The current equity market environment reflects soaring inflation, increasing interest rates and the first half of calendar year 2022 saw a double-digit decline in most major indices.
The popularity of large-cap U.S. equities decreased significantly in the wake of their 2020 high point and the volatility of mid-cap and small-cap stocks has been dramatic. Even central bank responses are hard to predict, with investors in the U.S. market fretting over how aggressively the U.S. Federal Reserve will act to address the economic malaise.
With the price-to-earnings ratio considered an indicator of a stock’s popularity, the question on everyone’s minds is whether we have reached the bottom of the latest volatility cycle? It is our view that price-to-earnings ratios will, sooner or later, re-rate.
This paper suggests a framework that can help investors navigate the current situation – and more importantly, any period of market volatility.
The framework involves understanding the relationship between price-to-earnings ratios and returns – appreciating that an investor’s rate of return will equal the earnings per share growth rate when a company retains all its profits (by paying no dividends) and the investor purchases and sells the shares at the same price-to-earnings ratio.
It all comes back to knowing how to invest in quality, profitable companies with growth and remembering that the lower the price one pays, the higher one’s subsequent return.