The Biggest Valuation Disconnects in the S&P 500

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Although S&P 500 core earnings hit record highs in 1Q22, we find that this earnings power is very unevenly distributed. 40 companies, or only 8% of S&P 500 companies, account for 50% of Core Earnings in the the entire S&P 500. Further analysis reveals that these 40 companies are trading at lower valuations than the rest of the index.

Perhaps the most telling sign that investors aren’t digging below the surface when allocating capital is this mismatch between earnings capacity and market capitalization.

Obviously, the rising tide not always raise all boats so investors need to find individual stocks that will outperform in any environment. Below we reveal the three sectors with the most concentrated Core Earnings power[1] and stocks in sectors where investors put premiums and discounts in the wrong places.

Investors undervalue strong earnings

According to Figure 1, the top 40 companies, based on core earnings, of the S&P 500 trade at a core price-to-earnings (P/CE) ratio[2]­[3] from 17.4. The rest of the index is trading at a P/CE ratio of 21.0. Of course, stock prices are based on coming earnings, so one could argue that these valuations simply reflect lower expectations for the 40 companies with the highest core earnings. However, on closer inspection, it becomes clear that the market is mispricing the earnings potential of some of the biggest companies.

Of the top 40 earners, only one is rated below our neutral equity rating and twenty are rated attractive or better, indicating strong overall earnings potential. Indeed, our Long Ideas specifically identified several of the top 40 Core Earnings companies as outperformance opportunities. These include Microsoft (MSFT), Alphabet (GOOGL, GOOG), Cisco (CSCO), Johnson & Johnson (JNJ), Walmart (WMT), Oracle (ORCL), JPMorgan Chase (JPM), Intel (INTC) , and others discussed below.

Figure 1: S&P 500 earnings disparity and valuation

Disparity Profit Valuation S&P 500

S&P 500 Earnings Disparity Assessment (New Constructs, LLC)

Below, we zoom in on earnings at the sector and company level to highlight examples where valuations are not properly aligned with earning power.

Unequal distribution of the earning capacity of the energy sector

When we look below the surface, we see that the energy sector’s core earnings, at $109.8 billion in 1Q22, are largely driven by just a few companies.

Exxon Mobil (XOM), Chevron Corporation (CVX), ConocoPhillips (COP), Occidental Petroleum Corp (OXY) and Pioneer Natural Resources Company (PXD) account for 67% of industry core earnings and account for the highest percentage of industry earnings. base. among the top five companies in an industry across all S&P 500 sectors.

In other words, 22% of companies in the S&P 500 Energy sector generate 67% of the sector’s core earnings.

Figure 2: Five companies generate 67% of the energy sector’s core earnings profitability

Distribution of basic profits of the energy sector

Energy Sector Base Profit Distribution (New Constructs, LLC)

Top earners look cheap compared to the rest of the energy industry

The five companies that account for 67% of core earnings in the energy sector are trading at a P/CE ratio of just 13.5, while the other 18 companies in the sector are trading at a P/CE ratio of 19, 2.

According to Figure 3, investors are paying a premium for some of the lowest earners in the industry, while the highest earning companies, which again include Exxon, Chevron, ConocoPhillips, Occidental Petroleum and Pioneer Natural Resources, are trading at a discount.

Figure 3: S&P 500 Energy Sector Earnings and Valuation Disparity

Disparity Profit Valuation S&P 500 Energy sector

Disparity Earnings Valuation S&P 500 Energy Sector (New Constructs, LLC)

To quantify expectations for future earnings growth, we look at the economic price-to-book (PEBV) ratio, which measures the difference between the market’s expectations of future earnings and the stock’s value without growth. Overall, the PEBV ratio for the Energy sector as of 06/13/22 is 0.9. Three of the five highest paying stocks in the energy sector are trading at or below the PEBV of the entire sector. Additionally, each of the five companies has grown core earnings at double-digit compound annual growth rates (CAGR) over the past five years, further illustrating the disconnect between current valuation, past earnings and future profits.

Technology: Digging deeper reveals some big winners

When we look below the surface, we see that the technology sector’s core earnings, at $480.5 billion, are unevenly distributed, although somewhat less burdensome than the energy sector.

Apple Inc. (AAPL), Alphabet, Microsoft, Meta Platforms (META), and Intel Corporation account for 61% of industry base revenue.

