Barron's 400 Index logo

Can B400 rise again in 2014?

Barron's 400 Newsletter. Powered by: MarketGrader.com

A good deal of our time every January is spent listening to (and mostly reading from) some of the brightest economic forecasters and market strategists around and this year has been no exception. Of particular interest to us, and to followers of B400, of course, is how strategists think equities will perform in the New Year. While market forecasts are nothing new, this year’s stock market predictions seem to have taken on additional importance following last year’s stellar equity returns, particularly in the United States. A unique confluence of factors seems to have conspired to give the turn of the calendar a more ominous meaning than actual economic reports seem to warrant, especially considering that the U.S. economy is unequivocally on the mend. But before looking ahead, a look back at what drove equity returns in 2013 will help lay out our case for another pretty decent year for B400 in 2014.

Our favorite read this year came courtesy of the KKR Global Macro & Asset Allocation Team, titled “Outlook 2014: Stay the Course”. We find it to be not only the most enlightened of all strategy pieces we have read recently but also the most clear and concise in its issuance of forward looking values that actually help the investor look and plan ahead. According to the KKR report, the bulk of the S&P 500’s 29.6% gain in 2013 came as a result of multiple expansion and not from actual growth in earnings per share. To be precise, the 5.5% growth in S&P 500 EPS last year accounted for 18.6% of that index’s gain, with the remaining 81.4% coming from the expansion of valuation multiples; such expansion, by the way, is what’s in most investors minds these days as many believe valuations may have gotten ahead of the fundamentals. But before we get into that, we should compare the S&P 500’s returns with those of B400. By our own calculations, earnings for the current stable of Barron’s 400 Index companies grew at a 15.1% rate on a trailing 12-month basis. This would account for a little over one third of the 40% gain in B400 last year, with the remaining two thirds courtesy of multiple expansion. While this is a much more balanced breakdown than for the S&P 500, it still suggests close attention must be paid to valuation multiples as 2014 unfolds. 

While the contribution of B400 EPS growth to the index’s return last year was just about double that of S&P 500 constituents, this does not mean that B400 is cheaper than the S&P. In fact, both indexes trade today at 17 times trailing earnings. But what about forward earnings and what they may tell us about equity returns in this nascent year? Here two points are worth highlighting from the KKR report. First, the company expects a 9% growth in earnings for the S&P 500 in 2014, which is actually pretty close to the FactSet consensus estimate of 9.7% growth. Second, KKR’s team expects very little to no multiple expansion in 2014, leaving the heavy lifting of further gains in the index to actual earnings growth. In fact, they expect the index’s trailing P/E by the end of the year to be at 16.7 times earnings, a tad lower than its current 17 times EPS. Translation: KKR expects the S&P 500 to gain 8.8% in 2014, about 900 basis points above today’s level. Considering B400’s proven ability to select companies in the U.S. market with above average growth, we’ll call this 8.8% S&P 500 forecast our baseline.

As cited above, earnings for current B400 components grew a little over 15% in the last 12 months compared to the equivalent period a year earlier. Here we should make two important distinctions between the S&P 500 numbers and what might be expected from B400. First, the KKR 5.5% growth for S&P 500 companies in 2013 includes estimates for the fourth quarter whose reporting season barely got under way a couple of weeks ago; this means that the majority of companies in either index have yet to report their most recent earnings. That’s why we emphasize “trailing 12-month” growth in our 15% figure, since it excludes earnings for most companies’ fourth quarter. When estimates for the fourth quarter are included in our growth calculation, earnings growth for B400 relative to 2012 climbs to more than 19%. Second, while the S&P 500 is a largely static list of companies, which might see a handful of changes on a yearly basis, at most, B400 is a much more dynamic list, by design of course. Thus, today’s list of B400 components bears relatively little resemblance to the new list of stocks that will be in the index following the upcoming March rebalance, much less the September one. Keep in mind that, historically, roughly 40% of all B400 components are replaced at each rebalance. Why is this important to our current analysis? As some B400 companies disappoint in terms of growth, their overall MarketGrader grade, the basis of B400’s selection, will suffer, likely excluding them from being selected again in the immediate future. The same grade slippage occurs when stocks in the list appreciate considerably in value, stretching their multiples and depressing their value grades. This combination is what gets many of B400’s adherents to label it as a GARP (Growth at a Reasonable Price) index. Looking forward, we are able to calculate that based on the current set of B400 components, earnings are forecast to grow for B400 by 8.7% in the next 12 months. Notice how close this number is to the 9% expected EPS growth for the S&P 500 by KKR and the 9.7% consensus growth estimate gathered by FactSet. Our bet is, however, that once B400 rebalances in March that forward estimate will be higher and more closely in line with B400’s past earnings growth. The question is, how much higher?

