BLACKROCK THROGMORTON TRUST PLC

Do low valuations equal real value?

‘Value vs growth’ has become a hot topic, tied to a debate on whether ‘value is cheap’ or ‘growth is expensive’. However, different people have very different views of what constitutes value vs growth, and on what metrics they decide cheap vs expensive. Dan Whitestone, Portfolio Manager, believes the debate needs to be reframed.

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Given my philosophy is to focus on emerging companies I’m often asked by clients about my view on ‘value vs growth’. And usually this is tied to a view on whether ‘value is cheap’ or ‘growth is expensive’. This discussion can be difficult to conclude on, not least because we find that different people have very different views of what constitutes value vs growth, and on what metrics they decide cheap vs expensive! Nevertheless, it is clearly an area that investors are interested in, and so I have set out my thoughts below.

Most statistical definitions of growth and value do show an outperformance of growth over value in recent years. When looking at valuation metrics these same baskets show that growth shares are currently more expensive than their average valuation over time, while value shares are currently less expensive than their average valuation over time. The combination of these observations leads some to conclude that a portfolio of growth shares will now enter a prolonged period of underperformance. We disagree with this thought process.

Defining value and growth

Firstly, I would simply observe that any individual portfolio cannot be compared to an average. While it is entirely likely that there will be rotations between growth and value (as we have already seen while managing this Trust), I do not agree that in these periods every portfolio with growth underperforms (as we have seen with this Trust). The major skill in stock picking is to avoid picking the average and instead to pick the differentiated. As a team, we place much emphasis on trying to understand all the characteristics of a company that can result in long-term compounding success. We think this approach has shown differentiated success and we would not pick shares just because they ticked some statistical growth criteria.

Secondly, I don’t expect a sustained regime change towards value shares. In this era of low inflation, low interest rates and low economic growth, the attraction of genuine secular growth is high and hard to come by. Many growth companies with strong balance sheets and cash conversion have been able to invest ahead of their peers in their people, products and tangible assets. I think this investment combined with the right opportunities will result in years of above market growth for these companies and we expect them to continue to outperform.

value and growth

The problem of Price to Earnings ratios (P/E)

Thirdly, this then leads to a question of valuation, and whether growth is just too expensive? Usually we are told a share is expensive because its P/E is high. The argument being its year 1 price to ‘adjusted earnings’ is higher than the average of the stock market. We think this is far too simplistic a thought process and it causes investors to miss the best investments. In contrast, we are not overly focused on the year 1 P/E ratio. It is a very short-term metric and it tells you very little about a company’s real prospects or its ability to deliver materially higher profits over the coming years. It also suffers another serious flaw, which is that most observers are using ‘adjusted earnings’.

On closer inspection many of these adjustments reveal a large disconnect between the earnings and the cash flow, i.e. adjusted earnings are simply not cash backed and therefore we don’t think they are a reliable yardstick for value. As an example, where the earnings of a company are genuine (i.e. not adjusted, and are cash backed), an optically ‘expensive’ company on 30x P/E can actually immediately generate a 3% Free Cash Flow yield. This is a number that we view as very favourable when compared to, say, a government bond yielding 2% or a struggling business that trades on 15x earnings but where only half of these profits arrive in cash (again a 3% Free Cash Flow yield but without the growth prospects). Therefore, while our long book does have a higher year 1 P/E ratio than average, this does not unduly concern us because we think that there is far more value behind our investments than that metric implies.

Value traps

We often find that shares that flag as cheap or value have, on closer inspection, poor cash conversion. Rather than buy these as good value, we work hard to avoid or to short companies with poor cash conversion. We think it is a reliable yardstick for a troubled company, and not a good yardstick for value. This is where our most productive shorts have been sourced.

Today there remain many companies that we think are masquerading as ‘cheap value’ just because they trade on a low price to ‘adjusted earnings’. But they have poor cash flows and in many cases these companies are then also over-distributing dividends and consequently their balance sheets are weak. This leaves them in a very disadvantaged position should their industry deteriorate, or a slowdown occur. We have already seen many high-profile dividend cuts in 2019 and we expect more in 2020. We’ve witnessed the implosion of equity value amidst ‘cheap’ UK contracting firms (low price to adjusted earnings, high dividends, weak cash flow, and overindebted). We have also seen the demise of Thomas Cook (low price to adjusted earnings, high dividend yield, and weak cash flow) that was unable to deal with mounting industry pressures.

Looking forward I can think of several other sectors which typically flag as ‘value’ and ‘cheap’ but which we intend to either avoid or short because of the fundamental problems they face. These are problems that are not captured by the P/E ratio. Therefore, we do not think these areas represent ‘good value’:

  • The banking sector regularly flags as ‘cheap’ and ‘value’. However, our view is that many of their profitable and high Return on Equity (ROE) business lines are being competed away in an era when consumer and small business technology is able to undermine the banks’ historic barriers of scale and brand. Banks are being left with the most capital intensive and most cyclical business (lending) at a time when the regulators prefer even more capital and promote competition. This is an unattractive mix for bank shareholders, and not a recipe for good value.

  • The telecom industry is another area that trades on optically cheap, and value, metrics. Yet this is an industry with large amounts of sunk capital that displays highly competitive and marginal cost pricing, and where the profitable back book of legacy customers is also under threat from internet-based telephony. For us this is an industry where the apparently ‘cheap’ price to adjusted earnings is desperately misleading.

  • One last observation is in the oil sector. Another sector of apparently cheap valuations given low P/E ratios and high dividend yields. Yet these profits and these dividends are based on historic investments made at a time before shale oil, and at a time when it was expected that the oil price had a ‘floor’, given strong demand growth and lack of alternative supply. Fast forward and the oil market has structurally changed. Shale oil represents a long-term supply threat that is able to quickly respond if the oil price rises, while growth in demand is now reduced given the ‘energy transition’ and slower industrial growth of the BRICs (Brazil, Russia, India and China). In our view the oil price now has a ‘ceiling’ and the effect of this should not be underestimated. Major oil companies no longer have attractive business models and a low P/E ratio is not going to help.

Overall, investors need to make sure they aren’t seduced by merely a low P/E, a high dividend yield, or a recently weak share price. Nor should they necessarily be put off by a rising share price or an apparently high P/E. In our view, all companies should be evaluated in the framework we outlined above, because the rewards for identifying well financed, self-funding, differentiated growth companies can be incredibly attractive, and can persist for a lot longer than people think. This approach continues to underpin our investment philosophy.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. Unless otherwise stated all data is sourced from BlackRock as at May 2020.