Matthew Beddall

The grandfather of value investing, Ben Graham, famously said that “in the short run, the market is a voting machine but in the long run, it is a weighing machine”.

What Graham meant is that in the long-term market prices move to reflect the economic fundamentals of companies, whereas in the short-term they are dictated by the whims of market participants. By “economic fundamentals” I really mean the earnings that a company generates for shareholders, as measured by either the rules of accounting or cashflows. Graham’s opinion that prices move much more than is justified by earnings was validated in the 1990s by the academic Robert Shiller, for which Shiller was later awarded a Nobel Prize.

The chart below shows the relative expensiveness of “growth” versus “value” companies, US versus non-US companies, and large versus mid-size companies[1]. The lines tell us the extent to which investors are currently willing to pay a premium to own the former, over the latter.

This shows that the premium to own growth companies, US listed companies and large cap companies appears to be as high as it has ever been in the last 30 years. As value investors we think this trend is more likely to reverse than continue.

We believe these premiums are the product of the “voting machine”, with the enthusiasm that many investors have for certain companies running well ahead of a reasonable expectation of their ability to generate earnings. The counterargument, based on the “weighing machine”, is that the premium investors are paying is because a select group of companies are likely to grow earnings at a much faster pace than they have done historically.

Our portfolio is not just focused on value companies, but is currently also exposed to non-US listed mid sized companies. This is because it is where we see opportunity. The fund has made money in each of the five calendar years that it has been running, but the trends that I describe mean that its relative performance has faced multiple headwinds. If these trends reverse, the fund stands to benefit, as they should move to become tailwinds to our performance. We cannot know if, or when, this might happen, but we believe history is on our side.

In short, we believe our fund provides exposure to the “weighing” machine, not the “voting” one.

Appendix

The table below outlines the data that was used to produce the chart:

We used price earnings ratios based on 10-year average inflation adjusted earnings, as this removes the “noise” of individual years’ earnings. We also produced charts based on the prior year’s earnings and prior year’s cashflows, which show the same overall trends. These are shown below:

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[1] The MSCI World size indices have a limited history, and so the size factor uses just US data prior to 2009.

The performance of American public equities since the Global Financial Crisis has been exceptional, with the result that they account for more than 70% of the MSCI World index. This is demonstrated in the chart below, that shows the relative returns of owning American equities versus other developed markets.

The chart also shows that there have been periods of time when the reverse has been true, with the returns from US equities lagging the rest of the developed world during the 1970s and 1980s. This pattern of prolonged periods of under and over performance held for the entire twentieth century[1], despite the long-term trend of US dominance versus “old world” economies.

The technological revolution that we are currently living through has very much been centered in the US, meaning that it has spawned many of the world’s largest and most profitable companies. The outperformance that is shown above tells us nothing about the growth in earnings power in US companies, and the extent to which it has also outpaced the rest of the world.

The MSCI US index currently has a price-to-earnings ratio of 25x, versus the MSCI World index ex US having a ratio of 15x. This tells us that US companies look more expensive than their developed market counterparts, based on their previous year’s earnings. On this basis, the US index has become progressively more expensive in the last decade, which is only rationalised by a growing belief that future earnings have much higher growth yet to come.

The “Magnificent Seven” companies account for 28% of the MSCI US Index, and so have become the focal point for US equities. They have been the driving force of strong earnings growth, strong share price performance and high valuations. The next chart shows the average net profit margin for the group of seven, which is the fraction of their sales left over after they have paid all operating expenses, finance costs, and taxes. On this basis these companies have never had it so good.

The average price earnings ratio for the Magnificent Seven is 37x last year’s earnings, meaning that they appear markedly more expensive than the MSCI US index on 25x earnings. To justify this valuation, they either need to see strong sales growth or increase profit margins[2]. At their current size, growth in relative terms corresponds to large quantities of incremental sales in absolute terms, which is a challenge. Likewise, growing margins from current peak levels will also be a challenge.

I cannot know that the premium investors are currently paying to own US equities, and specifically the Magnificent Seven, will not eventually be justified by higher earnings. What I do know is that because much growth is already “priced in”, there is a substantial risk of disappointment if they fall short. The dominance of these companies means that many portfolios will, like the passive MSCI World index, have a concentrated exposure to this risk.

The next chart shows the price to ten-year average inflation adjusted earnings for the MSCI World and MSCI World ex US indices. This tells us that if long term average earnings were to be a good guide to the future, then US equities currently look very expensive. For the Magnificent 7 this ratio is, on average, 65x, making them look more expensive still.

We do not want to rely on optimism, and are particularly cautious about requiring record-high profit margins to justify an investment. We see plenty of opportunities where only modest expectations for the future are required, for valuations to be attractive. This “glass half empty” approach means that we do not currently own any of the Magnificent Seven, despite the fact that they are attractive businesses. Put simply, we believe a good business only makes for a good investment at the right price.

