Commentary

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.

The collapse of Silicon Valley Bank has sent shockwaves through the financial markets, with many investors being blind-sided by the true state of their balance sheet that led to a run on the bank. There is no shortage of analysis on what happened at SVB, but the question I think investors now need to ask is what are the further implications of higher interest rates for the banking industry.

There are, broadly speaking, two ways that a bank can earn a profit with the money lent to it by depositors. The first, and obvious, is to lend directly to one of the bank’s customers, and the second is to purchase financial securities. These securities typically are also loans, but that have been conveniently packaged so as to be easily bought and sold within the financial markets. Whether they take the form of government bonds, corporate bonds, or bundle of mortgages, all are loans.

The risk that the world has woken up to, is that if a bank declares an intention to hold investment securities until they mature, it need not recognise the interim losses suffered from their fall in value. This is fine until the point that depositors ask for their money back. As we saw with SVB, if customers think that the bank doesn’t have the capacity to absorb these losses, then a stampede to exit will follow.

Loans when packaged into financial securities provide transparency, as their market prices give the consensus view of what they are worth. This, arguably, can deviate from their true intrinsic value, but it does reflect changes to interest rates and concerns on the risk of credit losses. A bank’s direct loans to customers, on the other hand, do not have this transparency. They will be impacted by higher rates, but it will take a long time to know exactly how.

The strategy that SVB followed was to own liquid securities, as opposed to making illiquid loans. Given the risk of their depositors leaving, it was not a crazy thing to do, but it is ironic that it then caused a “liquidity” crisis. The mistake that they made was not due to the medium of purchase being tradeable securities, but rather due to the underlying exposure to the risk of higher interest rates.  

Direct loans held by banks are also at risk from higher interest rates as, in the same way as if they were tradeable securities, the resale value of these loans will have declined. It is incorrect to think that a bank that owns lots of securities has assumed more interest rate risk, than a bank that has instead made lots of illiquid private loans. Yet, if recent share price falls are anything to go by, many investors are making this mistake.

Although there are as yet few signs of distress, higher interest rates will also increase the chances of borrowers not making their interest payments or being able to roll-over loans when they come due. I believe that the credit losses that follow from this will take time to become apparent, as the pressure of higher rates will have a lagged effect on many borrowers.

The three big risks that bank shareholders are exposed to are interest rate risk, credit risk and liquidity risk. I think that investors must think about all three of these risks if they are to avoid nasty surprises. The current narrative on SVB threatens not only to confuse interest rate risk for liquidity risk, but also ignoring the risk of credit losses that will follow from higher rates.

The world appears to be at something of a crossroads, with investors divided as to if last year was a temporary setback for markets, or if we have moved into a new paradigm. I do not know what the future holds but, after a decade of “free money” interest rate policies, believe investors face a lopsided outlook.  

What do I mean by lopsided? There are several ways in which our global economic system looks extreme relative to history, and I think it more likely that these reverse, than they continue. My views are based on a simple “trees don’t grow to the sky” logic, and in what follows I set out the three major sources of asymmetric risk that I see.

Debt

The high level of debt that has been built up in the last two decades is the first risk I see. It means that we have collectively all consumed more than we earnt, which generated extra demand for goods and services. I think it more likely that this trend reverses, than continues, which would result in reduced consumption. This would clearly be bad news for corporate profits and bad news for investors.

The chart below shows the total amount of debt in the US economy, expressed as a percentage of GDP, and split between government, individuals, and companies. The US is not alone in having a post-war record level of debt, with most mature economies having followed similar paths. This build-up reached a crunch point in 2008, since when the “can” was kicked down the road by governments increasing their borrowings to shore up their economies.

The increase in debt since the 2008 financial crisis was helped by the world’s major central banks increasing the supply of money – in layman’s terms “printing” it. This newly created money flowed to borrowers, via the workings of the banking system, and low interest rates kept the cost of this debt manageable. These low rates effectively meant that “free money” was given out, much of which was used to buy existing financial assets. Some of it flowed to new entrepreneurial endeavours, many of which perhaps would not be viable in the absence of free money. This became known as the “everything rally” since every investment imaginable appeared to only ever go up.

I think it fair to describe this as “unprecedented” – certainly nothing like this has happened within living memory. It seems more likely, to me, that we now see debt levels fall, rather than rise to ever more extreme levels. If this does happen, we will all be consuming less, as more money flows to repay debts rather than buy new stuff. It will also mean less competition to own assets which, with all else being equal, will make them cheaper. Finally, the least viable enterprises will not survive without free money, and so they will fail, which will make investors more fearful of losing their shirt.

