Global and US corporate aggregate earnings remained flat with no growth for the last couple of years.

In November 2014, S&P 500 LTM EPS hit the peak of $113.57. MSCI All Country LTM EPS hit the peak of $24.74. In February 2017, S&P 500 and MSCI All Country LTM EPS were $21.35 and $84.37 respectively. Obviously, the market price is an appraisal of the sum of the current value of the deployed asset, the investment return on the existing investment and the future investment return. So as long as the weight of valuation toward future increases, the appraisal value should increase accordingly.

No doubt the global monetary expansion has been the key driver until recently, and the leadership seems to have been passed on to the fiscal and regulatory issue. Now people are debating whether US corporate tax cut can be agreed and done successfully or not – even to the level of 25%. For the US companies with the extensive international operation, tax-free repatriation of foreign cash seems to be in the list. The idea here is that the pro-growth reinvestment by corporates should increase the investment as well as the return in the future and thus the market price of equities should be trading positively.

 

For this line of logic, I think the quality of investment is crucial. Going back to the logic of valuation, the incremental investment from such pro-growth measures should generate the return above the cost of capital. As a provider of financial capital, I have seen many excessive pricing of assets – and the financial bubble – and nearly all of them are followed by the previous investments in low return assets with IRR or ROI below WACC (even below zero!). When people and business are either too short-sighted or too loose in certainty (or distance) of future cash flow from investments, the aggregate group behavior creates such assets with a particular book value that remains as a very high hurdle for the future. I am wondering if the repatriated large cash piles to the US may be used to purchase such assets or business. In the first place, if the companies are already discovering the investment opportunities with IRR that exceeds WACC in the super-low interest rate environment, will it work as a trigger to create a series of investment activities just by getting a bit more relief from tax payables?

Back to the corporate earnings. As touched, global corporate earnings have been flat or down in the last couple of years – why?

The earnings landscape was primarily in a bipolar situation. The decline from energy and materials sector was so significant that any steady earnings growth from IT, Consumers, and Health Care was more than offset. That thus means the widespread consensus of earnings growth in 2017 is driven mostly by the recovery of energy and cyclical material sectors because WTI is now looking to range bounding around $50 which is a significant improvement from $35 last year. For instance, the leading energy companies like EOG Resources and Pioneer Natural Resources are expected to deliver revenue growth in Q1and Q2, 84% YoY & 47% YoY and 31% YoY & 22% YoY, respectively. Another individual driver of earnings is semiconductor industry which is benefiting from commodity semis recovery as well as semi capex race in addition to the steady growth of consumption of semis thanks to cloud technology infrastructure. Thus in the future, I think WTI still holds the core (as long as around $50 – it should be okay), and the disciplined corporative global supply and inventory control in the age of new sophisticated seismic technology in Permian Basin need attention. In the long run, the increasing discovery of new reserves such as in Guyana will shape new demand dynamics. For commodity technology memory, all depends on the project capex in the largest fab in China. As long as the drivers of the recovery are in the areas with cash flow of low-certainty and high-volatility, without the reasonable discount rate of higher risk premium, the valuation would not reflect what is to be ahead in a conservative way.

So – for a pure fundamental-oriented active investor – do not spend too much on market dynamics prediction. Be just aware of it as a market dynamics and separate “knowledge” and “location of investment risk.”

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