Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 261

Going global? Don’t break the 'Golden Rule'

With a backdrop of the Financial Services Royal Commission and a cooling property market, Australian investors are understandably looking to diversify from the bank-dominated ASX/S&P 200 Index.

Yet risks also abound offshore with interest rates rising after years of low real rates, inflation is inching higher and equities appear more expensive after a strong decade-long run.

So how does an investor navigate this environment?

While equity valuations are stretched, they are more attractive investments than fixed income securities and direct (unlisted) investments such as property and infrastructure. These asset classes could face even greater risks in an interest rate tightening environment.

There are, however, segments of the equity market that are trading at extreme valuations and that is where the greatest risk lies.

The Golden Rule

Why do we think these valuations are extreme and not just the 'new normal' as some commentators have said? A problem is that the market is pricing in low rates into perpetuity, while also maintaining heroic growth assumptions. This represents a theoretical mismatch. Why so?

Any company valuation essentially has two parts:

  1. Earnings or cash flows (the numerator)
  2. The multiple or discount rate, usually P/E (the denominator)

This is the basis for what we refer to as the 'Golden Rule' of equity investing. The Golden Rule is: In the long run, nominal GDP growth should correlate with nominal long-term interest rates. In other words, in the long run, there must be a link between the numerator (earnings growth or cash flow) and the denominator (the multiple or discount rate).

In times of heady investment markets, like today, we often see investors break this Golden Rule and build heroic growth assumptions without applying higher interest rates. In our view, there are only two alternatives: either growth will be higher and rates will rise, resulting in a higher discount rate and lower valuations; or growth will be structurally lower and earnings will come down.

The earnings side of the equation

The expansion in price to earnings ratios (P/Es) and other metrics in certain areas of the market is not what concerns us the most. We are also concerned about the risk of inflated earnings of some companies, or the ‘E side’ of the equation.

Profits as a percentage of the economy are now high by historical standards (Exhibit 1).

Exhibit 1 – Profit share of GDP

Corporate profit margins are expanding and are well above long-term averages (Exhibit 2). In our view, for most companies this margin growth is unsustainable in the long term. Ultimately, we believe profit margins over the long term will decline, either through slower sales growth (associated with lower GDP) or higher input costs (wages and cost of funding via higher interest rates). We believe this has the potential to dramatically impact some companies, particularly those with both high margins and a high P/E multiples.

Exhibit 2 – Corporate profit margins rising

A better guide is the Shiller P/E

To put market valuations in an historical context, we think the Shiller P/E acts as the best guide. Standard P/E uses the ratio of an index over the trailing 12-month earnings of its constituent companies. During economic expansions or bull markets, companies can have inflated profit margins and earnings and the P/E falls as a result.

The Shiller P/E eliminates fluctuations caused by the change in profit margins during different business cycles. Currently, the Shiller P/E is at a level only reached three times in history, the others being in 1929 and in 2000 (Exhibit 3).

Exhibit 3 – US 10-year cycle-adjusted P/E

What to avoid

We primarily see two main risks for investors:

1. Companies with unsustainably high margins

We are concerned about some companies’ rapidly rising profit margins, which lead to expanded earnings, and the hefty multiples paid for their stocks. It is dangerous to assume these companies can maintain such profitability into the future and an investor needs to understand how sustainable the current level of profitability is.

This sustainability is particularly important should the economy soften. The ability to generate stable margins is actually quite rare, particularly in times of economic dislocation.

2. Expensive defensives

The prolonged low-interest rate environment has driven investors to seek out bond proxies: companies that have a combination of relatively attractive dividend yields and stable earnings. Consumer staples companies are the classic case, as are other traditional safe havens such as North American utilities and global REITs.

In consumer staples, the growth rates required to justify current share prices are substantial, which contradicts the sluggish revenue growth most of these companies are actually experiencing today. We believe either rates will rise, making these stocks less appealing, or growth rates will disappoint, bringing multiples down.

Where to go?

