Growth at the Right Price (GARP) has been one of my guiding investment principles ever since I began managing money in the 1980s. By itself, buying value may not be enough, while investing in galloping growth often involves overpaying wildly. I believe the key to success is to buy strong, growing businesses without paying daft valuation multiples. And I also think you can apply this approach to whole markets, as well as to individual shares.
To see how buying into hot growth stocks can backfire, look no further than ASOS the other week. Its share price plunged by one-fifth after the online retailer revealed that its sales had grown at ‘only’ 26 per cent, rather than the 32.5 per cent that analysts were eagerly expecting. Sure, it is still expanding healthily, but its punchy valuation left it vulnerable to even the smallest of disappointments.
ASOS let-down
Contrast that with WH Smith, whose share price has doubled in recent years, despite achieving virtually no sales growth. Against a backdrop of low expectations and a valuation multiple to match, the company has worked hard to squeeze ever more profit out of its revenues. As such, even modest growth fed through into steadily improved earnings and a big boost to the share price.
Smiths shines
Can this be applied to markets? I firmly believe that it can. I despair of fund managers who say they are going to buy or sell a particular country’s market because of national economic growth, the domestic orientation of its companies, or its shale gas reserves. What you are actually investing in is listed shares and what matters at bottom is how much they grow and what you pay for them.
The easiest way to assess this is to compare the price/earnings (PE) multiple with the forecast earnings growth over the next few years. When investing through an index mutual fund or exchange-traded find (ETF), a private investor can freely use online tools such as Morningstar to work out the PE ratio compared to forecast growth for a particular market. I’m not saying this should be your sole methodology, but it is a very valuable one that can sniff out over-valued hype a mile off.
Our approach has helped to keep our clients out of the highly-rated, high-growth Nasdaq of late, but also out of humbly-rated, but low-growth Russia prior to its recent collapse. Earnings forecasts for a whole market are made up from many different analysts’ forecasts for many different companies, so they are much less prone to the large error of individual stock forecasts and tend to be more stable. They are a much more informative tool, yet normally ignored by so-called experts.
So, what's cheap and what's dear right now? It is interesting to see that some of the emerging-market (EM) indices combine low valuations with attractive prospective growth. In particular, I would highlight EM small cap indexes, which tend to be much better diversified by size and geography than emerging-market large-cap indices.
Although we have avoided Russia completely in our portfolios, it now stands out following its recent falls. Within Europe, Italy looks better value than other individual markets even after gains so far in 2014.
Another standout right now is real estate. Every manager will tell you that you 'need' to have some property as part of your asset allocation. However, the long-term returns of both direct commercial property funds in the UK and straight property shares has been dismal. They do have periods in the sun now and again, and I believe we have just had one. Discounts to asset values have been virtually erased after the sharp gains of the past 12 months, while underlying growth of profits from rental income remains workaday.
I would also warn about some new ‘smart beta’ indices, which seem to fall into the trap of buying inherently low-growth stocks on demanding valuations. I must admit I have never quite understood the logic of buying a basket of stocks because they have not changed much in price on a daily basis, a concept often known as ‘minimum volatility.’ Call me old-fashioned, but I think their share prices will be determined by how much they grow and the price demanded for this growth, which has no correlation to whether their share price changed yesterday!
I’m just as wary about the spate of new funds investing in ‘high-quality’ stocks that have consistently grown their earnings or dividends or both. Pay too much for such quality and you will probably find the price simply stays the same as the companies ‘grow’ into their demanding valuations.
Applying this to the main markets, shows that Japan and Emerging markets look interesting and that the US, European and UK markets are broadly similar on this measure:
The bottom line is to ignore fashions and focus upon fundamentals. Compare the price you are being asked to pay with the likely growth. There could be a special reason for the abnormally low or high valuation, but most of the time it is down to emotion trumping logic. Eventually, logic and therefore fundamentals will inevitably prevail.
Alan Miller is founder and chief investment Officer of SCM Private, an investment management company.