Inflation

The risk of higher for longer inflation is the second threat I see. I think this because of the possibility that historic structural deflationary forces fall away, revealing the consequences of zero interest rate policies. This would be bad news for investors, both because higher costs squeeze profit margins and because it erodes the purchasing power of savings.

Central banks oversaw an increase in debt because their mandate was to manage inflation, and whilst it was low, they were single minded in trying to make it higher. They wanted to do this by getting us to all spend more. Their actions were based on the economic theory that they can control the “temperature” of the economy by altering the supply of money – the ideal being steady economic growth, a low level of unemployment, and a modest level of inflation.

This economic orthodoxy meant that the tidal wave like force of mobilising the Chinese population into the global workforce was somewhat ignored. Since the actions of central bankers appeared to create little risk of run-away inflation, creating new money started to look consequence free. This spawned the “Modern Monetary Theory”, that we can print money, grow governments debts, and there will be no nasty consequences.

There are many historical examples of how enthusiastically printing new money led to high inflation, such as the story of Scotsman John Law[1] and the French monarchy. I think it is too soon to know that the recent bout of inflation is under control, not least because I think that factors like wage negotiations or debt refinancing introduce significant lags in the way the economy responds to changed conditions. By contrast the commentary in financial markets seems to assume a near instantaneous transmission of central banks actions into every corner of the economy.

The deflationary impact of moving manufacturing to lower cost countries should be expected to diminish, as we run out of things to offshore. On top of this aging populations in mature economies will mean fewer workers, who in turn demand higher wages that add to inflationary pressures. We are already seeing signs of the baby boom generation prioritising a gentile retirement over working.

Cynically, high inflation will also offer governments an easy way out of their large debt burdens, by repaying lenders with “debased” currency. Allowing inflation to run above the much-heralded target of 2%, would be a form of hidden taxation that is more palatable than the alternative of direct tax hikes.

Profit Margins

The risk of falling profit margins is the third threat I see. I think this because they look high relative to history, and the higher they are the more difficult it is for them to further increase. This would be bad news for investors because falling corporate profits would both reduce dividends and probably also equity market valuations, lowering the returns from owning stocks.

The economic environment of recent history provided companies with low borrowing costs, low taxes, and opportunities to grow margins by offshoring. Against this backdrop corporate profit margins have been running at post-war highs.

The chart below shows the history of after-tax profit margins in the US. The long-term data in blue is the total corporate profits reported to US tax authorities as a percentage of GDP, whereas the more recent data in red is based on the margins of individual S&P 500 companies.

The chart demonstrates how corporate profit margins have been drifting higher for the last two decades and appear to have had a particular boost in the last couple of years. I have shown data for the US, but other regions have generally seen the same trend, albeit with less extreme increases.

Part of the rise in profit margins appears to have come from a shift towards asset owners receiving more of the spoils of capitalism than workers. This has partly played out via lower corporate taxes, meaning that Governments have been less able to keep pay in the burgeoning public sector in line with inflation. A shrinking workforce and high levels of employment may tip the balance of power back towards employees, with the current strikes in the UK making this seem like a very real prospect.

Current expectations among investors seem anchored on profit margins continuing at levels that look extreme versus history. There is no reason that this can’t happen, but it is clearly not a given.

Conclusion

We do not make investment decisions based on macro-economic forecasts, because I have no reason to think that we can do so successfully. We do, however, want to own a portfolio of companies that will be robust to whatever the future might hold, which means that we spend time thinking about how different economic threats would impact them. We want a “margin of safety” in our investment decisions, such that they are not made based on the assumptions that the favourable conditions of recent history are a given.

Before you start stuffing gold bars under your mattress, what I see are threats, not certainties. There are reasonable counterarguments for why the status quo might continue. For example, automation might offset the impact of an ageing workforce and support higher profit margins, or the rise of India could follow in the footsteps of China to the benefit of the world economy. Perhaps we can fund government spending by printing new money, with no ill effects?

My message is that there are several important ways in which the current economic environment looks extreme relative to history, and so I think investors face a lopsided future with a greater chance of a tough road ahead than a favourable one. Although I think the future is mostly unknowable, I believe it is possible to reason about what is more likely based on an understanding of history.

The “playbook” that has worked so well for investors in recent years will work less well in a world of higher interest rates, higher inflation, and lower profit margins. In the extreme it may not work at all. Optimistically a move towards this new paradigm might create opportunities for thoughtful investors. In a world where “everything” doesn’t always go up, I believe that focusing on the fundamental value of what you own offers the best chance of a favourable outcome.

What have we learnt from history? In the words of Warren Buffet:

“What we learn from history is that people don’t learn from history.”