As the investment environment normalises, investors must adapt their portfolios to achieve their return target. Generating an adequate return from global equities will not be as easy as in the past. Now investors need to:

  • Focus on the right companies, such as higher quality names with more predictable earnings.
  • Focus on valuation, and invest in the right companies but only at the right prices.
  • Diversify sensibly, not naively. A widely diversified portfolio perversely may be more risky than a concentrated portfolio given the overall level of risk in equity benchmarks.
  • Expect currency exposure to play a major role in the performance process.

We expect a greater spread between the small number of winners and the larger number of losers. Risk should be defined as the probability of a permanent loss of capital, and, in the environment we face today, that risk is coming into sharper focus.


Warryn Robertson is a Portfolio Manager and Analyst at Lazard Asset Management. This article is general information and does not consider the circumstances of any investor.

July 05, 2018

Interesting piece. Not sure I'd call the first a ‘Golden Rule’ of investing. It's the old Taylor rule (ie long term average nominal cash rates should more or less equal the expected long term average nominal output growth rate) which gained popularity in the 1990s, ignored in the 2000s and abandoned by current central bankers this decade.

The second is the idea that a company’s profits can really only sustain growth rates of the economy in which it operates. This assumes companies operate purely in their home country, they start out as big mature slow-growth market leaders, and ignores cost cutting, efficiencies, automation, technology, etc, etc

Which country or market does the first chart relate to? If it is the US then he should go back to the 1920s to show the similar pattern to today – then the 1930s depression, etc

The Shiller PER calls the top several years too early in most cycles. If you sell when it gets above say 20 you miss out on the best years of the booms. And if you buy when it is cheap then you get clobbered in the worst parts of the sell-offs. Eg I know of several fund managers/advisers who sold out/under-weighted in 2005 or 2006 (way too early) then over-weighted based on Shiller PER being cheap in early-mid 2008 – then they got clobbered by the Lehman crash! Many just gave up in early 2009 – licked their wounds and went to cash – and many still remain petrified in cash for life!. If you want to lose clients / investors for life then use Shiller!


Leave a Comment:



Investors face their own Breaking Bad moment

Best and worst performing equity funds of 2020

Beware of burning down the barn to bury the debt


Most viewed in recent weeks

Noel's share winners and loser plus budget reality check

Among the share success stories is a poor personal experience as Telstra's service needs improving. Plus why the new budget announcements on downsizing and buying a home don't deserve the super hype.

Grantham interview on the coming day of reckoning

Jeremy Grantham has seen it all before, with bubbles every 15 years or so. The higher you go, the longer and greater the fall. You can have a high-priced asset or a high-yielding asset, but not both at the same time.

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

BHP v Rio v Fortescue: it's all about the iron ore price

Don’t look at an earnings forecast or a DCF valuation or a broker target price for a mining company. Share price forecasts are only as good as the commodity price assumptions they are based on, and they are a guess.

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Latest Updates


Jane Hume shakes up super, but what will it achieve?

The Government calls 'Your Future, Your Super' the most significant reforms since the start of compulsory super. Stapling has benefits and we should remove poor funds, but performance comparisons are difficult.


Launch of the 'Wealth of Experience' podcast

Welcome to the first episode of our fortnightly podcast, Wealth of Experience, with Graham Hand and Peter Warnes. They have a combined 99 years in markets and they will share this experience to help build your wealth.

Investment strategies

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

Investment strategies

Where will investment returns come from in 2021?

There are only three sources of returns when investing in companies. Whether an investment delivers on dividends, earnings or valuation expansion determines performance, and the contribution of each varies over time.

Investment strategies

Portfolio composition and what you find under the bonnet

Powerful structural themes such as technology disruption and demographic changes may disguise what is driving company success. Watch these broad categories as they may not apply in ways you expect.

Investment strategies

When rates rise, it's time to look for new players on the team

Long duration assets such as government bonds and property have benefitted from falling interest rates, but a turn is coming. It's time to find assets that may benefit from rising rates, such as private debt.

Investment strategies

How are high net worths investing and thinking now?

Citi research delves into how high net worth investors are feeling in the current market, and how they are investing during the drama of the pandemic. There is plenty of optimism and a willingness to stay invested.



© 2021 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.