Lazy truths and sedimentary crock – why do some investors seem to miss the obvious

In the UK equity market, when a tech or other highly valued growth company goes wrong, we hear wails about another one letting the market down. And there are usually plenty of commentators asking how fund managers could have been fooled yet again, when everyone else, it seems, could see the red flags.

It takes more than a few investors to make it real

After the event, every commentator and their dog appears to think that the vast majority of market participants agreed with the lofty market price and acclaim that the company once attracted.  Most times this is far from the case. A handful of known institutional investor names on a shareholder list does not amount to wider equity market acceptance or validation.  This is particularly so in small cap where the holdings may be just tiny fragments of a sizeable, diversified fund, and where the investment was likely made with a clear understanding that it was very high risk.

That said, fund managers make mistakes and can still get caught up in a false narrative.  It would be odd if they were to do otherwise. They are, after all, paid to take decisions based on a tsunami of information and opinions with no real guarantee that the information is necessarily accurate or complete, particularly in small-cap land.

The lazy truth

While many, both inside and outside the equity market, will recognise the problems with listed companies and gaps in their stories, there is no compelling reason to speak out.

For fund managers who don’t own the stock, the view is almost always going to be more a case of fool those who do own it.

Short selling is rare in the small- and mid-cap market. An illiquid market where shares can double, treble or more in relatively short order is not a good place to play for a short seller.  As a stock picker in small cap, it is easier to play the multiple upsides than the fractional downsides to share prices.

For sell-side analysts, there is often no functioning reward mechanism for ‘sell’ recommendations.  In the small-cap market in particular, analysts are all too aware of the skeletons in their employer’s corporate broking relationship cupboards. Sell-side analysts may ask themselves what would happen if the corporate analyst at the broker to the subject of the sell note chose to retaliate.  In some sectors, that might well mean mutually assured destruction.

Plenty of examples, but few easy ones

Perhaps the best way to explain how companies can end up with a false narrative and a ‘fanboy’ share price is with an example.

The problem with using a current poster child company is that people get upset and it is all too easy to get tied up in the technical issues.  Using a historical case usually ends up with a catalogue of hindsight obscuring the actual factors and stories that drove the share price ever upwards.

So instead, we will illustrate with an example of how some in the market buy into an idea, proposition or concept – this way nobody threatens to sue and there is no risk of portfolios getting dented.

Perhaps the most apposite would be the idea that UK fund managers don’t value growth in the same way that US investors do, or more correctly, the proposition that we can measure and analyse this by looking at P/Es and earnings growth rates.

Give them what they want and make them feel clever

The way that this story is told and has gained currency parallels the way that false investment narratives grow and are sustained for months, even years, whether by chance or (heaven forefend) by design.

To get a fund manager to bite, you need a clear and appealing story.

Fund managers want to identify and understand something that is not fully reflected in the current share price; something that they get by their genius, hard work or through application of their carefully honed investment process.

The idea that by looking at P/Es and growth rates between markets we can gain insight, and perhaps cut the Gordian knot of understanding the lacklustre UK stock market, has obvious appeal.

Everyone gets the idea that, in general terms, ceteris paribus, you should pay more for faster-growing earnings.

The story runs that by plotting P/Es vs growth we can use a line of best fit to ‘show’ how increases in the growth rate are linked with increases in the P/E that fund managers are willing to pay for that growth rate. – i.e. the slope of the line. By doing this for different stock markets, we can ‘see’ how investors in these different markets reward growth in earnings differently.

So let’s examine UK vs US listed companies, considering listed companies above $1bn market capitalisation (Source: Refinitiv, July 2023).  To reduce outlier issues (and to make the chart easier to see), we remove annualised growth over the three-year period <100% and >-300%.  To help provide a clearer result, we only include positive earnings for which we have earnings forecasts over a three-year period. This gives us 1,461 US listed stocks and 236 UK listed stocks.  The P/E vs earnings growth charts are shown below with the lines of best fit.

