If the recent fortunes of growth-orientated investments proves anything, it is that valuation matters, argues Alan Dobbie, co-manager of the Rathbone Income Fund.
As prevailing interest rates marched ever lower in the decade preceding the pandemic, ever more investors fell into step. This helped create a cult around ‘quality growth’ investing.
A belief formed that the stocks of the best businesses – those with competitive advantages, high returns on capital, attractive growth opportunities, great management teams and strong balance sheets – would outperform simply by dint of their superior fundamentals. Valuation metrics, if considered at all, were often downplayed – a footnote to the investment case. This strategy worked brilliantly in the long bull market following the Great Financial Crisis, as tumbling bond yields juiced the total returns of long-duration assets.
Perhaps this is just sour grapes; UK equity income funds didn’t exactly play a starring role in the US tech-led bull market! However, in the fullness of time, we don’t think that the history books will look favourably upon this period of financial exuberance. Though earnings growth was strong, the real driver of the outsized returns came from investors’ willingness to pay an ever higher multiple for each dollar of those profits. Towards the end of the last decade, the US cyclically adjusted P/E ratio broke through 30x. In its 142-year history, this threshold had only previously been breached on two occasions: 1929 and 1997 – years that ultimately became synonymous with financial market excess, and an almighty hangover.
Quality matters, but so does the purchase price
The notion that the best businesses always deserve to outperform jars with our valuation-conscious style. Surely investment skill isn’t simply about identifying the best businesses. It’s about knowing the right price to pay for them so that they will generate an attractive return in the future. We may all know that Lionel Messi and Cristiano Ronaldo are the best footballers in the world, but that doesn’t tell us anything about whether they offer their clubs bang for their buck. Crazy-rich football club owners may not care much about return on investment, but the rest of us should. Price matters. Valuation matters.
Our own ‘Trinity of Risk’ investment process aims to balance valuation (price risk) with leverage (financial risk) and measures of business quality (business risk). We favour this approach because it affords equal status to each of these three risk factors (meaning we never treat valuation as an afterthought). We’re acutely aware that it’s easier, and usually more fun, to discuss business models, competition, macro drivers and management quality. However, if they are already well-appreciated and incorporated in the stock price, they mean nothing. You’re getting exactly what you pay for (and maybe less if something unexpectedly goes wrong).
Twenty Twenty-Two will be remembered as the year when valuation (price risk in our parlance) suddenly mattered again. The much-used Warren Buffett aphorism, “Only when the tide goes out do you discover who’s been swimming naked,” is typically used to describe situations where an external shock suddenly triggers losses from companies with poor business models (business risk) or excess leverage (financial risk). We think Buffett’s wise words are also apt for 2022. However, the stocks left high and dry last year were not the frail or overly indebted, they were those which carried egregious price risk. An abrupt reversal of the interest rate cycle was all it took for this hitherto ignored fragility to be exposed. The fact that many of these companies continued to grow sales, margins and cashflows throughout didn’t matter…valuation mattered.
Clearing the hurdle
So what of the future? Valuations on both sides of the Atlantic have fallen over the past year. Yet the S&P 500 index is down and the FTSE 100 is up. However, differing starting points mean that the US market still trades on elevated multiples compared with its own history. In contrast, the UK market sits at a significant discount compared with its 20-year average. In truth, this understates the patient’s condition. Despite the FTSE 100 recently hitting an all-time high, the UK market trades on a multiple more frequently associated with periods of financial market distress.
Is this justified? Not to our mind. The view that the UK market is populated by mega-caps from a bygone age, while the American market is home to the businesses of the future, is trite yet not entirely without merit. But, to parrot myself again, valuation matters. For the US market to do well, its companies must beat their – already rosy – growth projections.
The UK market, on the other hand, has a much lower hurdle. Taking current valuations at face value, simply avoiding financial market distress may be enough to deliver decent returns. In fact, with better-than-expected economic data, more sensible government policy, the possibility of more constructive relations with Europe and the reality that we do actually have some decent businesses in the UK (garnished with a modicum of self-belief), you never know, the UK may just hit its stride.
This is a financial promotion relating to a particular fund. Any views and opinions are those of the investment manager, and coverage of any assets held must be taken in context of the constitution of the funds and in no way reflect an investment recommendation. Past performance should not be seen as an indication of future performance. The value of investments may go down as well as up and you may not get back your original investment.
