Are U.S. Equities in a sweet spot?
March 17 2021 - Research@Stockal in collaboration with Omniscience Capital
Does an appreciated INR make it sweeter for Indian Investors?
Indian investors are attracted to the US markets because of the presence of well-known companies with popular products. However, the dilemma is whether these companies present the right investment opportunity, especially, currently? Or does the US market as a whole present an investment opportunity? What about companies which are lesser known in India? Maybe those present a better opportunity?
“One can start with a 5% to 10% allocation to US markets and take it up to 20-30% depending on the suitability to their investment goals and risk profile”
“It is a capital mistake to theorise before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.” -Sherlock Holmes, “A Scandal in Bohemia”, Arthur Conan Doyle
A scientific approach to the question of capital allocation requires collecting the required data before forming an opinion as to the relative attractiveness of different asset classes.
US markets present several well-known companies with popular products across multiple sectors as shown in Exhibit 1 below.
Exhibit 1: US Market products and services. Source: OmniScience Research
Investigating the U.S. Economic Fundamentals
Fundamentally, the US economy is on a strong footing. Despite, Covid-19-related disruption, the US nominal GDP dropped by barely -1.2%. The 2021 nominal GDP growth is expected to be around 6% in 2022 around 5.3% and 2023 around 4%.
Exhibit 2: US Nominal GDP Projections. Source: OmniScience Research | Federal Reserve, Summary of Economic Projections Dec. 16, 2020 – link
The Unemployment rate at the end of 2020 was 6.7% and is expected to be 5% in 2021, 4.2% in 2022, and 3.7% in 2023.
Exhibit 3: US unemployment rate Projections. Source: OmniScience Research | Federal Reserve, Summary of Economic Projections Dec. 16, 2020
Inflation at the end of 2020 was 1.4% and is expected to be in the range of 1.8%-2% during 2021-2023.
Exhibit 4: US Inflation rate Projections. Source: OmniScience Research | Federal Reserve, Summary of Economic Projections Dec. 16, 2020
Nominal GDP above 4% growth rate, i.e., nearly $1 Trillion addition to GDP every year for the next several years, combined sustaining at around 2% is considered ideal for the US economy.
All these fundamental data point to a robust and healthy economy which has fully recovered from the Covid-19 disruption and is well on its way to utilise the fiscal and monetary stimulus programs towards strong economic growth with increasing employment.
Now that we have established that according to the most authentic data available at this time, the U.S. economy is on strong fundamentals for the next several years, it is likely that the U.S.-listed companies would also have strong revenue and earnings growth. In fact, the U.S. economic growth would be a result of the revenue and earnings growth of the US companies.
Given that the fundamental growth of U.S. companies over the next several years has a strong likelihood, the most important question to focus on is: Are the valuations appropriate?
Investigating the U.S. Bond Market Data
Exhibit 5: US Treasury Yields. Source: OmniScience Research | Treasure.gov as of 19th Feb 2021
Exhibit 6: US Treasury Yields and PE Ratio. Source: OmniScience Research | Treasure.gov as of 19th Feb 2021
The U.S. Treasury yields show that even for the 30-year bonds, the expected returns are 2.14% if held to maturity. This translates to a PE ratio of 47. 10-year bonds are yielding 1.34% with a PE ratio of 75.
Investigating the U.S. Stock Market Valuations
To understand how the stock market is currently being priced by Mr. Market the collective version of all investors we look at the ratios of different indexes. S&P 500 represents the US large-caps, S&P 400, the mid-caps, and S&P 600, the small-caps. S&P 1500 Information Technology index represents all the companies within the composite universe of large, mid, and small-caps which are from the Information Technology sector. S&P 600 Information Technology index represents the small cap companies which are from the information technology sector.
What we observe is that the large-caps are at a slight premium to the mid and small-caps. All the broad indexes are in the range of 20-22 PE. The S&P 1500 Info Tech index is at a premium with a PE of nearly 27. The S&P 600 Info Tech is at a slight premium with PE of 22.
