27 Sep 2018
The vast outperformance of growth stocks over value stocks in recent years has benefitted many and hurt others
For us, the conversation on valuation begins with how we define our roles as investors
We can’t stress enough the importance of this: an investor becomes an owner of the business
We believe most investors should be value managers in the sense they are looking to exploit the difference between the current price of a stock and what they estimate is its intrinsic worth
We believe energy and health care offer very favourable risk/reward characteristics
It’s hard to have a conversation on the US markets these days without being drawn to a debate on value versus growth. And with good reason: the vast outperformance of growth stocks over value stocks in recent years has benefitted many and hurt others - count ourselves in the latter camp. We think it is important, however, to pick up on a nuance that is often overlooked in that debate.
The Invesco Perpetual US Equity Fund is not a value fund, but we do have an investment process that has valuation as one of its critical components. In fact valuation is nearly always the last determination in our investment decision and more often than not it is the reason we have missed some opportunities. But, more importantly, it has helped to avoid some howlers. For us, valuation is most definitely not the sole reason an investment is made, and that is what distinguishes us from traditional value funds and indices where valuation is the key criteria for potential investment.
In fact, we would suggest that many growth investors are also seeking value. A great example of this is the Google IPO in August 2004. At that time the market‘s expectation was for Google to earn c.$2.40 in 2006. At the IPO price of $42.50 (split adjusted) that was a PE ratio of 18x two years out, a rich multiple, compared to the market’s then c.14x PE. However, if you were prescient enough to appreciate Google’s growth opportunity you may have correctly predicted that Google would actually earn $5.30 in 2006. That means at IPO, you were actually paying a PE multiple of 8x for Google. That is value in anyone’s book! Yet Google was a growth stock by the market’s definition.
For us, the conversation on valuation begins with how we define our roles as investors. In purchasing a share you are buying a stake in a company and therefore owning a call on the company’s future cash flows. We can’t stress enough the importance of this: an investor becomes an owner of the business. And to assess the potential return on your investment, you need to make an estimate of the intrinsic value of your business compared to your purchase price.
Over time a stock price will be drawn like a magnet back to the intrinsic value of the company. It may rise from being too cheap or fall from being too expensive, and it is anybody’s guess when that reversion will take place - but it will. As Benjamin Graham said: ”In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
We believe most investors should be value managers in the sense they are looking to exploit the difference between the current price of a stock and what they estimate is its intrinsic worth. That stock could be Bank of America, it could be Netflix. Our fund may look a lot like a traditional value fund right now, but that will not always be the case. It is merely a function of the fact that our valuation framework currently leads us to favour those areas of the market.
In our fundamental analysis, we are not blind to the opportunities within technology - cloud, AI, blockchain are all fascinating trends. But we do question the valuation of many of the companies in the technology sector. Good equity analysis requires a recognition that the only certainty in your forecast is that you will be wrong. Therefore a proper appreciation of the downside risk is essential, and this is the main issue we have with many valuations in the technology sector right now.
In many instances we can get to the current share price or somewhat higher. But the growth and margin assumptions we are making are often staggeringly aggressive. And when we attempt to sensitise our models to more normal assumptions, we often get considerable downside. As we look at all our investment opportunities on a risk adjusted basis, we often decide to pass on such a stock, full in the knowledge that we could be wrong if the company hits those aggressive assumptions or stock market momentum continues to feed on itself.
There are areas of the stock market where we can find companies with very favourable risk /reward characteristics. In particular energy and healthcare stand out in our work. The Oil & Gas E&P sector fell by over 60% from 2014 to 2016 as the oil price fell c.70%. From the $30 bottom, oil prices have recovered to c.$70, yet many stocks in the energy sector have barely recovered, lagging the oil price recovery markedly. Importantly we don’t see a lot of downside to many of these stocks given the lack of investment in future oil supply and a continued backdrop of decent demand.
Crucially, we have also seen dramatic change in behaviour from oil executives, with a commitment to spend within their cash flow generation and return cash to shareholders. ROIC, which now forms a large part of compensation structures, is now improving for many of these companies after years of decline. In fact this is the exact opposite of what is happening in the technology sector as the charts from Empirical Research below illustrate.
Figure 1 shows the growth in capital expenditure by sector with technology growth dwarfing every other sector, including energy. Figure 2 shows that, historically, high capital spending growth by a company is accompanied by underperformance of that company’s shares (usually because it leads to declining returns). However, contrary to 66 years of history, the fastest growing spenders in software have seen their shares actually outperform over the last decade.
Source: Empirical Research Partners, as at 16 August 2018.
Source: Empirical Research Partners, as at 16 August 2018.
So we continue to prefer the risk reward being offered in stocks and sectors off the beaten track. We can offer out several events we think should serve as a catalyst for investors to pay more heed to valuation – we are 10 years into this economic cycle, inflation is finally rising, we are in the third year of rate hikes.
But looking back at history, catalysts are hard to spot. Why did the NASDAQ peak on the 10th March 2000? Why did home prices finally top out in 2007? With the benefit of hindsight, we can see lots of warnings signs around both events but actually pinpointing a catalyst is very tough. Today we see lots of warning signs in technology. It will be interesting to look back again from some point in the future to identify what those, as yet, undetermined catalysts for change might be.
Simon Laing is Head of US Equities for Invesco.
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