Let Compounding Unfold: Resist the Sirens' Song
Over the second half of 2016, a number of developed and commodity export markets rallied hard, largely driven by a positive view on the U.S. economy, the chances of higher interest rates, and OPEC-sponsored higher energy prices. As a result in the equity market, "Value" sharply outperformed "Quality Growth" (QG) as it usually does during cyclical runs. During cyclical market rallies, investors may be tempted to switch out of QG and into Value to avoid missing the opportunity cost of a cyclical leg up. We have strong views on this trade – and believe it is not compatible with the promise of QG.
We think of the QG promise to investors as returns delivered over the long term from a consistent bottom-up style driven by investing into the growth of earnings and value of solid, well run, and predictable businesses managed by unusually capable people. Market timing is not a key part of the QG investment process. Not only are long-term holdings only bought once, but valuation multiples are range-bound while earnings and dividends can grow for decades.
The perception of missed returns, or relative risk, is often exaggerated by the mismatch of terms between the investment horizon of several years against the period of observed performance – which is often three months, or on occasion even less.
When the observation period covers a sharp market upswing, the shriek of opportunity cost can be deafeningly loud. At times like this, such as the tough period Warren Buffett went through during the tech bubble, a manager who has promised a consistent style must resist the Sirens' song of short-term opportunity cost. In Greek mythology, the song of the dangerous half-bird, half-woman Sirens lured sailors, who could not resist their enchanting music, onto the rocks and away from their original promise of sailing safely to port. The Greeks had an interesting message.
Regarding the trade into Value – we think of Value as a style focused on investing into low valuations – which are often available specifically due to the lack of predictability in underlying earnings, or assets in need of better management – the antithesis of QG. The chart on page one outlines the performance of Value relative to Quality (red line) compared to the cyclical ISM (Institute for Supply Management) purchasing managers survey that covers the U.S. The relationship is relatively close; in other words, Value’s performance relative to Quality tends to rise and fall with the sentiment of the cycle – a top-down call.
Investing in Quality Growth
Our view is simple. As we look to generate absolute returns, if we are able to invest into relatively predictable and stable earnings and dividend growth, the value of the portfolio should grow consistently alongside. To do this, we need to get the profit forecasts right, and have the patience to hold for extended periods to let the compounding unfold. Key drivers of long-term potential we look for in our investments include:
1. Track record of stable earnings growth through a full economic cycle
2. Predictable business run by easily understood people
3. Opportunities to reinvest earnings at high rates of return
4. Sustainable for many years
5. Sensible price
Market timing is not a core long-term driver.
PE versus Earnings Growth
Calling a move in valuation multiples as a return driver, to us, is limited to shorter periods and involves reinvestment risk. PEs are generally range-bound, while EPS and dividends have the potential to sustain growth over many years. As an example, Essilor International, based in France, is the world's leading eyeglass lens manufacturer and a company we have held in a number of our portfolios for many years. Between January 1999 and March 2017, its PE ranged between 13.7x and 30.5x, yet its share price rose 5.8x. Performance was driven by a 5.4x increase in profit, which rose from U.S. $140 million in 1999 to U.S. $899 million in 2016. Its annualized total shareholder return (TSR) over the 18 years was 11.6% in U.S. dollar terms. For a QG investor to have benefited from this return, there was only one time of purchase; the rest was delivered by earnings growth, dividends, conviction, and time.
Switching out of QG Sells Predictability as well as Stability
When we think of predictability, we do not just refer to getting the direction of the earnings growth right. Rather, it’s a question of, if we miss the reported figure, how much are we likely to miss it by – a bit or a lot? The magnitude of the estimated miss can be the difference between disappointing and serious value destruction. The tables below compare the FactSet consensus EPS forecasts (red lines) in place two years ahead of a given year, compared to the figures that were actually reported (blue lines) for two Brazilian companies – Ambev (brewer, Consumer Staples) and Petrobras (Energy).
When an investor switches out of QG into Value, we feel what is given in exchange can be underappreciated. While the valuation multiple would likely go from high to low, growth predictability follows in the same direction. The point of Value investing is that these companies can trade below their intrinsic value due to their lack of predictability. As we see it, once switched, the analysis of steady compounding momentum changes to "will it turn?"
The companies may or may not represent a position in our portfolio. This is not a recommendation to purchase or sell, but merely an illustrated example. Past performance is not indicative of future results
The chart below illustrates quality, which continues to see steady if uneventful rises in earnings growth forecasts, while Value is "wait and see."
What’s The Trade-off?
Perhaps the greatest trade-off an investor takes making a long-term investment into QG is exposure to valuation swings early on. The investment style is driven by earnings that can grow for many years in a predictable way. As a result, a good deal of a QG valuation comes from a multiple based on larger earnings expected in the future. So, when QG valuations are rebased onto a present day EPS, they generally have PEs above the broader benchmarks – which are exposed to an array of profiles; including post-growth giants and volatile commodity businesses. Buying a company on a PE above the market comes with the risk of a contraction in valuation multiple over the early holding period before earnings growth has a chance to compensate. This risk is mitigated to a fair extent by:
- pricing discipline
- superior earnings growth
When calculating price targets, we look to balance out some valuation risk. In general, we value companies based on a five-year view. If a company is trading on a valuation that is relatively high in its historic range, without a specific justification, we will typically calculate a target price assuming a pullback in valuation multiple. This pricing discipline also leads us to exit a name when valuation becomes excessive.
A key indicator of companies able to achieve the growth we look for is a high and stable Return on Equity (ROE). A company able to reinvest its cash flow into high Return On Invested Capital(ROIC) projects on a consistent basis (as it has lots of opportunities) will generate higher EPS growth than a company with less profitable choices. Earnings growth helps offset PE contraction in the early stages of an investment, but over a long-term holding period, it’s the core return driver.
To illustrate how QG valuation risk is diluted over time, the table on the following page compares the impact of PE on a higher growth company or portfolio (constant 15% EPS growth) versus a lower growth company or portfolio (constant EPS 8% growth), and how this differs between longer (Example 1) and shorter (Example 2) investment periods. The returns are cumulative and given as a proportion of the original investment. Over two years, PE impact is notable, but over the longer term, quicker earnings growth more than compensates for a sharp pullback in PE.
As QG investors, we believe the style should be managed consistently through the cycle in order to allow managements to deliver the growth their franchises are capable of, while minimizing the risks of market timing within the investment process. We believe resisting the Sirens' song to switch will allow the effect of compounding value to unfold for those with long-term investment horizons.
Authored by: Sudhir Roc-Sennett, Senior Portfolio Adviser, Vontobel
Disclosures and Disclaimers
Past performance is not indicative of future results. Any companies described in this commentary may or may not currently represent a position in our client portfolios. Also, any sector and industry weights described in the commentary may or may not have changed since the writing of this commentary. The information and methodology described in this commentary should not be construed as a recommendation to purchase or sell securities.
Any projections, forecasts or estimates contained in this commentary are based on a variety of estimates and assumptions. There can be no assurance that the estimates or assumptions made will prove accurate, and actual results may differ materially. The inclusion of projections or forecasts should not be regarded as an indication that Vontobel considers the projections or forecasts to be reliable predictors of future events, and they should not be relied upon as such.
In the event a company described in this commentary is a position in client portfolios, the securities identified and described do not represent all of the securities purchased, sold or recommended. The reader should not assume that an investment in any securities identified was or will be profitable or that investment recommendations or investment decisions we make in the future will be profitable.
© 2017 Vontobel Asset Management, Inc. All Rights Reserved.
Past performance is not a guarantee of future results.
Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.