Quality Outperforms Growth Investing in Times of Uncertainty
While we are not qualified to assess the humanitarian impact of the virus, nor can we say how long the whole situation will last, we thank the medical and scientific community for their efforts in trying to solve the problem and caring for those impacted. We also acknowledge those leaders in the world who are providing rational, clear guidance to maintain the safety of the population.
As was the case during the GFC in 2008, investors quite correctly are concerned about the recent volatility in the public markets and the impact this has on the future value of their investments. Unlike the GFC, the current panic that is evident in the investment markets has been fuelled by the forecasts and predictions made in the media by various “experts” on the likely impact of the virus. It seems that it has been forgotten that on many occasions, the expert forecasts which caused the pandemonium turned out to be totally incorrect. The best known of these massive errors in judgement were Y2K and the Club of Rome oil predictions.
The Y2K Scare or “Millennium Bug” occurred at the turn of the 21st century when it was feared that computers would stop working on December 31, 1999 causing massive disruption to Banks, Insurance Companies, Hospitals, and Government Departments. The problem arose in the 1960s and 1970s, when engineers used only two-digit codes to represent the year to save on storage space which was very costly at the time. When the millennium rolled over, systems remained intact. However, the point is that many institutions spent billions of dollars and countless hours on the problem in an attempt to avert the risk which never materialised.
Another illustration of experts getting it totally wrong was a report for the Club of Rome, called “The Limits to Growth”, which was written by a team of researchers at MIT in 1972 and based on a computer simulation of exponential economic and population growth with a finite supply of resources. They attempted to model the interaction between earth systems and human systems and concluded that petroleum would run out after 31 years with world reserves depleted by 50 billion barrels by 1990. In fact, by 1990 unexploited reserves amounted to 900 billion barrels — not including the tar shales where a single deposit in Alberta contains more than 550 billion barrels. In times of crisis human ingenuity and resilience always comes to the fore.
Ensuring that one’s emotions are kept out of investment decisions is paramount and when the markets overreact to these predictions, what is certain is that Armageddon does not occur. The closest the world financial system came to total collapse was during the GFC when cool heads and steady hands averted a total disaster. During the SARS (also a Coronavirus) outbreak between February 2003 and July 2003 the ASX All Ordinaries only dropped 5.35% to 2,778.4 during February and by December 2003 was at 3,306.0 (+19.0%). During the GFC, September 2008 to June 2009 the All Ords moved from 5,209.2 to 3,937.8 (-24.4%) and by December 2009 it was back up to 4,882.7 (+24.0%).
The economics of a business
At ECP, our investment philosophy is that the economics of a business drives long-term investment returns. For us, finding high-quality businesses with strong balance sheets means we are confident to back management to manage presented issues. Markets are also notorious for over-reacting to temporary themes and having a long-term approach enables an investor to see turbulence as a normal part of the market. In turbulent times it is important to keep a clear focus on the fundamentals of the businesses when navigating the uncertainty presented, enabling one to capitalise on this market feature.
During February and March, high-quality companies were marked down along with the poor-quality companies in a complete reversal of the ebullience of the previous year with whole sectors being sold off indiscriminately. As we have discussed in presentations to AIA members throughout Australia, understanding the potential impacts of COVID-19 on each company and its ability to grow their economic footprint is of paramount importance. This now requires a significant amount of extra research and information gathering.
Holding good quality companies in times of volatility
Our own process focuses on investing in high-quality growth businesses, which means that the average price-earnings ratio of our companies through time is normally well above the market average price-earnings ratio. In times of uncertainty, higher PE companies tend to be sold down more heavily than lower-priced companies and investors should not be afraid of holding on to good quality companies in times of volatility. The recent stock market turmoil has resulted in debt and equity risk premiums moving to multi-decade highs and once equity markets stabilize, risk premiums will decline to more sustainable levels.