Before concluding with our estimate for B400 in 2014, it is once again worth going back to the KKR report for clues as to why they see S&P 500’s earnings jumping from 5.5% growth in 2013 to 9% in 2014. The answer: the U.S. economy. On this front, count KKR in the group of those firmly on the side of those who think the U.S. economy will not only continue to “recover” but will actually perform pretty well in 2014. In fact, three important facts in their report regarding the U.S. economy caught our attention. First, the rate of growth for the private sector of the economy is much higher than the headline numbers suggest. Between Q2 2009, when the ongoing recovery began, and last year’s third quarter, aggregate U.S. Real GDP grew at a 2.3% annual rate; when excluding the government, which has been in develeraging mode for the past few years, U.S. Real GDP in the private economy has been actually growing at a 3.3% compound annual growth rate. Second, all the government’s belt-tightening in recent years has actually yielded a much healthier economy in the U.S. than in Europe and most of the emerging world. KKR estimates that in 2014 the U.S. government deficit will be less than 3.5% compared to over 9.0% in 2010 (so much for the theory that divided government doesn’t work). Third, and perhaps most interesting of all, is where we are in the current expansionary cycle. Again, according to the KKR report, the last three economic recoveries have lasted an average of 95 months while the current one is just entering its 54th month. If the current expansion follows the recent trend, the current cycle could still have well over three years left. This, of course, does not necessarily translate into three-plus years of expanding equity markets. It does, however, bode well for what is most needed now for earnings to continue to grow based on healthy top line growth: accelerating nominal GDP. Lastly, worth mentioning is the ongoing strengthening of the dollar, which most economists expect will continue as the Fed further removes its monetary stimulus and rates continue to rise. A stronger dollar, of course, should give a boost to dollar-denominated assets such as U.S. equities. While we don’t expect this to be the primary driver of further stock market gains, it is a nice wind to have at your back, especially as easy Fed money continues to flee the emerging markets and makes its way back home.

To conclude, we believe that if an almost doubling in the earnings growth rate for S&P 500 companies to almost 10%, according to the consensus, is in the offing thanks to accelerating economic growth, a repeat of B400’s trailing 12-month growth rate of 15% is really nothing extravagant. If you couple that to a modest 1% multiple expansion for B400 companies, which tend to be a bit more expensive than the larger and slower S&P 500 components, you could see a 600 basis point premium to our S&P 500 baseline return of 9% in 2014. This would translate into a 2014 gain of 15% for B400. We’ll happily report on the accuracy of our target in a year’s time.  

Correction

Our previous Newsletter, dated January 3, 2014, stated that the Barron’s 400 ETF (NYSE Arca: BFOR) crossed the $200 million mark in a little under six months. Excitement over such news apparently got the better of us, causing us to misstate how long the fund has been around. By the time BFOR reached $200 million in assets, the fund was, in fact, just shy of seven months old. It will be eight months since it launched come February 4.

Similar Articles

U.S. Equities: Our Latest Views

Investors Continue to Underestimate the Impact Higher Interest Rates Are Having Across the Economy. Beware Expensive Large Cap Stocks.

Read More

The Barron’s 400, An Index for all Seasons

The Barron’s 400 index approach is focused on consistency rather than market timing. To use a baseball analogy, B400 focuses on consistently hitting singles and doubles to drive in runs,

Read More