Source: All data used in charts and commentary is sourced from Bloomberg.

[1] See https://globalfinancialdata.com/the-united-states-or-the-rest-of-the-world

[2] They can also grow earnings by buying back shares, but this is not very value accretive at current valuations.

If you are anything like me you will have arrived in January willing yourself to be a better person, full of resolutions to eat less, exercise more, and to use your time more wisely. As we all know it is much easier to plan to do this, than to actually do it! At every twist and turn temptation lures you down the alternative path. My personal nemesis is dark chocolate. Put a bar of it within a hundred feet of me and I turn into Augustus Gloop, shoveling it down as if I hadn’t eaten for a week. Now of course I know that my body would be better served by time on the treadmill, but my inner chimp is somehow blind to this in the moment that temptation strikes.

The reason we struggle to stick to our resolutions is that the “good stuff” invariably gives us a dopamine hit that we are evolved to desire. My pre-historic ancestors didn’t have to contend with a Hotel Chocolat outlet on every street corner, and with limited supply it made sense to indulge whenever the opportunity arose.

When you view the world through the lens of dopamine hits, you realise that many highly profitable businesses are built on our inability to suppress desire. Tobacco, alcohol, and sugar are all tangible examples that have spawned lucrative multi-trillion-dollar industries. Some other examples I can think of are perhaps less suited to a family audience!

Human ingenuity, being what it is, has increased the variety of ways that we can get our kicks, and made them more copious. Digital technology took this to another level, with social media platforms being examples of mighty businesses created in the knowledge of what makes our inner chimp tick. Search for a video of a cat, and Google will provide you with 466 million different choices. You could watch them for the rest of your days, without need for repetition.

Before you start thinking that I am subjecting you to a treatise[1] on healthy living, I will return my narrative to investment management.

In much the same way that our personal indulgences stimulate dopamine in our brains, many of the forces acting on us as professional investors do too. We are subject to a virtual firehose of information, analysis, and punditry that has been growing in size exponentially. The quest for our attention nudges much of this content away from the mundane and into the direction of the titillating or sensational.

I am a firm believer that most of what provides excitement in financial markets is irrelevant to the discipline of investing. Focusing on where the latest inflation “print” landed, which companies had a quarterly earnings “miss”, or what Elon Musk tweeted, directs attention towards the short-term and overestimates the importance of what is often just background noise. This in turn can lead to the “churning” of investments, which wastes money on transaction costs, and makes one more likely to crystallise loses and miss gains.

With all of this said, I like this status quo, because the fixation on the short-term creates miss-pricings that value investors, like us, can benefit from!

An example of this is an industrial business that we just added into the portfolio. It is a key supplier in the food chain, has served customers since 1842, and is the number two operator amongst four dominant suppliers. It has a number of barriers to entry, but its apparent downfall is that customer orders ebb and flow with the price of commodities, such that its economics are “cyclical”.

A recent broker note on this company argued that an 8x earnings multiple was a fair way to estimate the value of the business, versus the current share price being at 6.8x. I happen to think that it is a bargain, but this isn’t the point of the story. In the analyst’s mind uncertainty over the price of soyabeans next year seems to hold far more importance than 150 years of history. Judging the company as being worth only 8x earnings, suggests a very bleak outlook. That this analysis didn’t attempt to discuss the longer-term, tells me a lot.

I see a long-term focus as a key source of investment edge for us, but one that requires daily effort to maintain. The drumbeat in markets is focused on the short-term, and rushing to buy or sell investments on the back of it does, I believe, stimulate dopamine in the brain. Much has been written on the subject of behavioural finance, and our chimp brains bias towards activity is well documented. Warren Buffett summed this up well when he said that “the stock market is designed to transfer money from the active to the patient”.

The ugly twin of short-termism, is narratives. Our brains work best with stories, which is why much of what we read about markets takes this form. Pundits attempt to rationalise every up or down move in each financial instrument with a story as to why people were buying or selling. Narratives are what lends credibility to a focus on the short-term, as they make investors feel more confident about the certainty of the risks and opportunities they face.

Clearly some narratives will be accurate some of the time, but often they are pure conjectures. Our approach to investing is to be circumspect about accepting any explanation at face value, unless we can substantiate it. It helps to be able to hold multiple competing narratives[2] in your head at one time, but this is easier said than done, and is a source of discomfort. When you are less willing to accept a narrative, you are less inclined to knee-jerk reactions.

An area where we were actively investing last year was in UK mid-caps. Much ink has been spilt crafting narratives as to why they appear cheap, often rationalising it as a logical consequence of concerns about the British economy. Likewise, explanations as to why individual companies see their share prices fall, typically focus on the nuances of the outlook for their business.

We met the CEO of a FTSE 250 company which is priced around 7x next year’s earnings, suggesting major concerns about its longevity. It is an international business, being one of two dominant global players in their field. The CEO told us that many of their large shareholders were UK focused funds that had suffered large redemptions, which had caused them to be forced sellers of their holdings. Whilst this is a narrative, it is an alternative to the idea that investors are acting purely based on views of company fundamentals.

