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Unio Capital is an asset management firm—oriented to publicly-traded equities, global in scope, and equipped to manage hedged and long-only portfolios as funds and separately-managed accounts.

Under the Hood of the S&P 500

In Perspective

Unio's "In Perspective" short-form series covers the Unio team's views on topics ranging from investing to business to economics.  

 

Under the Hood of the S&P 500

John Allison

You've got to trust your auto mechanic.

Cars are so complicated today that if your mechanic tells you you’ve got such and such problems to fix under the hood, at such and such cost, you either trust him or you get another mechanic. Unless you've got very special expertise, there is no way to independently verify his diagnosis.

On the other hand, for one of the most complex “engines” on earth—the S&P 500—there is a way to get under the hood, look at the condition of the engine yourself, and independently verify what the experts are telling you.

However, all too often, many of us (even in the investment business) lift the hood, glance around, and make diagnoses a little too quickly, missing important details. Take a look at the chart below of the S&P 500 over the past five years and all you see is bull market.

S&P 500: Price (2009–14)

But if you pull back and look at a longer time frame—say the past 88 years (since 1926)—you see just how unusual the bull markets of the past 20 years have been, with their jagged ups and downs.

S&P 500: Price (1926–2014)

Price is plotted on a logarithmic scale so that equivalent price changes are represented by the same vertical distance on the scale. This allows for an “apples to apples” comparison between different time periods when looking at a multi-decade time-horizon. 

One of the standard things people do when they lift the hood is look at the S&P’s earnings—specifically at earnings-per-share (EPS). The next chart shows a very lovely upward line of EPS growth over the past 5 years—prima facie validation in many people’s eyes for the index’s upward price climb.

A bit more peering satisfyingly confirms that this earnings growth has been matched by revenue growth—a healthy sign—as embodied in the blue revenue growth line versus the red EPS growth line.

S&P 500: EPS vs. Revenue Growth (2009–14)

At this point there is every temptation to shut the hood and go away. Of course the S&P is up! Earnings and revenues are up! Case closed!

But a little more patience yields some troubling contra-facts. For example, see what’s been happening to cash flow over the past 5 years.

S&P 500: Cash Flow per Share (2009–14)

Cash flow growth per share is not as pretty and not as steady-eddy as EPS growth. And look a little further, this time at capital spending:

S&P 500: Capital Expenditure per Share (2009–14)

Pretty interesting! Despite great corporate prosperity, Corporate America is not investing with the same directional vigor as it is producing EPS.

The chart raises some important questions. Is Corporate America not investing because:

  • It is skimping on investing to generate free cash out of which to pay dividends and buy back stock?
  • It doesn’t have great profit-making investment opportunities?
  • The cost of investing is going down—for example, like the cost of computing is going down—thereby requiring fewer dollars to make a given quantum of investment?
  • Corporate America is becoming secularly less capital intensive—more intellectual-property oriented and less plant-and-equipment oriented?
  • There is a structural change to a lower-growth world, with Corporate America just mirroring that reality?
  • Corporate America is under-investing, plain and simple, and will pay the price for its short-termism?

And if you study the S&P engine more closely, you notice a few other things. For example, revenue per employee is flat.

S&P 500: Revenue per Employee (2009–14)

Maybe this is one reason companies aren't hiring more. On the other hand, maybe employees aren't so productive because they’re not being supported by investment.

Another observation—which we've made for many years at UNIO—is that profit margins, while up a bit, are going toward a 20-year peak. It will be tough to go higher.

And one of the most telling measures of corporate success—return on assets or ROA—has been flattish, a distinct contrast to the upward slope of earnings which everyone is focused on.

S&P 500: Return on Assets (2009–14)

Finally, valuation: there is huge debate over whether the S&P is expensive or not. Here is the trailing price-to-earnings (PE) ratio for the past 64 years. What this tells us is that the S&P is on the expensive side, but not well above historical norms (look at the times the S&P’s PE ratio has been above where it is now: the late 1980s, early and late 1990’s, mid-2008, for example).

S&P 500: PE Ratio (1950–2014)

But the point is too simplistic. Something is “cheap” or “expensive” only in context. Very high quality paintings—Cézannes, for example—are expensive and deserve to be. Given what we've seen under the hood, is the S&P a Cézanne, or something less?

History is changing and the S&P’s valuation has to be dealt with in the context of whether its assets—and the earnings those assets can produce—are of higher- or lower-quality. One must also look at whether the low-interest-rate environment in which these assets and earnings exist is a higher- or lower-quality macro-financial environment.

All of which is to say: there is an abundance of information, analyzable and verifiable by you and me, on the S&P 500 Corporate Engine. You really can look under the hood and see things that look good as well as things that look bad (or, at least, that raise questions). And you really can make some independent judgments.

The problem is—and it is a core phenomenon of our age—what do you do with all the information available to you?

That’s where the real challenge and the real expertise come in.

  1. Where do you look when you lift up the hood?
  2. How do you organize the information you are looking at?
  3. How do you weigh, interpret and understand it effectively?
  4. How do you consolidate this into a decision?

That is the challenge of our bloated information age.

But you can’t even begin to meet it if you don’t lift up the hood and take a good long look.

– John Allison