We are sometimes asked why there is a difference between our forecasted earnings growth and our portfolio returns. It is logical to expect that if earnings are growing, then the portfolio returns will be growing too. However, the correlation between earnings and market returns is much lower in the short term than in the long term. As you will notice in the charts below, there are periods where the All Ordinaries Index can lag or outpace the earnings. However, when we look at earnings and price over multiple decades, they tend to follow each other quite closely.
For those who are data-centric we analysed the historical data and identified following insight. There is approximately 97.3% correlation between price and earnings over a 5-year period and over ten years it’s 98.7%. Which again highlights that in the short-term market prices aren’t always in lock step with earnings.
A great example of the disconnect between prices and earnings can be seen in the late 1980’s. Market prices accelerated far beyond the growth in earnings as sentiment drove share price rises across the board, right up to the Black Monday crash in 1987. What is interesting to note is although the market price correction was savage, the earnings never suffered the same significant decline. The 80’s really showed at a broad market level the ability for prices to be disconnected from the growth in earnings for extended periods and significant extremes.
As value investors, the growth in EPS is our guiding star to future performance. It confirms that we are on the right path especially during spells where the market is overlooking the businesses, we are invested in. With knowledge that prices ultimately return to the mean over the long term, we’re confident that investing in businesses which are growing their earnings at double digits will ultimately lead to success for our investors.
