Time to get back to basics
In this week’s video insight Roger discusses his views on what long-term investors should be focused on. Roger believes quality growth companies will ultimately return to popularity and when they do watch out.
The January rally in equities hit a brick wall in February. Perceptions of light at the end of the rate-rise tunnel, gave way to a more bearish interpretation of the persistence of inflation. And doubts about the effectiveness of the Fed’s monetary policy comes on the back of rate hikes, the pace of which has not been seen since the 1980s… and… moreover, officials indicate that there are more rate rises to come.
With reporting season over, attention will again turn to the state of the economy, central bank policy, liquidity concerns and whether stocks are reasonably priced with reference to P/E ratios.
This first chart from Ed Yardeni shows P/E ratios for S&P600 small caps remains near the low bound of values over the last 25 years.
This second chart shows the same ratio for the S&P500 large caps index, revealing P/E ratios are at about their 25-year average level.
And this final chart of the Cape Shiller version of the P/E ratio which is a cyclically adjusted P/E ratio averaged over ten years of earnings reveals P/E ratios are also at about their average level over the last 25 years but are elevated when compared to the last 150 years. Indeed, over the last 150 years the CAPE Shiller ratio has rarely been higher.
But long-term investors should be focused on something else. Those companies able to grow, able to retain profits and reinvest those retained profits at attractive rates of return.
Quality growth companies will ultimately return to popularity and when they do watch out.
But when will that be?
The answer is at best a guess. I think the end of 2022 brought with it the conclusion of the wild volatility that defined last year. I believe we have entered a period of normal volatility. That means a return to company share prices reflecting the performance of the underlying business. Good news is good news and bad news is treated harshly. Of course, investors are still reeling from the wild volatility of 2022 and so they believe that wild volatility is likely to return at any moment. But if their assumption is wrong, they will miss the opportunity to buy good quality companies at rational prices.
So what should investors do?
I think you should get back to basics. This could be the year to get set; yes there might be a recession, yes rates may go higher. But it’s also the case that we might avoid a recession, that inflation while persistent, might have peaked, and along with slowing growth, central banks could eventually ease off their rate-hiking pedals.
There are plenty of high-quality companies still growing out there – domestically and internationally – and eventually they will become popular again. But waiting until they’re popular again guarantees you’ll be paying a higher price. Our friends at Polen conducted a search for companies generating ROE of greater than 20 per cent, net debt to equity of less than 20 per cent, five-year compounded average revenue growth of more than 10 per cent. They found 370 companies across the US, Europe and China. They also found seven in their portfolio trading at the bottom quartile of P/Es for the last decade. Those companies include, Amazon, Alphabet, Service Now, Adobe, Autodesk, and those in the bottom half of their 10-year P/E range include Visa, SAP and Microsoft.
Back to basics also means remembering some immutable laws about investing. The lower the price you pay, the higher your return. If you buy a stock on a P/E of 10, and its EPS grows at 15 per cent for the next few years and then you sell it on the same P/E you paid of ten times earnings, you will end up with a 15 per cent return. It means remembering that if you buy that 15 per cent grower, its P/E could fall 25 per cent and you are still going to make nine per cent. Indeed, the P/E has to halve before you stop making a positive return and break even.
Though the U.S. Federal Reserve has emphasiaed the pain necessary to achieve its inflation goals, they are ultimately seeking the path toward a “soft landing”.
The future is never clear, but investors are rewarded for investing amid uncertainty. Reporting season revealed Australian companies like Harvey Norman, Nick Scali and JB Hi-Fi are seeing a slowing in sales. But reporting season also revealed companies like Lovisa – who sells fashion jewellery to a cohort of consumers who aren’t burdened by mortgages (and they have jobs) – is doing just fine opening stores globally at a phenomenal rate of knots.
So, you see, you can do what seems popular right now, avoiding the stock market and waiting for things to improve, or you can do what history and research shows is far more rewarding, zig when everyone else is zagging.
I’ll leave it to you to decide.
The Polen Capital Global Grown Fund owns shares in Amazon, Alphabet, Service Now, Adobe, Autodesk, Visa, SAP and Microsoft. This video was prepared 07 March 2022 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.