Senior PM explains that underlying earnings and strong fundamentals should buoy markets, even as pockets of hype fizzle out
In the past 12 months, the US stock market has gotten cheaper. Despite hitting and crossing multiple record highs, the actual earnings on the broader market have grown between 20 and 30 per cent. While trailing 12 month P/E ratios for the S&P 500 are still roughly above 30, reflecting a US market that got very expensive in the first years of this decade, forward P/E sits closer to 23.5, according to S&P Global, which reflects more of a reversion to the historical mean. When critics of this bull market come to Craig Jerusalim with stories about the dot com bubble, he shows them how different today’s earnings are from the froth of the early 2000s.
Jerusalim is a Senior Portfolio Manager at CIBC Asset Management. He explained why earnings have begun to turn on US markets and how valuations have come down while stocks have continued to grow. He outlined the role of AI in this theme, both as a source of hype and a source of meaningful productivity gains for businesses. While Jerusalim still sees areas of risk that investors and advisors need to be aware of, he cautions against the fear and panic that sometimes accompany outlooks tied to this market.
“This market is being driven by thematic momentum, algorithms, and a basket approach to investing. It almost doesn't matter the fundamentals. I say it ‘almost’ doesn't matter because if you're in the right basket and money is coming in, that is right now the most powerful force in stocks doing well. And that's why selling your winners hasn't worked because momentum is taking things a lot further than we've seen in the past,” Jerusalim says. “Even though we believe in the fundamentals, these trends are hard to fight against. In our work, because we're not chasing the hype of these investment cycles and we're looking at the fundamentals, we're trying not to fight against those broad momentum trends. Instead, we're still doing our bottom-up fundamental analysis, but we're also trying to pair it with not only the fundamentals but also the technicals and catalysts that are going to either stop a decline or keep an incline going.”
One of those catalysts has been the rise and implementation of Artificial Intelligence. Jerusalim says that as he and his team have interviewed business leaders, they’ve found meaningful productivity impacts from AI implementation. That has come on the cost side for some, on the growth side for others, but these tools are adding value which is being reflected in earnings. That real impact, in addition to other drivers of earnings growth, are much more fundamental to this market narrative than an IPO like SpaceX with a valuation at 100 times its sales, Jerusalim explains.
How to find fundamentals in a momentum market
While earnings growth is a strong fundamental metric for the broader market, Jerusalim says that in this cycle he and his team have placed particular focus on companies’ terminal value. Their process begins by contrasting future cash flow and earnings with consensus for a particular company, identifying companies where future earnings are likely to be above consensus. What’s changed, however, is the need to manage expectations around AI disruption.
Jerusalim notes the example of Thomson Reuters, an overall strong company with a stock that has lost more than half its value in the past 12 months, because investor consensus has formed around the idea that AI will erode its business. The challenge for a fundamental investor is that it’s very hard to disprove a negative. When investor consensus settles on the idea that a business model won’t be there in the future, there’s nothing that can be said in the present to change that.
To deal with that dynamic, Jerusalim and his team are triangulating terminal valuation by looking for moats, competitive advantages, and earnings while reconciling all those present metrics with the prospect of transformative change. They build a discounted cash flow model for a company and project that out ten years into the future to find that idea of a terminal valuation.
Conviction as the antidote to risk
While the US bull market may be moving towards more sustainable valuations, Jerusalim does still see some risks on the horizon. He puts those risks in context, however, noting that some technical pullbacks are healthy. Every year, he says, there are two or three pullbacks in the roughly five to ten per cent category. Once a year we tend to get a pullback at around 10 to 20 per cent. Corrections between 20 and 30 per cent tend to only happen in recessions, and corrections south of 40 per cent are typically only associated with a financial crisis. The takeaway, he says, is to expect pullbacks in those smaller technical categories.
Jerusalim’s belief is that there needs to be conviction in the portfolio to weather market swoons. He cautions against frequent trading and tells investors to find companies they believe in, companies they understand, and companies that can weather a downturn. He uses the example of Waste Connections, a garbage collection company that will continue to operate, take in revenue, and maintain pricing power in any economic environment. The market, currently, has that company out of favour, but Jerusalim suggests ‘barbelling’ the portfolio with companies like that as a counterpoint to some of the expensive free cash flow growers on the market now.
Pricing power in an inflationary environment is also an important metric for advisors to understand, Jerusalim says. He looks for companies that can pass price increases on to their customers without losing market share. Competitive moats are essential, he says. In the end, while the market continues to hit new heights and pockets of hype emerge, Jerusalim insists that advisors need a strong fundamental answer to the question of why someone would invest in a particular company.
“If a client comes to you and says, ‘I want to buy $100,000 of SpaceX, it's up 40 plus per cent since the IPO, it's hot, it's on the front page of the news, everyone's talking about it, talking about it at dinner parties, I want to put $100,000 into it’ I think the first question you have to ask is why,” Jerusalim says. “Ask, what do you know about the company? Why should a company whose revenue is in the billions trade in the trillions. If the answer is because it's hot, it's interesting and sexy, fine. But just be prepared for the consequences of if there is a disappointment. Understand what you're buying and why.”
