Graham Campbell discusses the curious enthusiasm for expensive shares…
A colleague attended two meetings on the same day last week in Edinburgh. The first, with the IR of Britvic, the soft drinks consumer company, was attended by around 17 interested investors; the second with the FD of Barclays, was attended by two!
This enthusiasm for all things consumer/staples was backed up by feedback from a recent investor trip to London. There is an appreciation that businesses classified as ‘Quality’ are expensive, relative to their history and compared to other investment styles, but we came across few sellers of shares in this classification. It reminded me when valuations became detached from expectations during the commodities and tech booms: there are few sellers at any price. When this mood takes shape it frequently suggests that we are entering dangerous territory.
I am wary of applying titles like Quality, Growth, Value and Defensive to describe a business, as these characteristics and are present to a greater or lesser extent in all investments. Also, some factors vary in relative importance over time as the industry or company changes (e.g. Vodafone was regarded as a growth stock in 2000 when it was the largest UK quoted company, is now regarded as a value stock after declining almost 75% and recently cutting the dividend).
For the sake of discussion, I will consider Quality to be a measure of sustainable cashflow, that delivers a high rate of return above the cost of capital. This is an attractive characteristic as returns are more predictable, but also because by generating a real return, the business creates value. However, this is only part of the story, as some businesses generate a positive return on capital employed (ROCE), but are unable to deploy surplus capital to earn the same return.
Take WD 40! It’s a fine business: every garage and shed has a can in case a nut is too tight or to loosen up some equipment. It earns a consistently high return on capital. However, as we are all unlikely to spend more of our lives loosening tight metal objects, a can lasts for years and the growth prospects are limited. In the 5 years to August 2018, revenue growth averaged a modest 1.6%. It is fair to add that management was able to boost earnings by more than this by using free cash to buy-back shares. Nevertheless, the shares are now valued on a prospective Price Earnings Ratio (PER) of over 32X and yield 1%.
It is not just WD 40 that appears to us to be expensive for expected growth: investors appear willing to pay higher valuations for businesses with quality attributes. The chart on the left below shows the strong outperformance of Quality. However, the chart on the right indicates that this has not been matched by an improvement in forecast earnings.
The example of WD 40 aims to illustrate that while quality is an important factor in assessing a business, investors must also consider growth and of course price. The price you pay is the basis of all future returns and it cannot be ignored when buying shares, or when assessing any other investment opportunity. This boils down to: there has to be a level when an objective investor considers a share as cheap and worth buying and another level when the price is too high and no more should be bought or selling should be considered. Is Quality cheap at any price?
This does not feel like the market environment we are currently enduring. There is little price support in some areas and only buyers in others. It is not my intention to attempt to convince objective investors in this blog that an alternative strategy, such as Value is cheap, but to highlight that some Quality businesses appear to us as expensive for the growth that they are forecast to deliver. History has shown that owning highly rated shares that do not deliver is a painful experience, as the examples of Anheuser Busch, Reckitt Benckiser and Kraft Heinz demonstrate. The chart below graphs the relationship between Like for Like Sales Growth and the PER. With 75% of the movements correlated, the chart suggests that investors are willing to pay a PER of 20X for 4% growth and around 28X for 5% growth.
Many of shares considered as Quality appear to us to be in a space that is expensive, overbought and crowded. Most investors we meet have some sympathy with the valuation argument but search for a visible catalyst to make this happen. Experience has shown that most catalysts are really only clear in hindsight.
There remains a close relationship between Quality and bond yields. These Quality shares appear still to be the bond proxies! If we follow the Japanese example and bonds yields fall further and stay low, then maybe these shares will continue to out-perform and for some time. However, we argue that with versions of QE applied across many countries, we have a large price insensitive buyer and bonds have therefore lost much of their predictive power to be a barometer of expected inflation.
In contrast, we expect to find more attractive investment opportunities in a less crowded environment. The TB Global Income & Growth portfolio has not been as Value biased or cyclically orientated, since launch almost 8 years ago. As can been seen below, this focussed portfolio is differentiated from our Peer Group and any relevant Index.
There is a risk that we enter a global recession in which case more cyclical businesses will suffer: we still view this as unlikely. Growth is more likely to persist at low levels. We value Quality as an attribute when we consider a business for investment, but we also consider the relationship between the prospects for growth and the forecast valuation of the shares. We also have strong views about balance sheet strength. Owning expensive shares in the hope that they keep going up is a dangerous endeavour.
Graham H Campbell
Joint Manager of TB Saracen Global Income & Growth