The slopes on the two lines of best fit are clearly different. The line of best fit ‘shows’ that on average for every 5%-6% greater growth rate in earnings for US stocks, the market ‘awards’ an additional 1 P/E multiple, while on average in the UK the market requires around 25% extra EPS growth. The numbers are quite dramatic.

That is a lot of market data with some vaguely complicated maths to find the line of best fit.

The job of convincing some readers/investors that the due diligence has been undertaken and someone has done some good hard thinking is complete.  This is vaguely technical, so the reader/investor must be smart if they get this (a favourite play with tech stocks).

The information provided may fall short for many investors, but some will buy the idea, cutting the (unseen) corner to reach their decision and patting themselves on the back for ‘getting it’.

Sedimentary crock

With this idea now established, it is a simple matter to repeat.  More people talk about the proposition and more variables are thrown into the mix, to provide more ‘insight’.  The idea builds and hardens in the same way it does for a company’s investment story with every set of company results, every analyst note and every newspaper quote. The basics don’t get questioned and the story strengthens while the naysayers bite their tongues.

Of course, we know from relatively basic maths (see our blog on PEGs) that this idea is unlikely to work.  Basic valuation theory suggests that there is not going to be a straight line here and that looking for a relationship across a wide range of earnings growth rates is not going to produce anything reliable.  Most investors should know this too, but for some it seems that the lure of cutting the Gordian knot (much like an attractive investment return on a tech stock) is too much, and they drop their guard.

It turns out that for our sample data and line of best fit the coefficients of determination, R-squareds, are 0.02 for the UK and 0.07 for the US.  R-squared shows how much of the change in y is accounted for by changes in x.  In physical sciences, R-squared figures of 0.9 and above are generally seen as sound, and in social sciences there is usually scepticism for figures below 0.5.

This is not to say that there is not a relationship between P/E and earnings growth.  It’s just that P/E = 3.9 x EPS growth + 15.8 isn’t it – not even close – and while earnings growth is a major factor in determining valuations, it is just one of many, many factors that may interrelate and interreact.

Conclusion

As with a number of listed companies, plenty of people see the issue with this proposition and some might have asked what the R-squareds are or even got the data and found out for themselves, but there is little reason for them to tell anyone. I only make the observation about the earnings growth comparison issues to illustrate a point. We keep shtum on such issues as directors’ dubious pasts, empty framework agreements, accounting issues and pointless technologies, and so the share prices run.  In the small- and mid-cap market, the pricing of many stocks in the short to medium term ends up being driven by believers alone.

Postscript

It would be unfair/lazy not to attempt to clean the data further to make it more relevant. We therefore remove those companies for which P/Es are less relevant and where assets or ‘over the cycle’ multiples are more appropriate (using ICB sector definitions): banks, finance and credit services, closed end investments, life insurance, non-life insurance, oil, gas and coal, open end and miscellaneous investments, precious metals & mining, REITs, real estate investment and services, and industrial metals and mining.

As can be seen in the chart below, taking out the non-P/E sectors shows the UK market in a far better light, with a sensitivity to earnings growth not dissimilar to the wider US market data.  The removal of the non-P/E sectors has also increased the sensitivity to earnings growth for the US stock data.

For both markets, the R-squareds have increased significantly, to 0.14 for the UK and 0.13 for the US.  This is as we would expect.  Although the logic is still flawed, we are at least concentrating on areas of the market for which earnings growth is relevant.

Going one step further and taking out tech (software, hardware and telco equipment) leads to an interesting result.  As shown in the charts below, the sensitivity of the UK market to earnings growth for this population definition is greater than it is for the US market.

Of course, we know that this shouldn’t be relied on because the R-squareds are only 0.13 (UK) and 0.08 (US), but most of all because it doesn’t tell people what they want to hear.

Ian Robertson

irobertson@progressive-research.com