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[1] https://en.wikipedia.org/wiki/John_Law_(economist)

In the last decade quality has become something of a buzz word in investing. 

I suspect that no right-minded investment manager would set out their stall based on saying they look for poor quality businesses. Hence just talking about quality, without giving more detail, risks being vacuous.

With a background in quantitative finance, I am familiar with how “quality”, for some investors, has become synonymous with a narrow mathematical definition. I think of this a bit like choosing a life-partner based on their MENSA test results (or perhaps some other critical statistic that gets your pulse racing). It might influence your decision, but it is unlikely to tell you everything that you need to know.

Within investing a company’s return on equity, or return on invested capital, have become the go-to measures of quality. Both express the size of company profits, relative to the financial resources required to generate them. By way of example, the MSCI Quality index goes a bit further, using a combination of return on equity, a company’s debt to equity ratio and the variability of its profits. Basing investment decisions on such metrics make sense for portfolios that hold many stocks, but in a more concentrated portfolio I believe that such narrow definitions are inadequate. As far as the life partner analogy goes, I’d advocate for a concentrated portfolio of one, where narrow definitions make no sense at all!

The specific risk with a narrow definition of quality becoming popularised, is that it influences the behaviour of company management and sets up a feedback loop. I see some risk that this has already happened with a measure like return on equity. A company management that takes on additional debt to repurchase their shares, will see their return on equity increase. This type of “mortgaging the family farm” will work during the good times, but risks creating problems during lean years, which runs counter to the idea of “quality”.

The philosophical message behind this is that financial markets are not part of the natural world but are social constructs. The ability for theories to feedback and influence behaviours is the reason why I do not believe there are immutable laws that govern markets.

When evaluating the quality of a business we look at quantitative measures, but also want to understand the context behind them. For some businesses certain accounting measures can be based on rather flaky logic. An example of this is that within bank accounting rules, a company can elect to hold fixed income investments for sale or until they mature. In the former case they must immediately recognise a loss in value from rising interest rates, whereas if they decide on the latter, they can ignore it. This means that a bank with a high return on equity could be of superior quality or might just be adept at gaming the accounting rules!

We place importance on qualitative measures of quality, many of which look at company management. We like companies where there is a clear alignment of interest between management and shareholders. This means that we like companies where executives and directors have large shareholdings. A particular favourite of mine is to look at the clarity and credibility of a CEO’s communication. Does what they say make sense or is it devoid of content and overladen with jargon?

The nature of a company’s business model also tells us a lot about its quality. We like companies that have strong competitive positions, where it is hard for competitors to “eat their lunch”. We are not alone in this regard, and the Buffett/Munger characterisation of looking for companies with “wide moats” has well and truly entered the investment management lexicon.

The financial markets have no shortage of intelligent and competitive individuals, and so it is to be expected that any company that is obviously “high quality” will command a premium. Our investment approach is to place equal importance on the price that we pay to the quality of what we are buying. Hence, we generally find ourselves in a trade-off between the quality of a company and how cheap its share price looks.

With a growing number of investors chasing the very “best” quality, such companies have commanded increasingly steep premiums. Our response to this has been to invest in cheaper companies where we convince ourselves that the underlying business is of “decent” quality. However, we have also bought some “not so cheap” businesses because we think they are “really good” quality. It is hard to characterise this with words alone, and so measures like the portfolio level price earnings ratios give a less ambiguous guide as to the situations we are investing in.

If I was to summarise my views on quality – it is that it is in the eye of the beholder. Furthermore, a good business only makes for a good investment at the right price.

For some time, we have held the view that the UK stock market contains some decent companies that look cheap relative to a reasonable view of their future. We have not been alone in this regard, with other value investors making similar observations. Following last month’s “mini budget” I have seen at least one commentator[1] label the UK stock market as “uninvestable”. Where does this leave us? Is the UK presenting an opportunity for investors or is it a basket case?

Countries can become uninvestable when the rule of law is called into question, especially if this creates a risk of investors having their money confiscated. This is not obviously where the UK finds itself, but it does face multiple challenges.

The impact of BREXIT has, so far, been negative for the UK economy. It has limited access to the European Single Market, it has reduced the pool of available labour and has contributed to a falling exchange rate. On top of this the country finds itself with a high level of debt, an aging population, high inflation and a low level of productivity growth. However, many of these challenges that the UK faces are common to other developed countries. Furthermore, many “British” businesses are global and not singularly exposed to the UK economy.

