Article originally published on Forbes.com by Suraj K. Gupta.
There has been drastic change in equity markets over the past few years. Despite the uncertainty and market crash caused by the Covid-19 pandemic in March 2020, the U.S. stock market experienced a period of unabated growth thereafter on the back of strong economic support from world banks and governments. However, fears of inflationary pressures and a rising interest rate environment in Q4 2021 brought some volatility back into the market, and many growth stocks have had their valuations absolutely crushed since.
Many investors have questioned how to handle these markets. Is it a good time to buy, with many stocks significantly cheaper than they were in 2021, or is it a good time to sell due to the downward pressures on equities? In this article, I will share my thoughts on the fundamental changes we have seen in the market, and how to think about investing for the long term.
Too Big To Fail?
America’s largest corporations used to be some of the world’s oldest companies. In fact, a McKinsey study found that the average lifespan of S&P 500 companies was 61 years in 1958. Today, that number is below 18 years. Further, the study pointed to factors that could cause 75% of current S&P 500 companies to disappear before 2027 (either by merger, acquisition or bankruptcy).
One thing is certain: Innovation is taking place at an exponentially faster rate, and disruption is at its highest frequency in history. From 1962 to 1992, three new companies appeared in the S&P 500 Top 10 by total revenue. From 1992 to 2012, six new companies made the Top 10. From 2012 to 2022, eight new companies broke in, meaning that only two companies maintained their Top 10 by revenue status from 2012 to 2022 (Wal-Mart and Berkshire Hathaway). At this rate, companies like Apple, Amazon and Alphabet that recently broke into the Top 10 may not be there in another ten years.
Why does this matter? First and foremost, the stock market is a long-term game. It is exceedingly difficult to generate above-average returns in the market on short-term investments. The most-proven way of generating returns in the market is to take a long-term view on underlying businesses (something that Warren Buffet does very well). Now more than ever, we have to consider the effect of a rapidly changing technological environment on a company’s prospects. The world’s largest companies are unlikely to retain their mammoth status over the course of ten years, and the ones that will survive are those that can quickly adapt to their environment and decrease their reliance on shrinking legacy verticals.
Overvalued Or A New World Order?
Since the financial crisis in 2009, investors have consistently questioned if the market is overvalued. Pundits will decry that the S&P 500’s current price-to-earnings ratio (or P/E) of 24.46 is significantly higher than the historical average of 15.97. P/E ratios tell us how much investors are paying per $1 of company earnings, and these ratios are a great metric to understand company valuation. Higher P/Es are typically associated with high-growth companies where the market anticipates earnings to significantly increase in the future. Netflix, for example, had a P/E ratio well above 100x for the better part of the last decade, climbing as high as 400x in 2012 and 2015. Lower P/E ratios are usually associated with stagnating companies where the market anticipates earnings to shrink in the future. Deutsche Bank’s P/E dropped to 10x in 2021 as they faced significant pressures on their business.
With market P/E ratios nearly double the historical average, there is a strong argument to be made that the markets are overvalued. However, I believe there is another side of this equation. The S&P 500 is made up of the largest companies listed on the NYSE and NASDAQ. As discussed above, stable incumbent companies are being disrupted at an increasing rate as newer, innovative companies enter the market. This means that a company’s best recipe for success is to focus on disruptive growth and innovation. The market will reward these high-growth companies with higher stock prices, since growth intrinsically trades at higher P/Es, which means the shift we are seeing in the S&P 500’s new P/E average may be a signal that the market has fundamentally shifted and that companies can only survive and thrive if they are focused on growth and disruption. Incumbent companies that are stable or shrinking will receive lower valuations and P/Es as a result, which means they will exit the S&P 500 to make room for new, high-growth entrants.
This S&P 500 historical P/E chart demonstrates the point. Although the multi-decade average P/E ratio is around 15x, these ratios have consistently been above well above 15x since 1990. Interestingly, this chart plotting interest rates versus the S&P 500’s P/E ratios shows that rates fell below 6% in the 1990s at the same time that P/E ratios climbed well above 15x. Interest rates have an inverse relationship to P/E ratios, so as long as we maintain a low-to-modest interest rate environment with a high degree of innovation and disruption, higher P/E ratios may be here to stay.
Although we have faced some incredible changes and volatility in the markets, there continue to be fantastic investing opportunities out there if investors know where to look. Disruption is happening at a rate faster than ever before, and the largest companies in the 2030s may not be names most people would recognize today. Companies focused on growth will continue to outperform large, stable incumbents so long as they focus on innovation and disruption. Pinpointing the best teams that are looking at innovation and growth in the right way will go a long way in adding value to your portfolio and could be worth their current, historic premiums.
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Suraj Gupta Suraj K. Gupta is President & CEO of Rogue Insight Capital, an investment firm focused on supporting diversity, innovation and social impact. Read Suraj Gupta’s full executive profile here.
