are observing all of these positive activities as healthy businesses are managing their own destiny.
3. Profits & Earnings = Since businesses are leaner and more streamlined, as the economy continues to improve they are showing good profits. Many reported record profits in 2010 and earnings for most publicly traded U.S. corporations have risen consecutively for multiple quarters. The stock market has reflected this positive momentum.
4. International Growth = Many domestic companies are growing overseas which has also bolstered profits. Several foreign economies are growing considerably, so U.S. businesses are taking advantage of growth opportunities abroad where consumption is rising at a faster rate.
When we factor together these four fundamental reasons for investing in equities, it is likely that this decade will be much better for investor returns than the last.
Remember, stocks represent ownership in real companies. While we have challenges ahead, stable businesses will endure as they innovate, prosper, and grow. Companies that have strong financials, sustainable competitive advantages, solid management teams, and reasonable valuations will continue to be attractive investments over the long term.