The simplistic argument for the UK stock market being cheap rests on valuation metrics, such as the price earnings ratio, of the FTSE 100 versus that of other major stock indices. However, calculating one single number in this way tells you little about the individual constituents’ valuations, and is dominated by the largest companies as the indices are weighted by market capitalisation. In what follows we share some of our in-house analysis into the UK and US stock markets, where we attempted to do something more insightful.

The study that follows is based on data for every single company in the FTSE 350 and S&P 500 stock indices for the last 30 years, based on their historic constituents. By looking at the FTSE 350 we included a larger number of companies than the FTSE 100, with many more domestically focused businesses.

The solid line in the chart below shows the average (median) price earnings ratio for the companies in each index. This differs from the quoted ratio for the stock index, since each company contributes equally irrespective of its size. The shaded areas show information on the “dispersion” of the individual company valuations. We calculated these by ignoring the cheapest 15% and most expensive 15% of companies and show the range of valuations for the remaining 70%.

What does the chart tell us?

Firstly, the average company valuation in both countries has looked remarkably similar for most of the last 30 years. It is only in the last few that the US companies look, on average, more expensive than their UK peers. This corresponds to them also looking exepnsive versus their own history. Secondly, we have seen a high level of dispertion in valuations in both countries (made more extreme by the companies that had large falls in earnings during the COVID pandemic). For the UK there are now many companies experiencing really low valuations, matched only in the last 30 years by the 2008 crisis.

The next chart uses the same methodology as above, but shows the companies’ return on equity, with the bands again ignoring the “best” and “worst” 15% based on this measure. This is the ratio of earnings (or profits) to the amount of shareholder capital. This can be interpreted as how effective a company generates profits from its available resources – but it is not without its failings. For one it fails to distinguish between genuine efficiency and companies that just “leveage up” by taking on more debt.

The British and American companies have looked remarkably similar from this persective, except for in the last few years where the US companies have pulled ahead and delivered profits at a higher rate than in recent history. This could be a measure of how American companies have improved versus their UK peers, or it could equally be explained by them using more debt to leverage up their balance sheets.

The next chart again uses the same methodology, and shows net debt to equity. This is the ratio of the companies’ debts, less any cash they hold, to the amount of shareholder capital employed in the business.

It is clear from this chart that the American companies do currently look more leveraged than their British peers. This is a trend that has played out since the 2008 credit crisis. We know that share buying backs have tended to simultaneously reduce shareholder capital, and increased debts, which could help explain this recent trend in the data.

The final chart shows the ratios of company operating cashflows to their reported earnings. This chart is included for the cynics! The nuances of accounting give company management a certain amount of flexibility to put their actions in a favourable light. By comparison cash is a form of measurement that is far less open to being “massaged”. The chart shows that the US companies, unlike their UK counterparts, having been on a declining trend, with earnings having grown more quickly than actual cash in their till registers. It also shows that there is much greater dispersion for the British companies – with many companies generating low levels relative to their stated earnings.

What are my takeaway messages?

• British companies look cheap relative to their US counterparts. So much so that there are many British companies that appear to have “distressed” valuations.
• Despite recent price falls, US companies look expensive versus their own history. They also look more profitable than at any point in the last 30 years, which if not sustained will leave them looking even more expensive.
• The high level of profitability in US companies appears to be, in part, because their balance sheets have been leveraged up by simultaneously buying back shares and increasing debts.
• The high profitability of US companies versus history, is not entirely matched by growth in the cash they are generating. A cynic might suggest that this is the result of flattering accounting.

I do not know what is in store for the UK economy, but I think it is alarmist to suggest that the entire stock market has become uninvestable. Some of the challenges that the UK faces are unique, but many are common to other developed countries. I believe that some of the depressed valuations that we are witnessing in the UK will provide favourable opportunities for thoughtful investors.

I think the “macro-economic” risks of owning British companies need to be set against the risks that lie elsewhere. Many global investors have an outsized exposure to US companies, with their higher valuations, increased leverage and profits that are high versus both history and cashflows. This comes at a time when the US dollar has rapidly appreciated, saving many foreign investors from having felt the full force of this year’s downturn in US markets.

The valuation risk that I see in the US is of a “double whammy” impact of price earnings ratios simultaneously declining whilst earnings also fall. Furthermore, foreign investors risk being exposed to a “triple whammy”, where the US dollar also falls back towards historic levels against other currencies. This may not happen, but if it does it would be painful for many investors.

We move forward in the belief that whilst we cannot know what the future will hold, the biggest risks in investing are often those not seen by the consensus of public opinion.

[1] https://www.bloomberg.com/news/articles/2022-10-06/-uninvestable-uk-market-lost-300-billion-in-truss-first-month?leadSource=uverify%20wall