The ROIC Puzzle

“It is not intuitive. It’s actually perverse that we see a moderating of economic data is translating into a stronger market environment.”

— Mike Loewengart, Chief Investment Officer, E-Trade

The quote above perfectly summarizes the puzzle that market experts are grappling with at the moment. The majority of economic and market data coming out globally is indicating that the world on average is in a slight recession. Economic data from the EU and China, the next two largest economies in the world after the US, indicate that both economies are contracting. The data from the US is indicating that the economy is about flat and getting worse. Interest rates around the world (including the US) have plummeted as investors have stampeded into government bonds for safety. To understand the magnitude of this flight to safety, $15 trillion are currently invested in bonds with negative interest rates, in economies ranging from Germany to Japan — that means investors are not earning a return for investing in bonds, but instead paying a return for investing in bonds. One would think that given all of this data, stock markets around the world would be down substantially. Instead they have increased substantially. That is the puzzle.

One possible explanation for this is that an unusual phenomenon is occurring in the markets: investors’ expectations of long-run return on invested capital (ROIC) have decreased. Essentially, the valuation of stocks is determined by two factors: earnings (cashflow) growth and ROIC. For the most part, ROIC does not change very much. So, when stock markets move up or down, it is due to investors updating their expectations of earnings growth for companies up or down, respectively. However, the best explanation for the current dichotomy between the stock markets and bond markets/economic data is that we have had a substantial revision in ROIC by investors.

The following equation is widely used in the finance world to value stocks:

S = E*( 1 + g )/( r - g )

This is a highly simplified model, but it will provide enough to explain the two factors mentioned above, earnings growth and ROIC.[1] In this equation, S denotes the value of the stock markets, E represents companies’ current annual earnings, g represents investors’ expectations of the growth rate of those earnings into the future, and r represents the ROIC. For the most part, r does not change very much. However, E and g can change substantially. Therefore, when companies deliver substantially higher earnings this year, E increases. As a result, S increases, which means the stock market goes up. For a given level of current earnings, when g increases, it means that investors have revised upwards their expectation of earnings growth in the future. As a result, S increases, and the stock markets go up. Stock markets can also go down when either E or g decrease.

The puzzle that we discussed above can be easily seen in this simple model. Expected growth rates of earnings, g, have decreased globally as the world gets bad news about the prospects for the global economy. This should result in S decreasing, i.e., stock markets should go down. However, stock markets have been going up. That is the puzzle.

The model above also poses a possible explanation for this puzzle. We mentioned that r, the expected long-run return on invested capital, or ROIC, stays mostly fixed. However, one explanation of the puzzle is that while g has decreased, ROIC has also decreased — and substantially. When r decreases at a faster rate than g in the formula above, S will increase. So, stock markets will go up even though investors are revising downward their expectations of corporate earnings growth rates.

One of the sharpest points of evidence that this may be occurring is the substantial drop in interest rates around the world. If the expected returns on invested capital decrease, investors would have less motivation to take risk. In this case, they would invest in bonds, which in turn would cause interest rates to decrease.

If lower return on invested capital is indeed the explanation for this puzzle (and there are many pieces of evidence pointing to this), it would indicate that we are in for a period of low returns in stocks — hence the recent herding into bonds by investors. The question is how long of a period are we looking at. 3 months? 3 quarters? 3 years? At the moment, many market strategists are poring over economic and market data trying to figure this out.

Footnotes

[1] Those with some knowledge of finance will recognize this formula as the value of a growing perpetuity. Essentially, this formula is modeling the stock market as a growing perpetuity of earnings, i.e., an earnings engine.