As a headline indicator, the world’s major stock market indices act as a powerful gauge of economic wellbeing. But can investors really trust the headline equity market index as a barometer of corporate profitability? And if not the index, what can we trust?
In recent years, the rise in the indices was a function of shares getting more expensive, rather than underlying company profits growth. Between 2011 and the end of 2016, average earnings per share across the MSCI All Countries World index did not grow at all, but the index rose by 30% in dollar terms.
In 2017, the world earnings per share figure began to pick up and the index rose in line with that increase; so far in 2018, earnings have been rising strongly but the world index has fallen back. In essence, there has been a switch from price gains but no earnings growth (a rerating) to earnings growth but no price gains (a de-rating).
Dig a bit deeper and these headline trends disguise some unsettling divergence within the broad index.
Information technology has been a standout winner as platform companies increasingly dominate their markets and encroach on others, but many industries are struggling even without internet competition.
Since 2011, the sales per share for quoted companies in a number of industries – including utilities, machinery, tobacco, banks, oils and telecoms – have actually shrunk.
If the headline index return cannot be taken at face value as an indicator of corporate health, then it is increasingly important to discriminate in stock selection. As a result, the question of trust shifts: can investors trust their investee companies?
It is certainly in the interests of companies to win (and keep) the trust of shareholders and customers: any abuse will damage sales and cause share prices to be de-rated, and potentially lead to a rise in the risk premium applied to some equities.
To take but a few recent examples: millions of Facebook users did not appreciate their data being shared with Cambridge Analytica; Wells Fargo was recently caught creating millions of fake second bank accounts for customers in order to boost sales; Exxon and Shell spent millions of dollars lobbying against action on climate change while claiming to support decarbonisation.
We believe that long-term asset managers must take a holistic view of the underlying financial performance of a company and its sustainability: more responsible companies will tend to create more durable economic value for clients.
Relatedly, clients’ long-term interests are not always best served by a narrow focus on relative performance against a market index – least not an index which does not always demonstrate the full picture.
The whole financial system depends on trust, and it is worth paying attention to these growing trends.
Citywire AA-rated Henry Boucher is partner and deputy CIO of Sarasin & Partners LLP, and manager of its Food & Agriculture fund, which over the last three year has returned 36.2% versus a Global Themes peer average of 29%.