“Ensuring that one’s emotions are kept out of investment decisions is paramount”
In the bulletin we wrote to investors in March we said that we expected that the average price-earnings ratio of the stock market would expand and push stock prices higher (than their March lows). When this happens, portfolios with higher exposure to growth stocks are positioned to receive a boost from the growth in earnings and the re-establishment of the price-earnings premium that high-quality growth businesses typically enjoy. We don’t know how long the current situation will last or what shape the recovery will be, but we can be confident that with a three to five-year horizon great companies will continue to provide shareholder value and it is during these times that a world-class investment process comes to the fore.
Target quality companies with high IRRs
Our investment portfolio targets highquality, low capital-intensive growth companies that have a sustainable competitive advantage with the portfolio weighting determined by the expected return from the investment as determined by a risk-adjusted Internal rate of return (IRR). In our process, we calculate a five-year IRR for each investment in our portfolio. As a result of combining all the IRRs of the stock in the portfolio we can calculate an overall IRR or expected total return for the portfolio.
The current forecast IRR for the portfolio is currently sitting at around 13.4% having peaked at a high of 19.0% during the depths of the March sell-down. The last time our IRR was that elevated was in 2008, and the subsequent investment performance was strong in both absolute and relative terms over several years.
The investment horizon of investors whose portfolio comprises high-quality, low capital-intensive growth companies is longer than most investors, and we believe there is significant capital appreciation potential for these portfolios once risk premiums decline more in line with long term historical averages.
Closely monitor earnings
While our own forward portfolio PE fell and rose along with the market, we are still holding a premium to the overall market and investors in quality growth stocks should not be particularly concerned should their positions also. In the current environment earnings certainty of companies has to be questioned and vigilantly monitored. While we believe the high-quality nature of the companies in our own portfolio means that their earnings are considerably less uncertain than the broader market, if we make adjustments to the earnings in the current environment we would expect that the current market multiple of the broader market is likely to be closer to our portfolio multiple than what is currently stated. While there are always opportunities to be found by value-focussed investors, they must especially remain hyper-vigilant about earnings risk to positions in their portfolio through this period.
Once the market settles down, we believe that it will start differentiating between companies reliant on the economy for growth and those that have organic growth options. Given we are a growth investor, we believe that the best performing economic environment for growth investing is one where the economy is strengthening rather than weakening as it is at the moment. There is not much growth investors can do about this other than making sure that forecasts have accommodated the earnings downturn.
If the domestic and global economies should remain under pressure over the next 12 months, quality growth companies will be affected, but less so than the average company, due to the following reasons:
- When companies face reduced demand for their goods and services, this eventually becomes a liquidity issue as EBIT levels decline and, in some cases, turn negative triggering debt covenants. Our view is that portfolios, particularly those with a heightened exposure to growth stocks will be best protected where they have low debt levels. In the instance of our portfolio it has interest cover on the portfolio >20times, primarily as a result of our upfront interest cover requirement in companies.
- Such growth portfolios are protected to some extent from deflation. Quality companies possessing competitive advantages in our portfolio are in a better position than the average company to maintain pricing levels. In our portfolio these businesses are not capital intensive. They are able to better use their funding sources to trade through these tough times.
- Portfolios oriented towards businesses in the growth phase of their life cycle are not solely reliant on the economy for growth. In times where consumption shrinks these businesses have shown an ability to expand their market share. The combination of high returns on invested capital and organic growth models, these businesses do not rely on cheap debt or equity to take advantage of growth opportunities.
Looking ahead with confidence
We would imagine that members of the Australian Investors Association apply good processes and stock analysis when constructing their portfolios. While no two portfolios are the same, some familiar names from our portfolio may also appear in theirs. Looking forward we can say that our portfolio return profile is as attractive as any other time since the GFC and this has really piqued our interest - even provided a little a cautious excitement amongst the investment team, particularly should the recovery be quicker than perhaps expected. Investors who have done the research to find quality companies to introduce to their portfolio should have confidence that notwithstanding market volatility, over a medium to long term those companies should deliver strong performance for your portfolio.
Dr Manny Pohl, MD of ECP Asset Management
ECP is the investment manager of the ASX-listed LIC Flagship Investments Limited. The website contains more articles and content like this and you can subscribe for regular article and video updates https://www.flagshipinvestments.com.au/