Put another way, 6% of companies in the S&P 500 technology sector generate 61% of the sector’s core earnings. Extending this analysis, we also find that the top 10 companies, or 13% of companies in the S&P 500 technology sector, account for 73% of the sectors’ core revenues.

Figure 4: Only a few companies dominate tech sector profitability

Breakdown of Core Tech Sector Profits

Tech Core Profit Breakdown (New Constructs, LLC)

Not paying a premium for the highest-earning tech companies

The five companies that account for 61% of core earnings in the technology sector are trading at a P/CE ratio of 20.3, while the other 74 companies in the sector are trading at a P/CE ratio of 24.7.

According to Figure 5, investors can obtain the highest paying companies in the technology sector at a significant discount, based on the P/CE ratio, compared to the rest of the technology sector. We recently featured three top earners, Alphabet, Microsoft, and Intel, as long ideas and argued that each deserved higher valuation given the large scale, strong cash generation, and business operations diversified.

Figure 5: Earnings disparity and valuation of the S&P 500 technology sector

Disparity Profit Valuation S&P 500 Tech Sector

Disparity Earnings Valuation S&P 500 Technology Sector (New Constructs, LLC)

Overall, the PEBV ratio for the Technology sector as of 06/13/22 is 1.4. Four of the top five earners (Microsoft being the only stock) are trading at or below the overall sector PEBV. Additionally, four of the five companies have grown core earnings at a double-digit CAGR over the past five years, further illustrating the disconnect between current valuation, past earnings, and future earnings.

Base materials: Digging deeper reveals the industry’s heaviest nature

When we look below the surface, we see that the basic materials sector’s core earnings, at $60.1 billion, are also unevenly distributed, although less so than the energy and technology sectors. .

Nucor Corporation (NUE), Dow Inc. (DOW), LyondellBasell Industries (LYB), Freeport-McMoRan (FCX) and Linde plc (LIN) account for 53% of core earnings in the sector.

Put another way, 20% of companies in the S&P 500 basic materials sector generate 53% of the sector’s core earnings.

Figure 6: Five Companies Dominate Basic Materials Sector Profitability

Core Materials Sector Core Earnings Breakdown

Base Materials Business Core Profit Allocation (New Constructs, LLC)

Commodities companies are trading at a steep discount

The five companies that account for 53% of basic earnings in the basic materials sector trade at a P/CE ratio of 9.7, while the other 21 companies in the sector trade at a P/CE ratio of 18.2 .

According to Figure 7, despite generating more than half of the sector’s core earnings, the top five companies represent only 38% of the market capitalization of the entire sector and trade at a P/CE ratio of almost half of the other companies in the sector. Investors are effectively pricing lower earnings and under-allocating capital to companies in the sector with the highest core earnings until TTM ended 1Q22.

Figure 7: S&P 500 Basic Materials Sector Earnings and Valuation Disparity

Disparity Earnings S&P 500 Valuation Basic Materials Sector

Disparity Earnings Valuation S&P 500 Basic Materials Sector (New Constructs, LLC)

Overall, the PEBV ratio for the Basic Materials sector as of 06/13/22 is 0.9. Four of the top five earners (Linde being the only stock) are trading below the PEBV of the entire sector. Additionally, three of the five companies have grown core earnings at a double-digit CAGR over the past five years. One (LyondellBasell) has been growing at a CAGR of 8% and Dow has no history going back five years due to its formation in 2019. These growth rates further illustrate the disconnect between the current valuation, the past profits and future profits for these industry leaders. .

Diligence Matters – Superior Fundamental Analysis Delivers Insights

The dominance of core earnings by just a few companies, coupled with the disconnect from the valuation of these high earners, illustrates why investors should perform due diligence before investing, whether in an individual stock or even a basket of shares via an ETF or a mutual. funds.

Those who rush to invest in the energy, technology or basic materials sectors and do so blindly through passive funds allocate to a significant number of companies whose earnings strength is less than what the whole sector would indicate it.

This article was originally published on June 21, 2022.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, style, or theme.

[1] The top three excludes the telecommunications services sector as there are only five companies in the sector.

[2] We calculate this metric based on the S&P Global (SPGI) methodology, which sums individual S&P 500 values ​​for market capitalization and core earnings before using them to calculate the metric.

[3] Prices as of 6/13/22 and financials through calendar 1Q22.

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