Research Affiliates has sweeping new investing advice: Shun yesterday’s winners and embrace these three types of stock market ‘losers’ which may return 8-12% a year
You might think the S&P 500’s one-fifth selloff since January takes U.S. big caps close to a floor, and could even present a buying opportunity. Not so fast. With interest rates relentlessly on the rise—a trend that could puncture today’s still lofty valuations—a far bigger drop remains a strong possibility, especially now that the upwards earnings march that appeared to justify those fat PEs flipped to a retreat. Here’s the part that’s somewhat reassuring: If you’re investing for the long-haul, the sharp decline means you’ll enjoy much bigger gains over the next decade than if you’d bought at the summit just nine months ago.
But don’t get overly excited about profiting from the pullback. Three other equity categories are now promising returns between 50% and 100% higher than the S&P 500. The valuations of these neglected classes are a lot more beaten down, and hence far cheaper, than a broad portfolio of the largest U.S. stocks, and particularly one the that tilts to the high-flyers that despite their recent hammering, remain extremely pricey.
“What matters most in forecasting the gains to come is the starting valuation, the lower the better,” says Chris Brightman, CEO and chief investment officer at Research Affiliates, a firm that oversees investment strategies for $143 billion in mutual funds and ETFs. “The S&P is still relatively expensive, so shrinking PEs remain a major headwind. Investors will get their biggest returns from categories that have way underperformed that benchmark’s decline, and hence offer much higher dividend yields and room for their valuations to either grow, or at least stay pretty flat as rising earnings and payouts generate returns that are about average by historical standards, but way better than the U.S. market overall.”
This writer has always judged Research Affiliates’ predictions as the best in the business. That’s chiefly because they’re grounded in top academic research, as filtered by its many PhDs. Brightman and founder Rob Arnott, a former editor of the Financial Analysts Journal, are experts at interpreting what happens in the years ahead when you start with today’s valuations, real interest rates, and other key metrics. “If you’re a Cathie Wood looking for high-priced growth stocks about to take off, you wouldn’t make our picks,” Brightman told Fortune. “But if you’re following fundamentals as we do, you’d go with the out-of-favor places where the Wall Street and TV pundits shun.”
The selloff has lifted prospects for U.S. big caps, but they’re far from the place to be
On its website, Research Affiliates furnishes its outlook for ten-year, expected returns in sundry asset classes, from commodities, to corporate bonds, to big cap value and growth. (From the RA homepage click “tools,” then “asset allocation” to see interactive chart.) Before examining their top picks, let’s review how the RA methodology rates the prospects for the world’s top benchmark, the S&P 500. RA deploys the three factors that determine equity gains: the current dividend yield, the estimated annual growth in earnings-per-share, and yearly change in the PE multiple, as well as projected changes in currency for foreign stocks. It adds the three or four factors to get the total, average annual return over the next decade.
No mystery about the dividend yield—it’s just the current current payout per share divided by the price per share; the more a stock’s price falls, the more the yield rises, the phenomenon we’ve been witnessing in recent months. For profit growth, RA projects “real” increases in the low single-digits that are way below the “consensus” of Wall Street analysts. RA reckons that we’ve experienced something resembling an earnings bubble that’s now ending, and that EPS expansion return to the modest pace of GDP growth or below the prevailed before the explosion.
For valuation, RA uses one of the best tools in foreseeing the market’s trajectory, the cyclically-adjusted price-to-earning ratio developed by Yale economist Robert Shiller. The CAPE eliminates distortions that inflate PEs in a profit slump and make valuations appear artificially low in an unsustainable EPS boom like today’s. The measure smooths the volatile profit swings that make PEs from moment to moment such an unreliable yardstick by taking a 10-year average of inflation-adjusted earnings as the denominator. For each asset class, RA assumes that the Shiller PE over the next decade will revert halfway from today’s number, to the average figure over the trailing ten year span. As we’ll see, that “mean reversion” effect is a pivotal lever in positing the relative performance of different groups of equities, yanking down U.S. growth stocks while imposing no penalty on the likes of European equities, and aiding emerging markets.