Exhibit 7: US market P/E Ratios. Source: OmniScience Research | S&P Global Indices, Fact sheets Jan 29, 2021
Exhibit 8: US market projected P/E Ratios and yields. Source: OmniScience Research | S&P Global Indices, Fact sheets Jan 29, 2021
Estimates show that nearly 90% of the earnings is paid out as dividends and buybacks. (Source: Data from Ashwath Damodaran)
Based on this, we estimate that the pay-out yield or free cash flow yield to equity holders is as shown below:
Exhibit 9: US market Pay-out yields. Source: OmniScience Capital Research
The expected return would involve a growth factor. The US nominal GDP is expected to grow at 4-6% in the next few yearsand continue at 4% over the long-term. The S&P 500 companies have nearly 50% revenue from rest of the globe. The globalnominal GDP is expected to be 8.5% for 2021 and 7.2% for 2022 (assuming an inflation rate of 3%). (Source:https://www.imf.org/en/Publications/WEO/Issues/2021/01/26/2021-world-economic-outlook-update)
Accounting for this, the expected growth rate for S&P 500 companies is around 5.5%-6%. This tallies well with the analysts estimates in Damodaran’s data which is around 5.4%.
Expected Return Estimates for an Investor in the US markets today
If the companies remain profitable with free cash flows, the investor in the US markets would get the pay-out yield as shown in the table above. Further, the additional returns would come from the growth rate of these companies. The sum of the pay-out yield and expected growth rate is an estimate of the total expected return. There is one more factor which will impact the actual holding period returns. This is the yield at the time of selling. If the yields at the time of selling are higher, i.e. the PE ratios are lower, then the total returns for the investor will be lower. Similarly, if the ending yields are lower that is the PE ratios are higher, then the total returns would be higher still.
Based on this, the expected returns for an investor in S&P 500 is 4.1%+5.4% = 9.5%.
Even for a purely domestic revenue growth of 4% this translates to an 8.1% return for S&P 500.
Let us factor in the ending PE ratio or yields as well.
Expected Returns of S&P 500 in USD
However, if the interest rates go higher eventually and if the ending PE ratio is lower, say around 19 ten years later, i.e., an earnings yield of 5.2%, the total return from growth will be 3.87%. Adding, the pay-out yield of 4.1% will give a total annualized return as nearly 8% for a global revenue company and 2.49%+4.1% =6.59% for a domestic revenue company.
Expected Returns of S&P 500 in INR
All the above are USD-based estimates. For INR-based estimates one can add the INR depreciation rate over the long term. This would be around 2-3% or so. Over the past 10 years, the INR has depreciated at the rate of 4.9% per annum. This means that the S&P 500 could return around 8.6% to 12.9% in INR terms (assuming the lower bound of S&P 500 USD returns and the 2% INR depreciation rate and the upper bound of S&P 500 USD returns and the 4.9% INR depreciation rates).
Near term growth rate data is much more optimistic that our assumptions above
According to Yardeni Research1, based on data from Thomson Reuters I/B/E/S, S&P 500 earnings are expected to grow at 24.4% in Calendar Year 2021 followed by 15.4% in CY2022. Even being sceptical about forecasts, the forecasts are quite positive and high.
What have the actual returns of S&P 500 and Sensex 30 been in the past?
The actual returns from S&P 500 and S&P BSE Dollex 30 are shown in the table below. The data shows clearly that the S&P 500 has delivered significantly higher returns in USD terms compared to Dollex 30, which is the USD version of Sensex 30.
Exhibit 10: Benchmark returns in USD. Source: OmniScience Research | S&P Global Indices, Fact sheets Jan 29, 2021
We also show the INR version of the same data. This, too, shows that the S&P 500 returns have been nearly 18-19% CAGR over the last 10-years. The excess returns above Sensex 30 have been significantly high over all the periods.
Exhibit 11: Benchmark returns in INR. Source: OmniScience Research | S&P Global Indices, Fact sheets Jan 29, 2021
How correlated are the US and Indian equities?
Exhibit 12: 3 Year correlation between S&P 500 & S&P BSE Dollex 30. Source: OmniScience Research |https://www.spglobal.com/spdji/en/indices/equity/sp-500/
The data shows that the correlation between the S&P 500 and Dollex 30 is 0.346 which is fairly low. This means that adding S&P 500 to an Indian portfolio could add diversification benefits and lower the portfolio volatility.
Why should an investor add U.S. equities to their portfolio?
While it is clear from the above data and analytics that US equities are likely to deliver satisfactory returns, the core idea behind the allocation towards them is asset allocation and diversification. Adding just the US equities to your portfolio should provide exposure to the global economy, including developed and emerging markets, multiple sectors, especially disruptive technologies, and an uncorrelated market return.
Currency diversification helps significantly since Indian market crashes are typically accompanied by FII outflows (mostly caused by FII outflows) and hence the INR depreciates against the USD. In this scenario, the US portfolio will outperform the Indian portfolio in INR terms. This makes the total portfolio much more stable.
