Some investors may be scratching their heads as the S&P 500 has sunk 3 percent this year after surging 32 percent in 2013.
Has something fundamentally changed and, if so, what should investors’ response be?
Let’s start at the beginning. Stocks have dropped for two main reasons:
1. Worries about slowing growth in China and economic weakness in emerging markets. The fear is that lower demand from emerging markets will hurt U.S. companies doing business there and, as a result, handicap their future economic prospects.
2. Concerns that the Federal Reserve will reduce its stimulus, shutting off the flow of money to Wall Street that has propelled the stock market higher.
Let’s take a closer look to see why those two worries have Wall Street and other investors on the edge of their seats.
|Earnings power is what really matters when making investment decisions.|
Last year in a Money and Market’s column, I explained that there are three — and only three — factors that determine the investment return from any individual stock or the market as a whole.
These three factors are:
2. Earnings growth
3. Change in the price-to-earnings (P/E) ratio
Those three factors are expressed as a percentage and, better yet, all you have to do is add them together to get the total return earned from stocks.
Using the three factors and drilling deeper into the stock market’s astonishing 2013 return, we can see how the 32 percent was achieved: 2 percent was from dividends; about 5 percent was earnings growth; and 25 percent was from a change in the price-to-earnings ratio.
Yes, that’s right: Most of 2013’s return was attributable to the willingness of investors to simply pay more — a significant amount — for stocks at the end of 2013 than they were at the beginning of the year. So it was a change in pricing that was the primary reason that stocks soared in 2013, not a dramatic improvement in the underlying fundamentals of their businesses.
And with investors such as Warren Buffett warning about excessive valuations, it’s time for companies to begin to show a higher level of earnings growth. If not, the currently high price-to-earnings ratios are going to melt away as quickly as an ice cream cone on a sultry summer afternoon.
That’s why investors are so concerned about China, because if expansion and consumption slow in the emerging world, it will reduce growth rates for companies around the globe, causing valuations (as measured by the price-to-earnings ratio) to decline. What’s more, if the Fed continues to taper its stimulus while global growth is slowing, it could be a real mess.
What should you do to protect your portfolio in this environment?
During my 30-year career as an investment manager, I’ve invested in a broad range of businesses using a variety of strategies, and the one that I’ve found that works the best, especially in extremely uncertain times like today, is investing in companies with steadily growing earnings instead of the more conventional “value” situations.
That’s because a steadily growing earnings stream (often referred to as earnings power) is the primary driver behind steady, consistent and sustainable investment returns. That’s right: It is earnings power that really matters when making investment decisions.
Earnings power benefits investors in two ways: It protects your investments during periods of market declines, and it propels your portfolio higher when markets climb.
Why is the focus on earnings power?
Because — as investment icons Benjamin Graham and Warren Buffett have said — stock prices follow earnings growth over time. But you are not just looking for companies with normal, everyday earnings power. You’re searching for companies that have superior earnings power that can be sustained over long periods of time and prosper in a variety of economic circumstances — both good and bad.
In next week’s column, I’ll reveal how to find the exceptional companies that have a combination of hard-to-find attributes that make them dominate global franchises. For now, watch the Fed carefully — the central bank releases its policy statement today — because without continued easy-money support, the current lofty valuation levels are unsustainable.