New Report
We have posted a new report on Summit Industrial Income REIT (SMU.UN). This REIT focuses on the light industrial markets across Canada and has locations primarily in the Greater Toronto Area (GTA) and Greater Montreal Area (GMA). The company has a high occupancy rate, roughly 20.7 million of Gross Leasable Area (GLA), and has employed a robust property acquisition strategy. Boosted by tailwinds of the Canadian real estate market, a strong light industrial industry, and high economic growth in the GTA and GMA, we think that this is a name to watch.
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Report Updates
We have posted a report update on Sun Life Financial (SLF). Sun Life provides insurance, wealth and asset management solutions and has operations in a number of markets across the globe. The company recently made an acquisition of DentaQuest which is expected to grow its employee benefits market share in the US. This is a solid option for investors looking for growth and dividends, and it is supported by tailwinds of strong asset management performance, and rising interest rates and health care costs.
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Market Update
Markets have rebounded significantly over the past couple of weeks following the announcement of increased interest rates by the Federal Reserve. The 2 and 10-year yield curve briefly inverted this past week, which has been a long-standing warning of recessionary risks. The Biden Administration is considering releasing 180 million barrels of oil to combat the negative impacts of rising oil prices. The strong rise in markets over the past two weeks has been encouraging for a market recovery, and in this market update, we plan on discussing the strong fundamentals that continue to underpin the markets.
Stock Market's Meteoric Rise and Underlying Fundamentals
With the stock market's meteoric rise since the pandemic began and its most recent correction phase, we wanted to touch on the fundamentals that underpin its value. Arguably, the most important metric that determines how valuable a stock or the stock market should be are its earnings (net profits). Net profits are determined by two factors: sales and net profit margins. Either of these two factors increasing causes net profits to increase.
We have charted below the three-year cumulative S&P 500 price against its underlying earnings growth. One of the first things that we can see is that price tends to lead earnings – ie. in early 2020, the price declined months before forward earnings, and the same with the rebound in early 2020, price climbed before earnings. Most recently, price has been declining and is flat since mid-2021, whereas earnings have continued to rise. This has led to some narrowing between price and earnings, as earnings begin to catch up to the rise in price that we have seen over the past couple of years. Based on the data below, earnings grew roughly 1.35 times since three years ago, reflecting roughly an 11% annual growth rate. This meteoric rise in earnings is our basis for rationalizing the meteoric rise in price over the past few years. While we do not necessarily expect earnings to continue growing at 11% moving forward, even a modest single-digit growth going forward will create further compression between the price and its fundamentals.
Relation Between Sales and Earnings
Adding in the component of forward sales against price and EPS, we can see that at some point in early 2021, earnings outpaced sales growth. Earnings over the past three years have grown at an annualized rate of 11% and revenue has grown at a pace of 6%. This gap between sales and earnings growth is explained by an expansion in net profit margins. As companies expand their profit margins, their earnings grow at a faster pace than sales, thus supporting higher company (stock market) valuations.
To demonstrate the above point of expanding profit margins, we have plotted the weighted net profit margins of the S&P 500 over the past 15 years. Net profit margins have grown from 10% in 2007 to more than 13% in 2022. This expansion in margins means that companies are becoming more profitable, more efficient in their expense management, identifying new synergies through acquisitions, and/or reaching economies of scale. Over a long period of time, we believe that companies will continue to increase their profit margins as new technologies enable cost efficiencies, synergies are achieved through further consolidations, and management teams become more effective at cost savings.
Historic Sales and Earnings Growth Rates
Below we have the past 15 years of the S&P 500’s cumulative forward EPS and sales growth. This includes the recession of 2008, and on an annualized basis implies a growth rate of ~6% for EPS and roughly 4% for sales. There are two themes that stand out to us; one is that earnings and sales have experienced a few large impulses up, but have largely trended up and to the right, and secondly, that earnings have outpaced sales growth. Earnings outpacing sales growth is important (and directly tied to our net profit margin chart above) and implies that we can expect our basis for what a ‘fair’ price to sales multiple is to expand over time, as earnings are expected to drive company valuations.
What Can We Expect Going Forward?
Going forward, we expect earnings and sales to continue growing over a long timeframe, and we also expect earnings efficiency to continue. While we may not see the same level of earnings and sales growth that we have over the past few years, even if EPS and sales grow at their 15-year historical average levels would imply further valuation contraction as the market consolidates at these price levels. We think that investors should be encouraged by the rapid rise in company profits, the long-term growth rates of sales and earnings, and the prospects of further net profit margin expansion. We are comforted in the fact the market's rise in price is justly supported by a near-equally rapid rise in fundamentals. Company earnings are high, have been growing at a fast rate, and are continuing to rise in the face of stagnating markets. We believe that if company earnings continue to ascend from here, it is difficult to imagine the market not heading higher.
Best wishes for your investing!
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