Executive Corner: Wall Street Sentiments Suggest Strong A/E Industry Outlook
Sometimes the movement of money in capital markets can tell us a lot about investors’ expectations for a particular stock or a particular industry. In the case of the A/E industry, there are a number of factors that are likely impacting investors’ sentiments. Will increasing rates from the Federal Reserve offset any decrease in tax rates? Will reducing regulations have a positive impact on corporate growth? Will Trump’s trade policies help or hurt U.S.-based companies? Based on market performance so far, it seems that investors’ sentiments are favorable.
The chart below shows the trend in stock prices in the A/E industry compared to the S&P 500 from Sept. 30, 2016, into the first week in February 2017. The A/E Index (“A/E” in red) and the S&P 500 Index (“S&P” in blue), both saw declines of nearly 5 percent through Election Day. But on Nov. 9, 2017, the day after Trump was elected, the S&P increased 1 percent and the A/E increased 9 percent. The increase in the A/E sector stock index shortly after the election implies that investors felt that a Trump victory and Republican control of both houses of Congress would be good for the industry.
Through Feb. 6, 2017, the S&P 500 increased 6 percent, and the A/E Index increase reached as high as 20 percent. The A/E index has since decreased to about 16 percent (as of Feb. 6, 2017), but has still outpaced the overall broad market.
What This Means to Firms in A/E Industry
Stock prices don’t always tell the whole story, but, since the election, the S&P 500’s P/E (price/earnings) multiple (Chart 2) increased from 16.6x on Nov. 8, 2016, to 17.7x on Feb. 6, 2017, an increase of 6.6 percent. In contrast, the A/E firms’ P/E multiples increased from 24.1x to 29.4x over that same period: an increase of 21.9 percent. Again, this suggests that markets are reacting favorably to the new administration’s proposed agenda.
There are three critical elements of a P/E Multiple: 1) Earnings Per Share (EPS), 2) projected EPS growth rates, and 3) the risk of future EPS (the discount rate or required rate of return). Understanding the risks of your investment requires understanding the risk to your current earnings stream and its future growth expectations.
When we analyze investors’ growth expectations for the broad stock market and the A/E industry specifically (chart on page 15), the S&P 500 enjoyed the biggest percentage increase in earnings growth potential of 21 percent (an increase from 3.3 percent to 3.7 percent), while the A/E industry growth expectation only changed 8.8 percent (an increase from 9.1 to 9.9 percent).
This is a very important factor in your risk to future earnings. Had the A/E industry change been much faster than the overall broad market, the perceived risk associated with A/E industry returns would be much greater. Instead, we are seeing a slight decrease in the A/E industry’s perceived risk, and this decrease is the first we have observed since before the recession.
Why This Matters
When we first started following firms in the A/E industry, the risk profile of A/E firms was generally lower than the risk profile of the overall broad market. Around the time of the last recession, this risk shifted to be much greater than the broad market. Today, while A/E firms’ perceived risk is still higher than the broad market, it’s decreasing. If the A/E industry risk continues to decrease, the impact on values will be positive, and the investment opportunity in this sector could benefit enormously.
Of course, when it comes to the overall outlook for the U.S. economy, there are still many uncertainties, and public markets have been known for their “irrational exuberance.” Only time will tell if the aforementioned trends will continue, but, so far, the outlook for the A/E industry in the United States seems positive
About Michael O'Brien
Michael S. O’Brien is a principal in the Washington, D.C., office of Rusk O’Brien Gido + Partners, specializing in corporate financial advisory services including business valuation, fairness and solvency opinions, mergers and acquisitions, internal ownership transition consulting, ESOPs, and strategic planning; email: [email protected].