One of the most frequent questions I have been asked in recent years concerns valuation. My focus on long-term growth trends in consumer spending and the companies that can benefit from these often leads me to stocks with high absolute and relative valuations. Stocks of companies with sustainability practices that give them a competitive edge, global brand strength and superior growth prospects are rewarded with an above-average price-earnings ratio.
It is only logical that clients ask questions about high valuations. To start with, you have the well-known value effect. This is the principle that, in the long term, value stocks – adjusted for risk – generate better returns that their growth counterparts. Empirical research has been carried out on this, over long periods, and the effect has been observed in both developed and emerging markets. So if investors want to swim against the tide, they need to have good reasons for doing so.
In addition, there are – understandably – few investors who tell their clients they have the market’s most expensive stocks in their portfolio. Buying cheap stocks is seen as prudent: a sign of due care. However, if we zoom in on the last ten years, there seems to have been a structural change since the financial crisis. Cheap stocks have done much less well and significantly lagged growth stocks.
Nevertheless, holding expensive stocks is often deemed speculative or reckless. This is partly because in the financial industry the words ‘expensive’ and ‘overvalued’ are often confused, despite their significant differences. There are many investors who have simply discarded Amazon shares as ‘much too expensive’ in the last ten years. But in that same period, Amazon is up more than 2000%. While the stock might have been expensive ten years ago, with hindsight it certainly wasn’t overvalued.
The same applies for ‘cheap’ and ‘undervalued’. Stocks with a low price-earnings ratio, price-to-book ratio or high dividend yield are classified as cheap, but that doesn’t mean they are undervalued. Companies in the oil and gas, telecommunications, automotive, banking or commodities sectors have belonged to this category for decades. But often it is the stocks of these companies that structurally lag the broader market. Cheap, yes. Undervalued, no.
As a trends investor, therefore, I look mainly at companies’ fundamental developments. Valuation is, of course, important. But it’s certainly not the first characteristic I look at. I’m convinced that in the long term, high-quality companies with good growth prospects rightly deserve a valuation premium relative to their less well-positioned competitors. Moreover, I see a number of reasons to think that this premium will still apply in the future.
First, interest rates are historically low. Long-term returns on the bond market have been falling for years – an indication that investors anticipate lower future economic growth. This is a good environment for growth stocks, which have demonstrated they can achieve both revenue and earnings growth in difficult economic circumstances. For the time being, there is little cause to assume that global economic growth will pick up anytime soon.
Second, technology plays a key role. The world is digitalizing at an incredible rate, as a result of which traditional sectors such as energy, commodities and banks have become structural losers. Investors are therefore being forced to move into faster-growing alternatives. It is very clear that the economy, which used to be based on production, is shifting increasingly towards technology.
This is reflected in the weights of the traditional market industries. In the table below, we can see the sector weights of the more industrial part of the economy.
In the past 30 years, these traditional sectors have become much less relevant. So, it isn't surprising that companies from these sectors have lagged the rest of the market. Finally, I think investors have become much better at estimating the value of intangible assets in company valuations. Previously, investors looked mostly at things like book value, which comprised the value of, amongst others, factories, office buildings and machines. These accounted for the majority of a company’s total value.
Nowadays, intangible assets such as brand strength, software, patents or other intellectual property are often a company’s most valuable assets. It is these that enable companies to distinguish themselves from the competition in the battle for custom, profit and earnings.
As long as there is no unexpected growth acceleration or recession, I expect growth companies to continue performing above average. So, buying cheap might prove to be an expensive business in the years ahead, too!
This column has been published previously on IEX.nl