Markets are a race between fundamentals and expectations. When fundamentals get ahead, expectations have to catch up and prices follow. But when expectations get ahead, it's a different story. Fundamentals can't just run faster or jump higher. So it's expectations that need to take a knock, dragging share prices down with them. Rob Perrone from our offshore partner, Orbis, explains this relationship in this 7-minute video.
Now, my absolute favourite way of thinking about the relationship between fundamentals and expectations is the high jump. When a company's sales, profits and growth clear the bar easily, the bar goes up and so do prices. But when the bar is too high, fundamentals crash into expectations, knocking down both estimates and share prices. We see this all the time.
Take Nvidia's recent history.
It's May 2023, and the company is about to report earnings for the first full quarter since the launch of ChatGPT. Markets didn't expect much, and the company soared over the bar, beating sales estimates by 10%. Those estimates had to rise, and over the next week, the shares were up 28%.
The next quarter, as AI gathered steam, Nvidia did it again, beating higher estimates by a whopping 22%. Once again, those estimates had to rise, and the share price rose again over the following week.
Over the next several quarters, it was mostly more of the same. As Nvidia posted annual sales growth of 100%, 200%, even 250%, markets kept raising the bar and the company kept clearing it.
But each time, the gap narrowed. This February, Nvidia reported sales of US$39 billion in the single quarter, up sixfold from just two years prior. Those sales represented annual growth of 78%. But with expectations so high, 78% growth wasn't enough to clear the bar. Fundamentals crashed into expectations, and the shares tumbled the following week.
Amazon had much the same experience coming out of the pandemic.
Having grown by about 20% per year before COVID-19, Amazon's e-commerce business skyrocketed. Growth accelerated from 20% to 30% to 40% as online stores were the only ones open to consumers, and the company raced to invest in more fulfilment centres. As Amazon comfortably cleared its hurdles, expectations started to rise, bringing the shares along with it. From the start of 2020 to mid-2021, the company's share price doubled.
But before long, other stores opened again, and pandemic-level growth was no longer sustainable. The company had overbuilt capacity, leaving its fulfilment centres underused. Strained from the pace of its hurdling, Amazon's fundamentals started to disappoint. As expectations were knocked down, the stock fell behind, suffering a 56% decline. Investors who bought Amazon at the peak of its stride in mid-2021 had to wait nearly three years to recover.
Now, this race between fundamentals and expectations doesn't just apply to individual companies. It applies to whole markets too.
Of all the world stock markets, the US was the clear pacesetter in the last cycle. Over the last 15 years, the S&P 500 returned 14% per annum. That's an exceptional performance versus its own history, and a record-setting run versus bonds. After such a long cycle of outperformance, it's tempting to conclude that US stocks are simply better runners for investors. If they can beat the world over 15 years, why not 50?
But expecting the US to sustain such high returns is like expecting an athlete to run a distance race at a sprinting pace. If we look at what drove the S&P's returns, about half of that 14% came from profit margins getting higher and valuations getting more expensive. Both of those are cyclical. Both are currently near record highs, and neither can keep running up forever. If profit margins and valuations in the US relented to still healthy 20-year averages, the long-term returns on the S&P would be less than the yield currently available from bonds. A runner who starts a long distance race at a full sprint is likely to be straining, not sprinting, by the time they reach the finish line.
High expectations sound exciting. We all like stories of faster runners and higher jumpers, and the stories are usually convincing. Who isn't excited about AI? Who thinks the average US company isn't better than its peers elsewhere? But high expectations are not a reason to be enthusiastic as an investor. They're a risk factor. High expectations mean higher bars, more hurdles and faster times for company fundamentals to beat. And when companies fail to clear the bar, the result is disappointment and lower share prices.
Fortunately, great expectations are hardly universal. If we look beyond the US, we see neglect, not excitement. Stock markets elsewhere ran more slowly over the last cycle. As a result, expectations today are much lower. While the US trades at 24 times earnings, shares outside the US can be bought for 17 times on average. For bottom-up investors, that's terrific news, because the US does not have a monopoly on high-quality or fast-growing businesses. We've found dozens of companies across the world which we believe can run fast and jump high. It's just that no one expects it. For investors, soaring over a low bar is far more rewarding than knocking over a high one.