The bull market in global equities rampages on, aided if you believe the news headlines, by the tsunami of cash gushing into low cost tracking products such as exchange traded funds (ETFs).
The ETF industry is on course to attract record new business growth in 2017, continuing a winning streak that would run into its fourth year. The ETF market is dominated by three investment houses; BlackRock, Vanguard and State Street, who between them manage just under $3 trillion (£2.7 trillion) in total. This number has pretty much doubled from four years ago, fuelling speculation that the tide of money is helping form a bubble in equities, and US stocks in particular.
This got us thinking about how exposed we might be to the flow of cash that keeps streaming through ETFs and ultimately, by virtue of our preference for large cap stocks, into our holdings.
In our quest to discover more, we took the Huntress Global Blue Chip fund’s portfolio of stocks and calculated how much of the outstanding share capital the top three ETF providers owned. We then looked at ownership levels across the same list of stocks in 2009 (around the market low after the financial crisis in 2008). We also looked at the growth of market capitalisation, sales and earnings to see if there were any discernible trends that could be identified.
To ease comparisons, we based everything in US dollars and kept the exchange rate constant. The total value of our list of stocks measured by their total market capitalisation was $2.2 trillion in 2009, while the interest of the top three ETF providers in our list of companies totalled 8% of the outstanding share capital, with a market value of $186 billion. In 2017, the total market capitalisation had risen to $4.8 trillion and the interest of the top three ETF providers had grown to 12% of the outstanding share capital, now valued at $574 billion.
The market value of our US holdings in 2009 totalled $1.4 trillion and the top three ETF providers held roughly 11% of their share capital valued at $158 billion. Today these numbers have swollen to $3.3 trillion, 16% and $520 billion respectively. In order to accommodate their flows, these providers have had to increase their interest in these companies in a meaningful way. In the UK, interest has remained static at roughly 7%, but across our European holdings interest has doubled, albeit from a very low base (1.5% to 2.9%).
These trends pretty much mirror those underway in the ETF industry. The US is the most established ETF market and the biggest. Low cost index tracking has been championed by Warren Buffett and has enjoyed gargantuan flows. It would therefore seem reasonable for US companies to be the primary beneficiaries of this trend.
In Europe, the ETF industry is not so established, which is why interest levels are much lower and the pace of growth has been subdued in comparison. The UK market sits between the two and has arguably been a beneficiary of London’s status as a financial hub.
As one would expect during a bull market, valuations have risen and on a price to earnings (P/E) basis, the portfolio multiple has gone from 17x to 20.1x. Interestingly, the P/E expansion has been most prominent within the portfolio’s European holdings, where ETF interest is minimal.
When we look at the relationship between market capitalisation to sales, we see a similar expansion in median multiples, from 2.5x in 2009 to 3.6x in 2017. However, this has been driven more by the UK and European stocks than those in the US.
Whilst we cannot definitively draw a direct connection between ETF flows and valuation, we do notice that there is a disconnect between market capitalisation to sales multiples and P/E multiples.
This is definitely in keeping with observations made during the most recent round of earnings announcements, as companies were beating expectations and demonstrating growth on the bottom line, with little or no improvement to the top line. Without the support from a growing top line, we are beginning to question whether the progress being made on the bottom line is sustainable.
Bottom line improvements are being made from cost-cutting in the face of a tougher operating environment and flagging sales. At the earnings per share level even greater gains are being made as companies continue to buy back their own stock, an activity most favoured by American companies, in management’s desire to return even greater amounts of capital back to shareholders.
We question the rationale behind this allocation of capital. We would prefer shares were not bought back near cycle highs, preferring excess capital to be re-invested back into the business to improve sales, or used to reduce debt, bolster dividends or simply kept on the balance sheet to help fund value accretive acquisitions (should such a thing exist at this point in the cycle). Easier said than done when there are very powerful, short-term actors patrolling the market for stakes in businesses they feel are under-delivering. At least we cannot blame passives for driving this behaviour.