RA’s analysis shows the see-saw effect for the S&P 500: Its large decline has substantially lifted the prediction for future returns. The problem: The index was so richly priced before the fall that its prospects have only improved from poor to mediocre. As recently as April, the 500 sported a gigantic Shiller PE of 37. At those prices, its dividend yield was a paltry 1.35%, and RA had its multiple shrinking big time in the years ahead, imposing downward pressure of on annual returns of well over 4% a year. Add the 1.35% and 6.5% earnings growth (7.85%) and subtract the 4% drag from the PE erosion, and the S&P a few months ago was promising 10-year returns that merely matched expected inflation of 4%. Put simply, by buying big caps last spring, you’d barely match the CPI over the next ten years.
Today, that formerly depressing plotline’s brightened a bit. “A bear market will do that for you,” notes Brightman. The S&P 500 dividend yield has jumped by 20% to 1.7%, and RA maintained its annual EPS growth estimate of 6.5% (keep in mind this number includes 4% inflation). The big difference: The index’s 21% fall dropped the CAPE, or adjusted PE, by eight points from 37 to around 29. Once again, the RA system forecasts that the CAPE will revert halfway to the norm, defined as its average in the past decade, over the next ten years. Today, the S&P’s CAPE of 29 is still higher than that “normal” level of 23.4, but it’s gotten a lot closer to what might be called fair value.
As a result, trending back towards its much lower historic PE will impose a headwind of just 2.2% a year, less than half the downdraft this spring. All told, RA now sees the 500 logging total annual returns of 5.9% a year, besting inflation by 1.9 points, versus breaking even just months ago. That doesn’t make U.S. big caps a great deal by any means. Still, if you buy an S&P index fund today, your portfolio’s at least likely to grow faster than your bills for the likes of rent, groceries, and gas.
Value stocks remain a great buy
Since early last year, the value side of the S&P 500 has outperformed the entire index, and easily waxed the growth category. But value stocks are still the sweet spot for U.S. large caps. They’re the unalluring bunch featuring below average PEs, price-to-book value, cash flow and sales. Pillars of the group include energy, utilities, pharmaceuticals, and banks. Research by Nobel prize winner Eugene Fama and his research partner Kenneth French shows that over long periods, value consistently furnishes market-beating results. “That’s because their starting valuations are lower,” says Brightman. “The lower prices means that value stocks offer higher dividend yields and generate more cash for each dollar an investor pays than for growth stocks.”
Brightman adds that when value is extremely cheap relative to growth—measured by the gap in PEs between the two categories, for example—value outperforms its rival by an unusually wide margin over the next decade. That’s today’s scenario. “Despite value’s better performance over the past 18 months, the pricing differential between growth and value is at its most extreme in history excluding the late 1990s bubble and the market’s peak at the end of 2021 and start of 2022,” says Brightman. As the RA numbers demonstrate, that gulf in valuations should translate into a big win for value in the coming years. Handicapping the growth category are a puny dividend yield of 1%, and a still towering Shiller PE of 37. RA projects that a steep fall in its valuation will limit annual returns to just 5.3%, or 1.3% adjusted for inflation, through 2023. That’s what the future holds for a basket dominated by the Apples, Amazons, Metas and Teslas.
By comparison, “large value” boasts a starting yield that’s more than twice as fat at 2.3%, and the same earnings growth rate of 6.5%. It’s not that value is cheap compared to the category’s valuation in the past. In fact, it’s slightly expensive. So its PE will decline a bit in the years ahead, but not nearly as much as for growth. All told, RA foresees 8% returns for value over the next decade. That’s 2.7 points better than growth, and more than two points higher than the overall S&P 500. In the RA scenario, a value portfolio will be worth almost 30% more than a collection of big cap growth by 2023.
Europe is one of the investing world’s best destinations
Over the past five years, European stocks have ranked among the world’s worst performers, logging declines of 16%, including a drop of almost one-third since the highs of 2021. The upshot is that they’re a screaming bargain versus U.S. big caps, including even the value bucket. “European shares are a bit cheap versus their own history, but not extremely so,” says Brightman. “It’s the huge difference in valuation with the U.S. that make them such an opportunity.”
