The Politics of Stocks, Part 3: Valuation, P/E, Marginal ROIC

On the third part of our five part series “The Politics of Stocks,” Chris digs into the details of stock returns. Join Chris and learn how valuation, the P/E ratio, and marginal ROIC drive equity returns — and what part politics can play.

Chris: This is Chris Perras, Chief Investment Officer at Oak Harvest Financial Group. Welcome to the March 1st edition of our weekly Stock Talk Podcast, Keeping You Connected To Your Money. Each week, we try to recap the prior week’s events, share with you our views on the markets. We also try to educate you a little bit along the way. This week’s episode is titled The Politics of Stocks, Part 3 Valuation Price-earnings Ratio.

A few weeks ago, a client came in and asked about the impact of politics on stocks and the equity market. With the 2020 presidential election moving into focus later this year, we’ve chosen to address this topic in a five-part series, entitled the politics of stocks. This is the third installment in our series. Last week, we covered how political policies can change earnings and free cash flow for publicly traded companies.

This week, we’ll focus on how policies in the government can change evaluations or price-earnings ratios. All of this material can be found on our relaunched website, oakharvestfg.com. Once again, that’s oakharvestfg.com. Under the sub-tab Investment Management, and then look for the area that says Ideas and Insights. All of this material is there.

Today’s focus is how politics can change the second component of a stock’s total return. That would be valuation. Some of you know, it is a price-earnings ratio or abbreviated PE ratio. The PE ratio is the current price of a stock divided by a company’s current earnings per share. Many factors drive a company’s absolute future PE ratio, including the overall inflation rate of the economy, company sector growth, and a company’s individual growth rate.

In general, the easiest question to ask is, is the government policy going to make things better or worse for my investment or the market’s perception of my investment business? Specifically, the economic question to ask is the marginal return on invested capital also known as ROIC, for my investment accelerating, decelerating, or remaining constant? Changes in marginal ROIC can be brought about by many factors, including new product releases, company restructurings, interest rate changes, or even lower taxes.

When ROIC is stable to improving, investors most often are willing to pay a stable to expand price-earnings most bought for the stock. This PE expansion helps leverage and compound investment returns above and beyond a company’s actual growth rate as optimism takes over and rules the day. Alternatively, when the marginal return on invested capital for a company is peaked, it’s almost impossible for a company’s PE multiple to expand.

Most of the time, when a company is growing at high, but decelerating rates, investors are best served to invest in alternative areas or even indexing these funds. Think of this as trying to walk up a down escalator, that gravitational pull of a declining PE ratio outweighs the actual growth component of a company’s EPS. Government policies that can change marginal return on invested capital include tax rate changes like the Trump tax plan in 2017, 18.

Minimum wage changes, subsidies, or tariffs, which had been in the press a lot lately with regards to China, increase or decreases in regulation. Lots of policies during the Obama administration with the regulation on banks decrease their marginal return on invested capital and bank stocks didn’t do very well at all then. Finally, war, which is generally a government policy can dramatically change people’s valuations they pay for stocks.

All these changes are government-sponsored programs. Things that change, whether it be social security or Medicare, Medicaid, anything like a mandate insurance policy, all of those are government-sponsored programs and can change how people view an investment. Big picture, do these policies change the growth or cost of doing business? For the engineers out there, the question is does a government policy changed the velocity or the rate of change of my investment? Once again, simply ask yourself, will these government policies improve or hinder the businesses I’m invested in?

At Oak Harvest Financial Group, we look to invest in assets that have either a stable margin return on invested capital or a low but accelerating marginal return on invested capital.

When we find sustainability in these trends, we try to let our winners run. Once again, in closing, if you find any of our content helpful, please feel free to forward these podcasts to friends or have them give us a call here at 281-822-1350 or go to our website. We’ve updated a lot of new content there at oakharvestfg.com. Come visit us.

Remember, your most invaluable tool in investing is discipline. You shared your retirement vision with us, and we are here for you. Occasionally, the investment environment will change. It did in the fourth quarter, we actually accelerated investment program for those who had just brought us money late in the year.

If things change in the future, we’ll change. We make our changes gradually because we know it’s not all or nothing. You need some help? Give us a call. We’re here for you. This is Chris Perras with Oak Harvest Financial Group, many blessings.

Speaker 2: Content contained within this Oak Harvest podcast is for informational purposes only and is based upon information current, as of the time of recording. It should not be considered an offer or solicitation to buy or sell securities, nor is it tax or legal advice. Investments involve risks. Unless otherwise stated, particular investment returns are not guaranteed.