Equity markets produced outsized returns in Q2 2020, as shown in Figure 1 below. Much of the damage caused by the COVID-19 pandemic in the first quarter of 2020 was repaired in Q2. Although the equity market rebound was impressive in Q2, many of the S&P/ASX 300 sectors are still below their prepandemic levels. However, there are a few sectors that are almost back to their pre-pandemic levels. The best performing sectors for the financial year ended 30 June 2020 were Health Care, Information Technology, Consumer Staples and Discretionary. It is not surprising if investors are feeling significant relief in the recent rally.

Figure 1 - S&P/ASX 300 Index and Sector Returns for Q1, Q2 and Financial Year ending 30 June 2020

Source: Thomson Reuters, S&P as at 30 June 2020. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. 

Last month, we highlighted the growing disconnect between the expectations for company earnings and prices for some securities, especially in the Information Technology sector. We have observed many parallels to the dot-com period, when speculation was high and to talk about a company’s cash flow was scorned, and somehow short sighted or even small minded. The focus was on growth and the revolution that was the internet. If you issued an Initial Public Offering (IPO) that had a “.com” suffix in its name, you would likely have been assured of fresh capital. CEO’s were often chastised for not spending enough on the internet. It was a speculative market environment in which the investors purchased their favorite internet names fueling share price gains, which in turn encouraged investors to buy more. Eventually it all unwound and few were able to hang onto their temporary riches

Revolving doors – Top stocks by decade 

A quick trip down memory lane in Figure 2 and Figure 3 where we look at the largest capitalised stocks by each of the last 4 decades. The companies that are in bold and red have Price to Earnings (PE) multiples greater than 20. How many of these companies were in the top 10 in the following decade? And if they were how many were trading at the same multiple? How many of the now ‘market darlings’ in bold and red will be in the top 10 in 2030, and how many will still be trading at the same lofty multiple? History would suggest not many.

Figure 2 - S&P 500 Index – Top 10 stocks by market capitalisation by decade 

Source: Thomson Reuters Datastream as at 30 June 2020. PE = Price to Earnings. Past performance is not a reliable indicator of future performance. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown.

In Australia we can observe similarities with the S&P 500 Index. In June 2000 the S&P 500 Index top 10 had a greater representation from media and the internet and by 2010 only Telstra was still in the top 10 and had been de-rated from a PE multiple of 23 to only 10. In the S&P/ASX 300 Index in 2020 we don’t see as many IT names but we have observed many smaller tech companies rise to loft valuations on expectations of growth into perpetuity. The raging stock prices encourage more investors to buy in for fear of missing out.

Figure 3 - S&P/ASX 300 Index – Top 10 stocks by market capitalisation by decade

Source: Thomson Reuters Datastream as at 30 June 2020. PE = Price to Earnings. Past performance is not a reliable indicator of future performance. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown.

The Bottom Line

As fundamental investors, these market environments are somewhat testing. Searching out proven business models with solid financials that can generate free cash flow and are more resilient to economic shocks would appear to be out of vogue. In this environment we may take some criticism for our approach and be tested but we believe when the music stops, we will be glad we focused on the most enduring company fundamentals.

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Mark Milic

The FAANGs will come back to bite you.

Chris Koureas

Not sure why any rational person would not only compare PE ratios across companies, but also compare across industries. But what really defies belief is someone comparing across decades. If you must, I would expect some sort of statement such as "PE ratios should be higher now due to lower risk free rate" but I guess that is too quantitative for the Australian funds management industry.

David Heath

Hi Bruce, Very interesting tables. I wonder if a good strategy going forward is to hold say the top five - largest market cap - in the NASDAQ for each successive decade. The tables are only superficially similar comparing Aust to the US - e.g. volatility of changes. In terms of "growth" and "global" industries the US had several in 2010. Aust has none even in 2020. The tables also show how difficult it is to find future stocks for the next decade - e.g. FB was not even around in 2010 but as it controls around 60% of global social media I think it will be around in 2030.