Coming out on top during drawdowns

19 October 2018

As the profit cycle matures, we are increasingly being asked how long-term investors should best position themselves should the economic backdrop and equity markets become more challenging. 

There is a widely held belief – one we don’t subscribe to – that when the backdrop becomes more challenging, investors should shift out of higher multiple growth stocks towards lower multiple value stocks. This belief is based on the presumption that low multiples provide added defense when times are tough.

Unfortunately, the reality is more complicated, with little evidence supporting the claim that multiples are a powerful defense against worsening conditions.  

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In fact, our analysis of performance through downturns finds stable and rising cashflows are the most crucial line of defense during a market downturn. We find stocks that can continue to grow their cashflows during periods of tough economic conditions not only preserve more value during a market downturn, they also provide higher risk adjusted returns on a through-the-cycle basis. 

When we pull apart market returns across geographies, sectors, styles and stocks, we find performance of the underlying cashflows is most often the critical input into the total return that investors receive, particularly when it can be delivered largely irrespective of market conditions.

The importance of earnings on shareholder returns 

As we can see from chart one of the S&P 500 index, absolute share price performance of the index (blue line) is very closely correlated to the trajectory of earnings (brown line), over both the short term and through a full investment cycle.

Even in the most cyclical of sectors, where the inherent volatility of earnings should be well understood and widely anticipated, investors still seem reluctant to look beyond the regular deviations from the long-term trend in earnings.

Investors mark-to-market near term changes in earnings and are less willing to look through periods of earnings volatility. This fact is illustrated in chart two which is an example of the typical earnings and price behavior of companies operating in the notoriously cyclical shipping sector.  

The close relationship between earnings and share prices also transcends styles and sectors. For example, the uncomfortable truth is that the long-term performance differential between value and growth styles is almost entirely explained by the difference in earnings performance between the two.

As shown by charts three to four, since 2003 the S&P 500 Value Index has returned an annual price return of 6.9 per cent vs annualised earnings growth of 5.6 per cent, whereas the growth index has returned 9.2 per cent annualised over the same timeframe based on a 9.1 per cent annualised increase in earnings. The 33 per cent improvement in returns to growth over value could be explained by the difference in earnings and has little to do with valuation.

Taking a long-term view on one style over the other is really a call on the potential difference in earnings outcomes between the two styles and not, as is commonly believed, a call on valuation. 

Interestingly, and linking back to our original point, the Growth index was also more defensive during the GFC-led downturn. In the three years from 30 June 2007 to 30 June 2010, the S&P 500 Growth Index lost 24.7 per cent of its value and earnings declined 1.3 per cent. The value index in contrast lost 40.7 per cent of its value over the period and earnings declined 19.8 per cent. 

Both styles suffered similar de-rating over the period, but the superior earnings power of the S&P 500 Growth Index cushioned investors against the worst of the GFC fallout. The trajectory and stability of earnings really is the key differentiator when it comes to risk adjusted returns and defensive strategies.          

The very close relationship between share prices and profits speaks to the market inefficiency that is an opportunity for informed investors to exploit. It is clear shares price to near term fundamentals rather than attempt to price to longer term outcomes, which can provide long-term investors that take this approach with a clear and meaningful investable advantage. 

 If investors can identify companies that can genuinely sustain or improve their economic returns over the long term and combine that with structural, rather than cyclical, pathways to growth, investors will reap the rewards from the long-term compounding of those cash flows.

These kinds of companies should provide positive and stable earnings trajectories over our five-year timeframe and throughout all stages of the economic cycle, helping investors to preserve value when times are tough and grow value when conditions are more favourable. 

This is why we believe that fundamentals, not valuations, explain the vast majority of total shareholder returns (and risks) over the long run. 


Markets mark-to-market in the short term and are inefficient in the long run. This is an exploitable opportunity;

Earnings matter more than multiples over the long run and particularly during a downturn;

The impact from the compounding of cash flows outweighs the potential impact from valuations over the medium to long term;

Low multiples do not necessarily offer protection in a downturn, earnings and cashflows generally do;

Consistent and stable cashflow growth is an important cushion to protect and preserve value through a downturn; and

Combining structural growth with high or improving returns is the root cause of stable and expanding cashflows - it is the first line of defence in a downturn.  
Simon Steele is AMP Capital's head of global equities. 

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