How can investors grow their wealth at a time when global economic growth is stagnating? That was the question up for discussion last week at the Investors Chronicle’s private investor seminar, ‘Unlocking the potential of growth investing’. And the answers we heard suggest that growth is far from dead – although achieving it requires both investment discipline and conviction, as well as an understanding that growth can be uncovered in unlikely places.
Growth is good
It would not be unfair to suggest that equity growth has garnered a reputation as an underachieving and expensive investment strategy. Certainly the often-cited work of economists Marsh, Dimson and Staunton suggests that the long-term returns on equities are influenced more by the compounding effect of reinvested dividends than the strength of capital growth alone. And, as IC associate editor Algy Hall noted in his presentation at the event, the conventional wisdom – derived from a comparison of the MSCI World Growth and Value indices since the data began in 1975 – suggests that value investing has comfortably beaten growth over the long term.
Growth vs Value performance
|To present||MSCI World Growth||MSCI World Value||Growth vs Value|
Yet, as Algy pointed out, the comparison is skewed by the timing – if we begin a comparison of the data a decade later, in 1986, then in fact growth has beaten value over every noteworthy period, including the past year (see table below). The reason for the misleading comparison since the beginning of the indexed period, he explained, is that prior to 1975 growth shares had enjoyed a very significant period of excess returns from growth strategies, as investors in the so-called Nifty 50 drove their prices up in the mistaken belief that it was a one-way bet. This investor behaviour was not dissimilar to the mindset that afflicted investors in the bull market in growth shares that preceded the dot-com crash that marked the start of the new millennium.
Both periods of ‘irrational exuberance’ were followed by sharp sell-offs as it became clear that profit growth did not support the high valuations equities had reached. Those sharp falls have flattered, by comparison, the performance of value strategies.
In fact, says Algy, periods of low economic growth make it harder for value investing to outperform growth, essentially the result of the relative quality of their earnings. Genuine growth stocks can shrug off the drag of a weak economy, because their earnings growth is powered by their own fundamental characteristics. Value stocks, often cheap because they have previously suffered earnings disappointment, do not have the fundamental basis upon which to improve earnings, and are therefore far more reliant on an economic tailwind.
Yet, explained Algy, bullishness towards growth shares and the general asset price inflation caused by dovish monetary policy has seen their valuations begin to soar once again, with a forecast PE up from a 10-year median average of 15.7 to the current 18.2. This, he argues, makes them more vulnerable to a slump than more conservatively priced value shares if sentiment sours or profit growth fails to meet expectations – although, he noted, growth’s valuation premium over value does not look excessive either way.
Because of this, investors should be focused on looking for ‘growth at a reasonable price’ (Garp), Algy argues. And to do this, he says that the price-to-earnings-growth (PEG) ratio is one of the most important weapons in an investor’s arsenal. The PEG can be calculated by dividing a share’s trailing PE ratio by its rate of earnings growth over the next three years. However, calculating the rate of earnings growth points us towards an important shortcoming to consider: that the PEG is dependent on the accuracy of growth forecasts, and those forecasts are so often wrong.
More than valuation
But, according to Catharine Flood of Scottish Mortgage Investment Trust (SMT), valuation should not be the only consideration for genuine growth investors. In fact, said Catharine, growth at reasonable prices should give way to what she semi-flippantly described as “growth at an unreasonable price”, where the best companies with the most growth potential are concerned. To emphasise the point, she quoted Berkshire Hathaway’s Charlie Munger: “A great business at a fair price is superior to a fair business at a great price.”
Catharine argued that the investment case for genuine growth companies was often too complex to be reduced to a single figure like a PE ratio. Take, for example, the largest holding in the trust, Amazon, which has always looked expensive on valuation metrics but has also been the biggest contributor to the trust’s five-year performance, thanks to the willingness of its founder, Jeff Bezos, to relentlessly invest cash flows in pursuit of even bigger long-term payoffs – what Catharine described as “a willingness to be creatively destructive”.
Similarly, while Standard Life’s Harry Nimmo is “valuation aware”, his stock-screening-led approach focuses far more on indicators of quality and financial strength – what he described as “the Matrix”, and which has proved effective through multiple investment cycles. So while many of Standard Life Investments UK Smaller Companies Trust (SLS)’s holdings – like Ted Baker or Fevertree Drinks – do indeed look expensive on a forecast PE basis, the growth they have generated is likely to continue.
What’s more, many of the trust’s holdings, like Amazon in miniature, are industry disruptors in their own way. And more importantly they are much better able to deliver growth – and also grow or sustain dividend payment – than many large industry incumbents, “prisoners of their history” whose cash generation is often under threat from their inability to shift their business model to new paradigms. This in turn affects their ability to maintain the dividends that have previously been the lifeblood of many investors – Harry noted the swathes of dividend cuts from FTSE 100 companies over the past two years, from supermarkets to utilities, and the fallaway in dividend cover of the FTSE 100 when compared with the FTSE 250. And over 20 years, total returns from smaller FTSE 250 companies have significantly outperformed the FTSE 100, helped along in no small part by dividends. In this respect, he argues, small companies are often less risky than large ones, because they too embrace – and are best positioned to benefit from – the disruption that’s also apparent in the much larger blue-sky investments favoured by Scottish Mortgage.
Indeed, while in respect of their target investments the two trusts could not be more different – UK small companies versus global giants – there are nevertheless many striking similarities in their approaches beyond the shared appetite for disruption. Both look closely at the individuals running their investee companies, and favour the continued management involvement of founders with significant financial and reputational skin in the game. And, even if Harry prefers to take a more bottom-up approach to stock selection, both favour strong thematic approaches – whether the untrammelled growth of e-commerce that has lifted Amazon or Alibaba, or, for example the premiumisation of food and drink that’s boosted Fevertree and Cranswick.
The trusted choice
These lessons should be invaluable to self-directed stockpickers. But tapping into growth via the trusts themselves is also a viable option for those who are unable to build diversified growth portfolios themselves.
Standard Life Investments UK Smaller Companies Trust contains 55 equity holdings, while Scottish Mortgage Investment Trust contains 80 – quantities that spread risk effectively but that individual investors may find hard to manage. And, in the case of Scottish Mortgage, holdings are usually on international markets and sometimes in unquoted investments that private investors may find difficult to access directly.
This pre-packaged approach to growth is a technique put to very effective use in the portfolios of our investment trust columnist John Baron, our final speaker of the evening. Regular readers of his columns will know only too well some of the key strategies John employs when selecting investments to help his growth portfolio outperform, themes that also mirror the approaches of SLS and Scottish Mortgage: smaller companies, thematic exposure to technology, biotechnology and private equity, as well as specific geographic exposure to the continuing Far Eastern growth story – Go East! as he puts it.
Yet John’s approach to generating portfolio growth highlights an important point that individuals seeking to grow their wealth should consider – that you do not necessarily need to stick to traditional definitions of growth assets to do so.
Bonds, for example, have played a very important role in John’s portfolio, as the backdrop of quantitative easing has driven up their value. The same is true of income-producing equities, increasingly targeted as an alternative to contracting bond yields – and let us not forget that those equities capable of supporting regular distributions also often have the ingredients for capital growth in place too, as SLS’s portfolio demonstrates.
And of course, the compounding effect of reinvesting that income is the real key to delivering substantial outperformance over time.