US Equities: Revenue Is King In 2016 by James T. Tierney, Jr., AllianceBernstein
US markets are facing complex conditions. Stocks have been volatile. An interest-rate hike looms. Corporate profit margins have likely peaked. So what’s the right investing strategy for 2016?
In this environment, there are three keys to success. First, identify the drivers of market returns. Second, find companies that are best positioned to benefit from these drivers. Third, take a highly selective approach.
What’s Driving Stock Returns?
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It’s been a volatile year for equity investors. After posting modest gains in the first half, the S&P 500 Index plunged by 11% in late August and then posted a 9% recovery through mid November.
Taking a longer view, US equities have marched upwards since 2009, driven by improving margins and the expansion of price/earnings multiples (Display). In 2008–2009, operating margins for the S&P 500 fell to a low of 4.5%. Today, margins have rebounded to about 10%, according to Standard & Poor’s. But profitability gains have mostly come from cost-cutting rather than revenue growth.
P/E expansion is the other tailwind. The S&P 500’s market price has surged from below 12 times earnings in 2009 to almost 19 times earnings today. We estimate that more than 80% of investor returns over the past six years has come from corporate profit margins and P/E expansion.
Margin Gains Are Ending
But don’t count on margins to drive earnings in the coming years. Margins today are 1% higher than the prior cycle peak and 3% above the average since the early 1950s. Potential pressures on margins include wage inflation, a rebound in commodity prices and higher interest rates.
The same can be said of P/E multiples. To get a similar expansion benefit as those in recent years, P/E ratios would have to reach the high 20s—an uncomfortably bubbly level not seen since 2000. We expect the P/E multiple for US stocks to remain stable, while returns should increase in line with earnings growth.
In these conditions, a different approach is needed to make money in US equities. Instead of focusing on margins and P/E multiples, look for companies that can deliver sustained revenue growth.
Consumer Spending to Pick Up
The US economy’s modest recovery continued in 2015. GDP is expected to grow by about 2.5%, according to consensus estimates. We think better economic growth and diminishing headwinds to revenue gains can make a difference.
Consumer spending accounts for nearly 70% of US GDP. Today, low unemployment, accelerating wage increases and low fuel prices should augment US consumer purchasing power. Indeed, US car sales are booming today. Over time, we believe consumer purchases should extend to lower-ticket purchases, propelling a broader cross-section of the economy.
Currency and energy trends should also help support growth. A strong US dollar has eroded revenues. But at current currency rates, the impact in 2016 will be much lower than in 2015. Likewise, stable energy prices will remove the significant revenue headwinds seen in 2015 in the energy sector.
These two factors should push revenues back into positive growth territory—from an expected decline in 2015. We believe revenue growth will distinguish the winners from the losers.
It’s All About Revenue Growth
Revenue trends are diverse (Display). While aggregate revenues slipped in the third quarter, 18% of US companies reporting increased their revenues by more than 10% in the third quarter compared to the same period last year, and 33% of companies boosted revenue by up to 10%. However, 49% of companies saw their revenues fall.
In this environment, we think being selective in stock-picking will become more important for portfolio returns in 2016. Simply buying a US stock index can be a risky strategy, since it will provide broad-based exposure to companies with stronger and weaker revenue growth. While index funds or ETFs have been successful over the last five years, we think the environment is swinging back in favor of active portfolio management.
Investing in US equities today isn’t easy. With low expected returns across various asset classes, we think choosing the right manager is likely to be increasingly important. One way to gain conviction is to focus on managers that take a highly selective approach to find companies that can increase revenues in a challenging market to deliver solid long-term investment returns.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.