After three supercharged years for US equities, many investors wonder whether the market still has fuel for 2022. While higher valuations warrant caution, we believe a carefully chosen allocation can capture advantages inherent to the US market that underpin solid long-term return potential.
Few investors expected US stocks to post such strong returns last year. The S&P 500 index surged by 28.7% in 2021, capping a three-year gain of 100.4%. The prolonged bull rally pushed up valuations, with the S&P 500’s price/earnings ratio ending the year at 21.3x, well above other developed markets.
In early January, volatility in US stocks—and particularly the technology sector—underscored investor concerns. Yet despite the risks, we think US stocks offer several advantages in 2022. First, US companies are expected to continue posting solid earnings growth and profitability. Second, beyond the five largest stocks, many high-quality businesses trade at more attractive valuations. Third, US firms have record amounts of cash available to deploy for share buybacks.
Stronger Earnings, Higher Profitability
During 2021, US stock performance was driven primarily by profits. US companies posted stronger earnings than expected, providing fundamental support for valuations. What’s more, American companies have delivered much higher earnings growth and profitability than overseas peers, based on metrics such as operating margins and return on equity, in developed and emerging markets (Display).
Around the world, earnings growth last year was powered by the sharp recovery from the pandemic-induced recession in 2020. The US market stood out. With world-leading scientific research institutions and the largest market for venture capital financing and start-ups, the US is a hotbed of innovation. Many publicly traded US companies are technology pioneers, enabling and leading the digital revolution that accelerated during the pandemic as remote working, shopping and leisure activities grew at an explosive pace.
Innovation reinforces high-quality businesses. Our research suggests that the US is home to 64% of the world’s profitable growth companies worth at least $15 billion.1 And many US firms benefit from robust shareholder governance and management expertise—features that provided an edge in coping with business challenges created by the pandemic.
Finding Growth at the Right Price
This ecosystem has also produced the megacap growth firms that powered US market performance in recent years. Skyrocketing share prices of companies like Amazon.com and Apple have created corporate behemoths with trillion-dollar market capitalizations—and fostered extreme market concentration. By the end of 2021, the five largest US companies comprised 38.1% of the Russell 1000 Growth Index and 23% of the S&P 500. Passive portfolios benefited from the huge gains but also are exposed to a small group of giant companies. While each megacap has its merits, we believe that holding too much of the entire cohort is a risky strategy, which could backfire if sentiment turns.
Instead, we think investors should actively search for other companies with still attractive profitability and growth profiles. Excluding the five largest companies, the S&P 500 Index and the Russell 1000 Growth Index trade at much more reasonable valuations, based on price to free cash flow (Display). While still more expensive than European and Asian stocks, the US market offers higher return on assets (ROA), as indicated by the horizontal axis in the display below. In other words, investors are paying up for companies with stronger profitability profiles.
We believe that ROA and return on invested capital (ROIC) are strong measures of economic performance and sustainability, especially when comparing across firms. Both metrics will be especially important for evaluating companies if interest rates rise, which would increase the cost of capital and discount rates used to value future cash flows.
As the US economy normalizes from the sharp post-recession recovery, growth will be harder for companies to maintain. As a result, in our view, investors must target high-quality businesses with ample opportunity for reinvesting profits to drive future growth. Each stock’s valuation should be analyzed based on a measured assessment of what the company’s normal earnings power will be after temporary factors fade.
Consistency is crucial, especially in uncertain times. Even amid today’s pressures, some companies are simply better equipped to continue delivering earnings growth than others. Identifying US companies with the ability to deliver persistent earnings growth of 10% annually over three to five years is another good strategy through changing market conditions. These companies are hard to find, but our research indicates that their returns regularly beat the market.
Rewarding Shareholders with Buybacks
Even in a tougher environment of slower economic growth, US companies have formidable cash firepower. With record amounts of cash on balance sheets, US companies are poised to buy back $872 billion of stock in 2022 (Display). Together with expected dividend payments of $590 billion, this means companies have many ways to reward shareholders this year. As the Federal Reserve begins to taper its quantitative easing program this year, we believe that share buybacks can serve as a replacement source of fresh liquidity for the market.
To be sure, there are plenty of risks. In particular, the US Federal Reserve’s plans to accelerate the pace of interest-rate hikes has some investors worried that the US market’s extraordinary winning streak is near its end. History suggests that the last five rate hike cycles only triggered a temporary slowdown in equity returns, usually followed by two years of strong performance (Display). With valuations relatively high today and rising inflation threatening to spark even tighter monetary policy moves, it’s an open question whether US stocks will follow historical patterns. Much will depend on the ability of individual companies to translate business advantages into consistent earnings and profit growth.
Since it’s almost impossible to accurately time market inflection points, we think exposure to US stocks is an important strategic component of an equity allocation. By selecting American stocks that embody the market’s advantages, we believe a high-quality portfolio can capture strategic benefits that can stand the test of time through changing market and macroeconomic conditions.
- James T. Tierney, Jr.
- Chief Investment Officer—Concentrated US Growth
- Kurt Feuerman
- Chief Investment Officer—Select US Equity Portfolios
1 Profitable growth companies defined as companies that fall into the top half of cash flow return on investment and also in the top half of five-year median asset growth. As of September 30, 2021