Chapter 42: Good companies, good stocks, and good valuations
Dear Clients,
In our last installment, we detailed our investment process of identifying good companies that are also good stocks. Good companies, as we discussed, have three characteristics – longevity, sustainability and profitability – that when paired with a valuation gap, also creates good stocks. Today, we wish to provide some historical perspective that shows valuations are still not overly extended, compared to past paradigms and investment climates. We would like to start with the US financials. Take Bank of America, for example. In the aftermath of the Great Financial Crisis (GFC) of 2008/2009, the company’s price to book (P/B) ratio climbed from a low of 0.25x to a 2018 cycle peak of 1.33x (annotated in Panel 1 below).
However, even as the bank repaired its balance sheet and demonstrated responsible growth characteristics in the decade after the GFC, its multiple continued to trade below its pre-GFC range of 2.0-3.0x price to book. With a strong deposit franchise, growing market share, and a prudently reserved balance sheet, BAC’s P/B ratio in the aftermath of the pandemic is only 1.11x. Translated into share price movements, BAC still trades below its September 2006 high of $53, a 42.6% difference from where the shares are currently trading ($37.55/share) shown in Panel 2.
Panel 1: BAC’s Price to Book Ratio versus Historicals (as of April 29th, 2024)
Panel 2: BAC’s Share Price versus Historicals (as of April 29th, 2024)
Even with stocks that are making fresh 52-week highs, their valuation multiples are nowhere near their historical peaks. Take Alphabet, for example. While its share price is at a 52-week high, its valuation multiple measured by its one-year forward price-to-earnings is still below its 2021 highs, shown in Panel 3. The reason for this is that Alphabet has successfully grown its earnings by 20% per year over the last 5 years, and over the next 3 years, it is expected to grow earnings by 15-17% per year. This will in turn further compress the forward valuation multiple, likely leading to a valuation gap which supports share price appreciation.
Panel 3: Bloomberg estimated 1 year forward P/E multiple (as of April 29th, 2024)
Finally, we will reiterate to clients that the markets are becoming more bifurcated, a theme that is well and alive. Bifurcation creates widening relative to valuations between companies in the same industries, as we detailed last time with our depiction of large cap innovators (Nvidia) versus their legacy counterparts (Intel), (Good Stocks & Good Companies). This time, we would like to highlight the example of the regional banks versus their large cap counterparts.
While S&P Global, the credit ratings agency, downgraded their outlook on five regional banks in March 2024, their large cap counterparts (JP Morgan, Bank of America) have demonstrated sustained asset quality, resilient credit health, and prudent reserve management practices possibly leading to an outsized share repurchase in the future. The large cap financials are well capitalized, supported by resilient and well diversified deposit franchises, and returns on equity that reflect prolonged strength in deposit margins. Finally, the large cap bellwethers have far more robust asset quality; for example, with JP Morgan reporting a surge in home lending revenue and releasing provisions from loan losses, a sign of improvement in consumer health. Herein lies an important point – while the book values of the regional banks are uncertain and vulnerable to commercial real estate risks (i.e. write-downs), the book values of the large cap financials are far more reliable and a reflection of their focus on responsible growth.
Part of successful portfolio management is to be able to assess bifurcation carefully, examining the intrinsic differences between business models and industries, and the implications on longevity and true intrinsic profitability. From this perspective, portfolio valuations in high quality large caps are by no means stretched – as our title implies, we identify good stocks that are also good companies, with attractive valuations.
We hope clients have found this installment informative and wish everyone a happy spring.
Warmest regards,
Grace Wang, CIM, PFP | Senior Portfolio Manager
Samuel Jang, CFA | Investment Associate | samuel.jang@rbc.com
Leslie Mah | Associate Advisor | leslie.mah@rbc.com | 604-257-7059
Katherine Jialing Yang | Associate | jialing.yang@rbc.com | 604-257-2537
Hazel Chen | Administrative Assistant | hazel.chen@rbc.com | 604-257-2483