Thus, adding the US equities to the Indian portfolio not only is likely to enhance the total portfolio returns, but also reduce the portfolio volatility. Further, there is true diversification on a fundamental basis in terms of exposure to the economies of the rest of the World and an allocation in a hard currency like the USD.
U.S. Market Valuations vs. Indian Market Valuations
Exhibit 13: Benchmark returns. Source: OmniScience Research | S&P Global Indices, Fact sheets Jan 29, 2021
From the above it can be seen that the PE ratios for the Indian markets are relatively higher compared to the US markets. This might be justified to some extent given the higher expected growth rates of Indian companies. However, one should be clear that the above are projected PE ratios, so they do incorporate the expected earnings growth one year forward.
In any case, it can be safely concluded that the U.S. markets are available at a relatively better valuations than Indian markets.
Stacks With OmniScience Capital U.S. Strategies- Offering You A Combined Portfolio of U.S. Equities and ETFs in One Click!
OmniScience Capital offers two main US strategies, viz. Omni Supreme and Omni AIoT.
Omni Supreme is a multi-cap (or flexi-cap based on SEBI’s recent definition) strategy on the scientific investing framework. Scientific Investing framework reduces fundamental risk while attempting to enhance expected returns. OmniSupreme is a curated portfolio, typically, consisting of 20-30 stocks, primarily, from the top 1500 US stocks represented by S&P 1500. There is a roughly equal allocation to the stocks, and they are reviewed and realigned on a quarterly and annual basis if there is a significant change in fundamentals or valuations.
Omni AIoT (Artificial Intelligence and Internet of Things) is a portfolio selected from a proprietary universe of nearly 180 USlistedequities which are working on Artificial Intelligence, Internet of Things, 5G, Cyber Security, Blockchain, Augmented Reality/Virtual Reality, Big Data, Analytics, Cloud or other related technologies. From this universe, using the Scientific Investing Framework, which modifies the financial statements to account for intangible asset creation, a curated portfolio of 15-20 stocks is created. This portfolio is reviewed and realigned on quarterly and annual basis.
The current Price to Cash Flow of Omni Supreme is around 11.9 as compared to S&P 1500 which is at 16. Similarly, the OmniAIoT is at a PCF of 17.6 compared to Nasdaq 100 which is at 23.1.
We think an investor should allocate to both the Omni Supreme to gain exposure to the general economy and also to OmniAIoT to get exposure to the disruptive technologies which are likely to dominate the future of the US and global economy.
Investing now allows Indian investors to benefit from the elevated INR vs the USD
Currently, the USD INR rate is 72.51. The USD INR 27-1-2022 futures contract is being traded at 75.945. This is around a 5% return just from currency point of view. It would make sense to take advantage of the elevated INR levels and remit money abroad for investing purposes. NRIs remit money to Indian when the INR is at a depreciated temporarily level so that they get more Rupees for their Dollars. Similarly, Indian investors should consider remitting money abroad when the INR is at an elevated level to get more Dollars for their Rupees.
Of course, the allocation to a global asset class would depend on the risk-return profile of any asset class at that point of time. We have clearly demonstrated the relative and absolute attractiveness of US equities at this point of time.
However, this is not investment advice. Each individual investor should analyse their financial goals, investment objectives, risk tolerance and capacity, liquidity requirements, investment horizon and the expected risk-return profile of an asset class before investing. They should, ideally, consult a financial planner for this purpose. This document CANNOT be used as a substitute for detailed financial planning.
We would like to point out that from a long-term perspective the U.S. Indexes are slightly on the higher side in terms of their PE ratios, which is justified given the low interest rate environment. However, as the interest rates normalize over a 10-year holding period there could be some derating which also we have accounted for. However, under such a scenario it is better to allocate to a carefully selected, actively managed portfolio as compared to an ETF. Of course, one must be careful that the active portfolio is not even more vulnerable to a derating over the long-term. Under this scenario we trust the Scientific Investing process to deliver the optimal active portfolios, which are Omni Supreme US and Omni AIoT US.
An investor should go through a full financial planning exercise. If they have a 5+ year investment horizon and the risk tolerance for equities as well as forex rates, then one should estimate an appropriate allocation for US equities in their portfolio. Probably, one can start with a 5% to 10% allocation and take it up to 20-30% depending on their comfort level and suitability to their investment goals and risk profile.
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Disclaimer: Any mention of company names DOES NOT mean an endorsement or recommendation to buy, sell or hold any of these companies, sectors or the index or index-linked products. This is not investment advice, please see the detailed disclaimer at the end of this report and at http://www.omnisciencecapital.com/disclaimer/