united kingdomen
Buying cheap is an expensive business

Buying cheap is an expensive business

09-09-2019 | Column

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.

  • Jack  Neele
    Jack
    Neele
    Portfolio Manager

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.

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

Figure 1. Value stocks > growth stocks

Caution is not always good

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.

Figure 2. Growth stocks have performed very well in the last 10 years

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.

There's more than valuation alone

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. 

Investors understand intangible assets

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.

Table 1. The weights of the industrial sectors have more than halved in the past 30 years

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

Subjects related to this article are:
Logo

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

I Disagree