Commentary

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

As a nation the British like to borrow. In the thirty years prior to 2008, companies and households steadily took on more debt, punctuated by a “credit crisis” that called into question the ability for it to be repaid. Since then, and despite “austerity” measures, the baton passed to the Government. The result is that total borrowing in the UK, excluding financial institutions, has been on a steady rise for 40 years – moving from around one times GDP to almost three.

Alongside this increase in debt, interest rates have fallen, such that we have not actually had to spend more to service the enlarged debt. This, of course, is because the Bank of England has justified low interest rates as a response to low levels of price inflation.

That brings us to the present day. The recent jump in inflation means it has reached levels not seen since the 1970s, leading many commentators to draw a comparison to these times. Stories of strike activity and wage disputes, together with an energy price shock, further justify the comparison. Where the comparison falls short, is with respect to both the amount of debt in the economy and the level of interest rates. This is made clear in the chart below:

With total debt in the UK of three times GDP, a 1% increase in interest rates would require an additional 3% of GDP to be spent on interest payments. Through this multiplier effect, a quite plausible scenario of a 3% rate rise would require an additional 9% of GDP to be spent servicing debts. Clearly it would need a high level of underlying growth to both cover such an additional cost and see overall GDP growth. This is a very different situation to the 1970s.

Although this narrative creates an uncomfortable picture for the UK, it is almost identical to the US, where debt accumulation has followed a strikingly similar path. It follows that the build-up of debt in the UK economy does not, on its own, justify this year’s large fall in the value of the Pound against the US Dollar.  Clearly the risk that this debt impacts future economic growth is much the same in both countries.

We do not make investment decisions based on macro-economic forecasts and so what is my interest in this data? It is because we want to own a portfolio that is robust to what the future could reasonably hold, and these insights makes me cautious about extrapolating recent experience. We want to allow for the risk that the investing climate moves into a new and unfamiliar paradigm. Could this be the end of a debt “super-cycle”, the eponymous Minsky[1] moment?

Based on the shadow that debt now casts over the world’s major economies, low interest rates and increased amounts of leverage have not only benefited corporate profit margins but have also supported high asset prices. With all else being equal, higher interest rates will put this into reverse. This comes at a time when profit margins are already under pressure from high commodity prices, rising wage pressure and a less friendly global stage for doing business.

Specific to the UK, this year’s circa 15% fall in the Pound against the US Dollar has shielded many investors from the full force of asset price falls abroad. This comes on the heels of a prolonged period of strong performance for US equity markets. I am under no illusions that the UK faces challenges ahead, but I believe that it is not alone in this regard. There is a risk that as attention moves to problems elsewhere in the World, a reversal of the exchange rate and premium on US equity markets will create a headwind for many investors.

Despite these concerns I see reasons for optimism, as I believe the current environment is creating opportunities for discerning investors. Based on valuations, among other observations, I believe that there is a lot of herd behaviour in markets – investors moving their capital based more on emotions than analytical insights. We see examples of companies with valuations close to 40-year lows, where we believe the challenges they face have had an exaggerated impact on prices, as investors “run scared” at the slightest sign of bad news.

Clearly, I do not know what the next chapter of this story will look like. However, as students of market history, I know that knowledge of the past can only make whatever happens next seem less surprising!

---

[1] https://en.wikipedia.org/wiki/Minsky_moment

After a sharp rally in July that saw many previous stock market darlings recover some of their earlier falls, investors could be tempted to ‘think it’s all over’.  The 10-year chart below shows that the price earnings multiple of the MSCI World Index had fallen to levels last seen in the depths of the COVID pandemic and suggests that many recent buyers might have been motivated to grab a bargain.

There is a joke amongst statisticians that the man who lays with his head in an oven and feet in a freezer is, on average, comfortable. The message is that statistics can often be misleading. In the chart above, summarising all 1,600 companies that are in the index with a single statistic really is not telling the whole story. MSCI produce ‘growth’ and ‘value’ indices that crudely divide these companies into one of the two classifications and despite being far from perfect, these indices tell a very different story to the chart above.

The chart of the price earnings ratio of the MSCI World Growth Index below shows that despite a significant fall, the index still stands at a 28x multiple., which hardly makes it look to be in bargain territory.

Conversely, the price earnings ratio of the MSCI World Value Index, below, shows that it has fallen to its lowest level in the last decade.

The first chart suggested that many excessive valuations, apparent at the start of the year, had moved to more sensible levels.  However, when going only slightly deeper the data suggests that many companies in the MSCI World Growth Index could still be exposed to significant valuation risk. In comparison the MSCI World Value Index looks cheap on this measure. 

Our approach to investment analysis runs much deeper than looking at simple valuation metrics, but despite the short comings of this analysis it hints at the opportunities we are finding. We believe that not all the companies that have seen large valuation falls are yesterday’s ‘has-beens’ and through patient analysis we believe there are now many more quality businesses available to buy at attractive prices.

*Note: The dotted lines in each of the charts shows the latest value.

The question that many investors appear to be asking themselves right now is if we will see a recession – prompted by concerns that higher interest rates will undermine economic growth.

I do not know if there will be a recession in the world’s major economies this year or next, and our approach to investing is not based on trying to second guess this. What I do know is that there have always been periods of economic contraction in history. I think of it like waiting at a bus stop with no timetable – you may have absolutely no idea when the next bus will arrive, but you shouldn’t be surprised when one does appear.

For the companies that we follow I take a casual interest in broker research and, of late, I have seen many “target prices” revised down by amounts as large as 25% or more. One way, or another, these revisions are blamed on the fear of a recession causing lower earnings. I struggle to see the justification for such large changes, as surely any reasonable judgement of valuation would look far enough into the future to anticipate one or two bad years.

Moving on from bus-stop analogies, the noise of financial punditry reminds me of the sirens from Greek mythology, who lured sailors to their death with their alluring songs. The mythical Greek hero Odysseus avoided this fate by strapping himself to the mast of his boat and plugging his sailors’ ears with beeswax. I wouldn’t advocate going this far to ignore the financial news, but I do think that it requires determination not to get drawn into the short-term narrative of markets. We certainly want to be alert to changes in our environment, but do not believe that success will come from trying to make timing calls about a recession.

What were we thinking?

So far this year the performance of the fund has been helped by two distinct views that I have previously written about. I thought it was worth recapping them.

In my first quarter 2021 investor letter I wrote about our growing concern that the amount of money that central banks and governments were injecting into their economies would cause higher inflation.

While we do not make investment decisions based on macro-economic forecasts, we do want to own a portfolio that will be robust to perceived threats. In this case we made efforts to consider the impact of higher levels of inflation on our holdings, and those companies engaged in the primary production of energy, food and gold have “held up” as we had hoped, as the threat became a reality.

In my year end 2020 letter I set out the case for financial markets being in a bubble, having shared our analysis in my Q3 2020 letter on the evidence for much of the outperformance of “growth” over “value” being driven by price earnings multiple expansion.

There have been two distinct types of “growth” company that investors have been pursuing. The first are companies, with no profits, where the value placed on them is based on a belief about the distant future. The second being companies that are highly profitable, but where investors have paid ever higher premiums to own them. In broad terms both types of growth company have seen price falls this year, with the former being impacted more than the latter.  Our valuation driven approach has helped us avoid the worst of this excess.

Before I start to sound too clever, we know full well that our abilities as investors can only reasonably be judged based on our long-term track record. Nonetheless it is gratifying to feel that our analytical investment views have been shown to have merit.

Matthew Beddall, CEO and Fund Manager