The Three Levers

February 4, 2021

Source: Bloomberg Source: Bloomberg

As I look ahead to the rest of 2021, I think it is important to reflect on where the equity market sits today and how it got there. I’m not going to focus on specific companies; rather, this week’s chart will explore the mechanics behind the components of the S&P 500 Index return.

As an equity income investor, I follow an investment process with many critical steps. In order to simplify this to its root, the goal of candidate screens, reading the Securities and Exchange Commission filings and speaking to management teams is to uncover companies that have the potential to pull three levers: sales growth, margin improvement and multiple expansion. The more levers to pull, the higher the potential upside return. In ideal situations, I believe that all three levers can be pulled and the portfolio can realize a significant total return in the security.

This week's chart attempts to illustrate the “levers” and their contribution to return, for each of the past five years. Sales and margins are represented by the earnings per share (EPS) change. Price-to-earnings (P/E) multiple change is the percentage of growth in the valuation metric year over year. Dividend yield is the cumulative dividends paid on the index for the year. The S&P 500 Index returned just over 18% last year and 31.5% for 2019. What is interesting to me in looking at the chart is that the market posted these impressive returns despite minimal earnings growth in 2019 and negative growth for 2020. The largest contributor to return, by far, was multiple expansion at nearly 30% growth each year. Investor expectations for a recovery in corporate earnings in the future surely played a role, but what could this portend going forward?

While it is certainly possible that history repeats itself and valuation multiples expand yet again, it is also possible for multiples to stagnate (or even contract) unless revenue and margins broadly recover. By the end of the first quarter, corporate earnings will begin to reflect the one-year anniversary of COVID-19 impacts, which should help with comparisons as the year progresses. A return to some form of normalcy should also work in the favor of a recovery. Time will tell whether this proves to be enough to support elevated valuations and perpetuate the trend of new all-time highs in broad equity prices.

Key Takeaway

It is important to take inventory of the fundamentals underlying the universe in which one invests. Reflecting on what has happened up to the current period is one way to do this, but it is certainly not meant to predict what will happen next. Instead, the chart above illustrates in unbiased terms where the market return has been generated and where the potential opportunities and risks lie for the future. My focus will continue to be on dividend-paying equities with what I believe are reasonable paths to a combination of sales growth, margin improvement and earnings-multiple expansion.

Tags: Equity market | S&P 500 Index | dividend-paying equities

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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