As financial markets watch the tensions between Russia and NATO over Ukraine, fixate on the number of interest rate hikes the US and UK central banks will impose this year (en route to 2% Fed Funds and Base Rates) and the announcements of companies’ latest quarterly results, it’s worth bearing mind that investing/saving is a longer-term phenomenon as depicted by this graphic seen last week on LinkedIn.
Growth vs Value – what does that mean?
There are many shades of Growth
Previously, we have referred to segmenting equities by the 3Gs
Or words to that effect.
The frequent referencing of the ‘growth’ to ‘value’ rotation requires a bit more definition of what we have often said are inappropriate labels.
Essentially, the rotation is about identifying different levels of growth. Below, we aim to shed some light on the growth choices before investors. Beforehand, it is worth revisiting the two bullet points from January 2022’s market and portfolio update as a starting point:
- As valuation metric, a price to earnings (PE) ratio or free cash flow yield is in isolation, a meaningless number. An investment outcome, good or bad, is determined by the valuation of a company relative to the outcome the business achieves. A high PE stock can be a rewarding investment if the company that sits behind it outperforms the expectations embedded in that rating. Equally, low PE stocks can be a poor investment if the business fundamentals behind it are deteriorating.
- The valuation of a company is a function of the future profits, and therefore cash, it generates and the discount rate (the cost of debt and equity prorated to match the funding structure of the company) attached to it. Although both have an influence on valuation, typically the discount rate is less important for the most successful companies as they produce profits higher and longer than expected.
SpecTech or SpacGrowth aka Cashburners
These are effectively companies that have come to market on a promise of future profits based on a great idea or ground-breaking technology or something similar. These companies benefit from extremely low interest rates (real and nominal) as the pot of gold is the future value of these companies. Many of these businesses came to the market on high valuations and ascended to even higher valuations leaving them vulnerable to a change in investor sentiment and/or a tightening of monetary policy while they continue to be in the loss-making phase of their development.
Sceptics and short-sellers need to be aware that when companies start to make profits, these companies can be viewed differently as sentiment changes towards the underlying business model. Tesla (still a marmite stock) was a good example, but valuations need to be watched to make sure they are not too stretched. A recent example might be Snap, a company which surprised analysts by posting its first ever profit in the first week of February for its Q4 2021 reporting period. Snap’s share price had almost halved in the tech sell-off over the past month. It’s emergence into profitability proved to be significant. Whether or not its increase in users, and therefore appeal to advertisers, is a long-term business model or theme that’s worth buying into, is another matter.
For those some distance away from profits, the bubble may well have burst.
Large-Cap Repeatable Growth
Often a large company with a leadership position and importantly, some pricing power. A recent example of this kind of growth business was Amazon who demonstrated the strength of their business with estimate-beating earnings announced in the first week of February 2022 for Q4 2021. AWS, the cloud computing business continues to deliver and Amazon Prime will be more expensive in future in the US because Amazon can raise prices. Despite the strength of Amazon’s businesses, the stock price got caught up in the ‘growth’ sell-off started by the first growth category above before, unsurprisingly, the stock bounced after the earnings announcement.
As the following graph sourced from Nasdaq shows, Amazon’s share price initially suffered from its growth stock label before its results prompted a reversal of fortunes.
The marketplace believes Netflix to be all about subscription numbers and competition from the Disney+ and Apple TV streaming services. Of course, it’s also about content and Netflix has some of the best content which should ensure it not only keeps its subscribers but also can charge them a bit more – which Netflix is doing.
Populated by businesses without pricing power and low barriers to entry. Two noteworthy examples that fared badly after their quarterly results were recently announced, are Meta (fka Facebook) and Paypal. Meta looks like a declining business, maybe the metaverse will be its saviour – time will tell.
Similar to large-cap repeatable growth but across all sizes of companies not just large-cap. The key is the ability to generate profits and be price-makers not price-takers and therefore maintain margins.
What value is really. Profitable businesses on attractive valuations. There are more of these around after the contagion from the sell-off in expensive growth at any price stocks into anything with a growth label attached to it.
Traps encourage the buying of challenged businesses in challenged industries. Price is what you pay, value is what you get. A cheap price or P/E isn’t necessarily good value, especially in a challenged industry with leverage, labour intensive (sensitive to higher wages), thin margins and being disrupted by unencumbered challengers e.g. High street banks vs Starling, Monzo & Aldermore. Compare UK net interest margin levels with those in Asia if you want to see why UK banks are unattractive investments.
The T. Bailey Funds only meaningful exposure to any of the companies mentioned above is to Amazon and Starling.
Value investors have emerged from a long hibernation squinting into the winter sunshine.
Investing is a long-term phenomenon; momentum and volatility are short-term distractions. Yet, short-termism is in vogue and the focus of many investors. The question should be: what will the oil price be in five years’ time, not the next five weeks and whether you should buy into oil companies which are not long-term businesses we want to own – directly or indirectly.
Our underlying funds typically exhibit higher P/Es than the index of the market they operate in. There is good reason for this. Investing is a long-term approach, but the media gets caught up in short-term moves. In truth, TBAM is not likely to buy into challenged businesses or try to trade in and out of short-term swings of volatility.
We are likely to invest in long-term themes that remain in demand and populated by companies that have a history of earnings delivery, have pricing power, leadership positions or challenge/disrupt existing businesses or industries. As fellow holders, we recognise there are uncomfortable periods when trends go against our way of investing. They may last for a few months but ultimately, we believe our methodology will persevere as it has done on previous occasions.
We have not got involved in market oscillations in the first half of February, maintaining cash levels during this period of uncertainty. The Dynamic Fund took part in a fund raise for one its real estate investment trust (REIT) holdings.
We greatly appreciate your support in these turbulent investment times. We are conscious of not bombarding you with emails but are here to inform and respond to any questions you may have.