(Cape TownWith the U.S. stock market soaring after the coronavirus crash, more and more attention has been paid to valuations of the big growth stocks that are driving the recovery. According to Bloomberg before yesterday’s US tech sell-offAmazon traded with a price-earnings ratio (PE) of 134, Netflix with a PE of 83 and Apple with a comparatively modest PE of 40.
“There is some big debate going on in the investment universe as to whether these are quality stocks or growth stocks like the Faangs have [Facebook, Apple, Amazon, Netflix and Google] and that we have some degree in our portfolio that we are overvalued and heading for a bubble, ”said AA-rated Citywire Terry Smith, the founder of Fundsmith and manager of the Fundsmith Equity Fund. He spoke this week during the Nedgroup Investments Multi-Manager Insights webinar in South Africa.
The consequence of this concern about the valuation of growth stocks is that value stocks become incredibly depressed. With some measures, the shift between growth and value is greater than ever before. For some, this represents a significant mean reversal.
Smith pointed out, however, that it is important to consider what Benjamin Graham advocated as value investing: buying companies that are worth below their intrinsic worth. In the current environment, it’s not as easy to do as spotting low earnings or a book value multiplier.
“That’s pretty important,” said Smith. “We’re talking about some banks trading below book value, for example, but if they are getting a return that is below their cost of capital, they should be.”
In his view, just being “low valued” does not automatically mean value.
The value of quality
Instead, Fundsmith’s approach has been to invest in quality companies with high ROI, strong margins, good cash conversion, and defensive business models. Smith noted that back in 2012, strong views were expressed that this type of stock was expensive and due to a reversal of the mean.
“If you had followed this advice you would be impoverished yourself,” he said. “That doesn’t mean there won’t be a day like that.” The problem is, in this current fork, it’s easy to be apprehensive of valuing quality stocks. “
However, he pointed out that it is important to understand that high PE multipliers don’t necessarily lead to poor future results.
Lessons from history
Fundsmith looked at 25 quality stocks and what an investor could have paid for a 7% compound annual growth rate (CAGR) between 1973 and 2019. Over the same period, the MSCI World Index achieved an annualized return of 6.2%.
With a CAGR of 7% of L’Oreal, an investor could have paid 281 times his profit. It would have been 156 for Colgate and 147 for Brown-Forman, the company that owns Jack Daniels.
“Given the patience, these quality stocks tend to have the type of performance over long periods of time that make their valuation lose importance,” said Smith.
Lessons from recent history
In a similar exercise, Fundsmith examined a basket of five value stocks that were trading at relatively low PEs in early 2015 and five growth stocks that were trading at relatively high PEs.
|Basket of values||Growth basket|
|camp||Dragging PE||camp||Dragging PE|
|Marks & Spencer||fifteen||Netflix||554|
For a valuation investor, those two baskets would have made a poor choice five and a half years ago. Given their historical earnings, it would have been pretty clear where the greater chance lay.
“The problem is, the revenue in the first group is gone – literally three times,” said Smith. “That compares to some very big gains in high-growth stocks – hundreds and thousands of percent.”
What happened to these two groups of stocks was so significant that “growth became value, but value didn’t”.
“This slump in earnings for value stocks means that if you looked them up in late August, they actually got very expensive,” said Smith. ‘Profits have fallen faster than the share price.
“If you look back on what you paid for the growth stocks, your forward PE – which you had to decide on even though you didn’t have the clarity of the past – was actually very low.”
The five value stocks in this example have declined a total of 45% since early 2015. The five growth stocks, on the other hand, are up 800% overall.
“After I’ve said all of this, and while I’m not particularly keen to generalize, I conclude that what can eventually make a difference is we get inflation back,” said Smith.
This is because inflation has a different effect – it is more of a negative impact on long-term assets like quality stocks.
“These businesses are being affected, and I have no doubt that it will eventually happen,” said Smith. “Then value stocks can have their day and even their year in the sun. But in the long run, quality outweighs value. “
Looking back over 34 years of data for the MSCI Quality World Index, Smith pointed out that there has never been a 10 year period in which the index failed to outperform the MSCI World Index.
“If you’re a long-term investor,” said Smith, “the quality will go down.”
Patrick Cairns is the editor of Citywire South Africa
Terry Smith: “Quality is coming out” and it is worth paying for it