Sustainability has been a buzzword over the last few years, with investors understandably becoming more concerned about the sustainability of earnings.
Furthermore, 2013 saw a vast rerating in the price-to-earnings (P/E) ratios placed on companies, as the market seemed to look ahead to improved macroeconomic prospects and growth in 2014.
However, the link between these two points is an area that could unlock a relatively large amount of value for investors. Indeed, it could be even more relevant for portfolios that are for retirement and which take a longer term view of earnings growth.
For example, a large number of stocks have seen their P/E ratios expand substantially over the last year. One stock that hasn’t is British American Tobacco (LSE: BATS) (NYSE: BTI.US). It currently trades on a P/E of 14.1, which is less than the 15.6 it was trading on a year ago.
One reason for the fall could be the fact that British American Tobacco’s P/E had already increased as a result of it being viewed as a defensive stock, so when the attitude of investors was ‘risk-off’ such companies gained in popularity, with increased demand pushing P/E ratios significantly higher.
Now that a more ‘risk-on’ attitude is prevailing, such stocks find their P/E ratios being nudged downwards in favour of cyclical, higher growth (but higher risk) stocks.
This last point is crucial: risk. Indeed, there is a relatively high chance than British American Tobacco will deliver above-average, sustainable growth over the long run as a result of the product it sells being relatively inelastic. Certainly, there are regulatory risks and the introduction of e-cigarettes could provide a boost to growth or hamper it. However, British American Tobacco is more likely than most companies to deliver above-average growth in the long run.
Contrast this to cyclical companies that may offer above-average growth prospects when interest rates are at historic lows but that may struggle to do so when interest rates increase in response to an overheating economy.
Therefore, long term investors could find good value in relatively unloved companies such as British American Tobacco. They may not quite offer sky-high growth prospects, but they are more likely to be sustainable over the course of an economic cycle and, as a result, may be more attractive for the long run. They may even make retirement come that bit quicker and cause less stress along the way.
