Can share prices continue to climb?

Paul Boyne doesn’t think so. He’s the senior managing director and lead portfolio manager of the Manulife’s global equity strategy. Though equity prices dominate investor discourse, what’s important is locating value, he argues in a report on valuation.

Boyne looks at various valuation metrics and identifies components he says are critical to understanding value.

For example, the cyclically adjusted price earnings (CAPE) ratio is calculated by taking the S&P 500 and dividing it by the 10-year average of earnings. Boyne says the CAPE ratio has only been higher in 1929 and 2000 — years associated with major market corrections.

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He also explains Dupont Analysis, used to identify regions where corporate earnings and margins have room to grow.

“Between 2010 and 2016, the U.S. corporate sector took on US$7.8 trillion worth of debt and other liabilities,” says Boyne, citing the IMF. “Median net debt across S&P 500 companies is close to 1.5 times earnings — near a historic high.” With rising debt levels matched by rising net margins, growth is all but elusive.

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He also provides evidence that firms aren’t investing in cap-ex, but are instead using resources for share buybacks, for example.

Where to invest

Boyne’s conclusion: “As bottom-up, long-term investors, we believe it is important to focus on the optimal mix between quality and valuation, as this intersection of the market is rewarded over the long term.”

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Quality is indicated by a track record of generating a rate of return on invested capital that’s greater than the cost of capital; a balance sheet with appropriate leverage and sustainable cash flows; and a strong management team that understands core business competencies and doesn’t deviate from them.

Boyne finds opportunities in financials — though he’s cautious on European banks — and consumer staples.

“It should also come as no surprise that we are underweight the most expensive markets and have maintained a negative view of the utilities sector,” he says.

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Download the full report.