High valuations and rising interest rates = Volatility

The chart above shows that the price of New Zealand shares had been rising in recent years. The price to earnings of the market weighted by market cap back in 2017 was around 17.5 times earnings, shown by the red line. That level is at the higher end of where New Zealand equities trade but it’s a realistic price to pay for a company with growing earnings and a healthy dividend. The chart shows how that ratio, the red line, rose significantly over ensuing years rising to nearly 33 times earnings. This is a very elevated level indeed, but it could be explained by zero interest rates. In a zero-interest rate environment future profits of a company are barely discounted which means that a discounted cashflow model spits out a higher company valuation than it did previously. Hence the rise to nearly 33 times earnings for the market weight average, which was a huge factor in the share market rising so strongly over this period.

Averages clearly have their uses, but they can also hide some important details. And a major detail is the difference between what investors have been paying for “growth” companies versus “value” companies, and the impact that has been having on market indices (which use a market weight approach). It’s a detail that has already made share markets volatile in 2022 and looks set to continue if the interest rate regime has indeed changed after nearly 40 years.

The crucial details lost in the average can be illustrated by taking a close look at two well-known New Zealand companies, Fletcher Building (FBU) and Fisher & Paykel Healthcare (FPH). These companies are similar in several ways. Both long established, FBU, as part of the Fletcher Challenge group, founded in 1910 while FPH was founded in 1934. They are both listed on the NZX and members of the S&P/NZX 50 index. In 2022 both are, according to Bloomberg consensus forecasts, expected to generate a profit of around $400m. And again in 2025 both are expected to earn a profit of around $500m. But there the similarities end, FPH’s earnings are viewed as far more valuable than FBU’s, with a current price to earnings multiple of 42 times versus the 12x that FBU merits according to the market.

Table showing two companies that currently earn the same but are valued very differently: 

Chart showing what a 250% valuation premium looks like: 

If that valuation gap does indeed close, its going to make market cap weighted indices, such as the S&P/NZX50, S&P/ASX200 and the S&P500, perform worse than the performance of the median member. This is best explained by returning to FPH and FBU. Due to its far higher price to earnings multiple FPH has a much larger market cap and as a consequence a much larger weighting in the S&P/NZX50, 13.6%. FBU with its lower valuation multiple and market cap only makes up 4.4% of the index. As a result, the share price moves of FPH have a much larger impact on the index than FBU.

Let’s illustrate this with a totally hypothetical, but far from improbable, scenario. FPH’s valuation premium drops to 30 times earnings which sees the share price drop over 25%. That move in itself would cause the S&P/NZX50 Index to drop 4%. Another hypothetical but not completely improbable scenario would be the market viewing FBU earnings more favourably, in light of recent earnings upgrades. That could easily see FBU share price rise 25% but that would only cause the S&P/NZX50 Index to rise by 1%. The net result of these two hypotheticals would be a 3% drop in the index, due to the index skew to an expensive large growth company.

This situation is seen across the globe. This article could have easily referenced Tesla and Walmart where a very similar valuation and index representation distortion is also evident.

Overall, the current combination of highly elevated multiples for large growth companies and market weighted indices creates a situation where the headline index can be far more volatile than the median index member, particularly if we see rising interest rates reduce the premium paid for those mega growth companies. While this would likely be a challenging time for the headline index, the more value focussed investors should fare considerably better than the market cap weighted average.