So why aren’t Wall Street money managers and analysts extolling Europe’s future? The reason, says Brightman, is the misconception that if nations, or an entire region, suffer from low GDP growth, the companies headquartered there will generate poor returns. “The difference in GDP growth between the U.S. and Germany tells you nothing in forecasting the difference in EPS growth between GM and Toyota,” says Brightman. “Same with the U.S. expansion versus Switzerland and P&G versus Nestle. The notion that a country’s GDP helps determine equity returns is implicit in the low regard the commentators have for European stocks.” The performance of leaders in individual countries is so detached from the economy of their home markets because these giant players serve a global market. Nestle is based in Switzerland, but the products it sells in Japan, China or the U.S. make the site of its headquarters irrelevant.
Europe holds the edge over the U.S., says Brightman, because the region’s loaded with traditional, stalwart value players. “Europe’s indexes exclude the world’s most valuable companies,” says Brightman. “They don’t have the equivalent of an Amazon, Tesla, or Google.” The dominant forces are manufacturers such as Philips and Siemens in Germany, banks including France’s Societe Generale and Switzerland’s UBS, drug giants such as Switzerland’s Roche and the UK’s AstraZeneca, and a heavy weighting of utilities, carmakers and phone companies. Overall, that collection sells at a much lower valuation than an S&P spiked by high-flyers that though they’ve declined, remain valued based on huge earnings gains unlikely to materialize.
For RA, European big caps—their proxy is the MSCI Europe index—carry a Shiller PE of only 16.4. That’s just over half the number for the S&P 500, and well below the 19.4% for U.S. large value. European shares offer a relatively big dividend yield of 3.2%, and projected earnings growth of 6.5%. According to RA, investors buying with dollars should also get a big boost in valuation from “real” gains in Europe’s exchange rate versus the dollar. For example, the pound sterling has fallen 20% against the dollar since mid-2021, and buys less U.S. currency than at any point since 1985. In the past 18 months, the Europe’s fallen almost 20% against the greenback. A rebound in the European currencies should help add an extra 1.6% to yearly gains.
Add the 6.5% from EPS, 3.2% from dividends and 1.6% from a jump in valuation, and the projected total return for European stocks reaches a sumptuous 11.4% a year. That’s more than double the figure for the S&P, and over three points better than the outlook for U.S. value.
Emerging markets offer the biggest upside of all
The best deal of all may be emerging markets, though investors will face a rockier ride to reap those premium returns. The RA’s benchmark is the MSCI EM index. By nation, its biggest allocations are to China (32%), Taiwan and India (around 14.5% each), and South Korea (11%). Among its top 8 holdings are Taiwan Semi, Tencent of China, Alibaba of Hong Kong, and Reliance Industries and Infosys of India. In the past five years, EM has delivered a virtually zero return, earning both condemnation and neglect from Wall Street.
But that poor performance provides the seeds for a flowering to come, according to the RA forecast. The main reason: EM stocks look like the world’s best bargains. Their Shiller PE is hovering around 14. Their pummeled prices have lifted their dividend yield to 3.2%, and EM thinks their earnings growth will beat the U.S. and Europe at 7.9% a year. They can also expect a combined boost of 0.8% a year from a combination of “real” appreciation in their currencies to the dollar, and a rise in their pummeled PEs. Add it all up, and the EM crowd’s projected, 10 year annual gains come to 11.9%, even edging Europe.
The downside: RA predicts that emerging markets will prove about one-third more volatile than U.S. big caps over the next decade, and will follow the most careening fever chart of virtually any asset class going forward. But once again, emerging markets exemplify the out-of-the-way places where investors will do best: Areas that are under appreciated, generally unsexy, and mainly done so poorly in the recent past that Wall Street hates them. Following that contrarian path takes nerve. But today as seldom before, chasing yesterday’s winners is a doomed journey, and embracing the “losers” opens the road to glory.
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