I mention this as I see the fall in valuation of many UK listed companies as an example of how a fixation on narratives by others is creating opportunity for us. Whilst the uncertainty of BREXIT was a legitimate reason for concern over domestically focused companies, it appears to have given way to a stampede of indiscriminate selling of UK listed assets. This is evident from the number of UK focused funds that have seen major redemptions.

We of course do not know when, if ever, the abandonment of the UK equity market will reverse, but the sale of Hotel Chocolat to Mars, provides an example of how counteracting forces can work.

Much like New Year’s resolutions, I think many investors know the right thing to do if they are to achieve improved financial health, but the hard part is to actually do it. I will be doing my best to stay away from dark chocolate this year, but I don’t suppose it will cause Mars to rescind their offer!  

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[1] If this is what you were looking for, I can highly recommend Anna Lembke’s book, “Dopamine Nation”.

[2] This is a concept recognised by psychologists and known as cognitive dissonance.

There has, of late, been a certain amount of punditry about “style rotation” within equity markets. Will last year’s outperformance of “value” over “growth” resume, or did the resetting of valuations set the stage for “growth” to romp home by a country mile?

This line of thinking is based on the idea that companies can be meaningfully categorised as offering either good value or growth prospects. I bridle at this, since “growth” and “value” are not mutually exclusive, but more than this, because classifying thousands of companies into one of two categories doesn’t convey as much meaning as the labels suggest. Despite these misgivings, it does at least provide a lens onto the stock market, at more than just an overall index level.

The index provider, MSCI, maintain style indices, that classify companies as either growth or value based on backwards looking quantitative measures. In the last decade, investors have been willing to pay increasingly high multiples of earnings to own the constituents of the growth index, as illustrated below. This was punctuated by the growth index seeing a large “multiple contraction” at the end of last year, which is what prompted talk of a “style rotation”.

It is not obvious that the constituents of the growth index were left looking cheap at the end of last year, and it would be hard to argue that there had been a “reset” in valuations. Far from the “rotation” being over, the chart begs the question if it ever really began! Nonetheless, the devotees of “buy the dip” appear to have been at work of late, as in valuation terms, the growth index has now regained much lost ground.

There are many ways in which this sort of broad brush analysis can deceive, and the growth index has increasingly become a proxy for a cohort of large companies popular with investors. To illustrate this, the MSCI growth index has a 37% weight in its ten largest constituents, all of which are US companies and most of which are “big-tech”. I will label these companies the “Growth 10”, albeit that due to both of Alphabet’s share classes appearing in the list there are only actually nine separate companies.

The graph below shows the average price earnings ratio of the constituents of the global S&P 1200 index, together with the range of their valuations (ignoring the “cheapest” and most “expensive” ten percents). The historic average valuation of the Growth 10 is overlayed in red. The graphic also  illustrates the available history for the Growth 10, determined both by their age and having delivered positive earnings such that a price earnings ratio is available to contribute to the average.

This analysis makes it clear that this small cohort of companies have seen their valuations rise to be far higher than the typical company, and higher than for much of their own history. Does it make sense that these companies should command their highest valuations, after a protracted period of profits growth, rather than before? May be trees do grow to the sky, after all.

I think that looking at a small cohort of popularly owned companies makes for a better lens on which to view the current dynamics of the equity market. It strips away the abstract notions of “growth” and “value”, replacing them with something more concrete. It suggests that those investors who are hoping that “growth” will deliver for them, may implicitly be betting that the very biggest companies can both outgrow the rest of the stock market and continue to demand elevated valuations. This may happen, but it is not a horse that I wish to back.

An alternative measure of “expensiveness” is to look at share prices relative to cashflows, rather than earnings. Viewed through this lens, the valuation of a typical company looks much more elevated versus history.

The two different stories that these metrics present, tells us that corporate profits have increased by more than cashflows. A cynic would suggest that this is because the bean counters have, for many companies, increasingly used the accounting rules to paint a flattering picture. This should give all investors pause for thought. More than this, those investors who are paying more than 25 times current cashflows to own a business, really must believe there are sunnier times ahead.

There are reasons to think that the prospects for economic growth will be challenged in the near term. High levels of government and corporate debt taken on when interest rates were much lower, corporate profit margins at very high levels, an anti-globalism political climate, and ageing populations, all make for heavy going. The rise in labour disputes tells us that many workers are unwilling to quietly watch inflation lower their standard of living, raising both the prospect of further inflation and a drag on profit margins. Against this backdrop the very largest companies will have to run hard to outpace the overall level of economic growth.

The constituents of the Growth 10 are all great companies. Self evidently. However, I am not backing these front-runners, as I believe great companies only make for great investments at the right price. This is not to say that they won’t be winners, but that I see better odds elsewhere.