Valuations no longer seem to matter

The flight to the shares of high-quality companies

I totally understand the logic of investing in the shares of good companies. Good companies provide goods or services that customers want but that other companies find difficult to copy. This, in turn, allows the companies concerned to produce steady, relatively predictable and growing profits. These companies have scarcity value and it is perfectly in order that these companies should sell for reasonably high valuations, in my opinion.

The tremendous success of fund managers such as Terry Smith who follow this quality investing approach have added more fuel to the bull market in these shares. He has demonstrated a very simple and powerful way of consistently beating the returns of stock markets – buy good companies and stay away from bad ones. 

So why don’t all investors copy this approach? I think they should, and my book How to pick Quality Shares goes into the process of showing you how to do this. 

To me, it is quite obvious that this strategy is continuing to gain traction. Since the financial crisis over a decade ago, investors have clamoured to own the shares of outstanding companies and have pushed up their valuations – a lot. 

I have a lot of sympathy with the view that over the long run the market can undervalue quality companies, but only for investors who paid the right entry price. Not overpaying is a core part of the quality investing strategy, but you might be forgiven for not thinking so in the current market.

It seems that investors are placing a bigger and bigger emphasis on the quality factor of a company and less and less about the value factor. I think, in the case of many companies, valuation doesn’t seem to matter any more. For some investors, the view seems to be: just buy quality shares, don’t worry about the price you pay and you will beat the market. 

The more people that subscribe to this point of view, the more self-fulfilling it seems to become – until it doesn’t. 

If you are a fund manager following the quality approach and riding its wave of popularity then you have to keep talking your own book. You cannot take the view that quality shares are overvalued and seek safety in cash. You have to keep owning them and when money keeps pouring into your fund you have to keep buying them. As a private investor, you are not stuck in this straightjacket.

What is the right valuation for high-quality companies?

This is almost the same as asking how long is a piece of string? There are lots of different answers depending on who you ask. A sensible approach to valuation takes into account the ability to grow, but also builds in a buffer against overpaying – the often mentioned ‘margin of safety’. 

Warren Buffett has a very simple approach to valuing high-quality businesses. He works out what he calls its owner earnings (its real profits adjusted for the cost of staying in business) and divides that number by the yield on long-term government bonds. There is no adjusting upwards the interest rate to reflect the increased riskiness of shares over government bonds. Mr Buffett’s view is that the predictability of profits and cash flows of high-quality companies means that they are very low risk and are in effect bond proxies. This characteristic, and the ability to keep on growing steadily, means that the treasury yield is the right interest rate to use.

So where does this approach leave us in terms of a ballpark valuation?

Well, as I write, 10-year government bonds yield 1.18 per cent in the UK and 2.5 per cent in the US. If we take the reciprocal of these (divide the number one by them) this gives an earnings or cash flow multiple of 85 times in the UK and 40 times in the US – most stocks are therefore cheap on this basis. 

Low interest rates underpin the argument of the bulls of quality shares. Where else can you invest your money and get a reasonable return on it? It is a very powerful and convincing argument.

Yet, as most of us know, interest rates on government bonds are operating in a false and manipulated market. They have been held down by the creation of billions of pounds in the UK and trillions of dollars in the US by their respective central banks, which was used to buy government bonds to increase their price and push down their yields. 

In more normal times, the yield on government bonds is more than the rate of inflation. Investors used to be given something to compensate them for the fact that inflation would gradually reduce the buying power of their bond coupons, which remained fixed throughout the term of the bonds.

This so-called inflation premium up until 10 years ago used to average around 2-3 per cent. Applying that to today’s bond market where inflation is around 2 per cent would imply ‘normal’ bond yields of 4-5 per cent. Turning that to an earnings and cash flow multiple under the Buffett approach would give a range between 20 and 25 times.

Current valuations of quality shares

Now, let’s look at the valuations currently being attached to high-quality companies both in the UK and US. I am not going to get into a debate about whether to value a company on the basis of its profits (earnings per share, EPS) or free cash flows. For the basis of simplicity, and the view that high-quality companies are generally good at turning their profits into free cash flows, I am going to use EPS and price/earnings (PE) ratios as a proxy for owner earnings and valuation.

In table one is a selection of what I consider to be high-quality UK companies. They are very profitable as measured by their return on capital employed (ROCE) and profit margins. The valuation is measured on a rolling one-year forecast PE ratio basis, which makes all valuations comparable. Finally, there is the increase in the share prices year to date.

UK quality shares

Source: SharePad

There are a few companies that can be bought for less than 20 times rolling forecast EPS, but not many. The other thing to note is that the expected earnings growth relative to the valuation is often quite modest.

Of course, those profit forecasts could be too low. But investors are being asked to pay what many would consider quite high – and in some cases very high – valuations. I think Halma (HLMA) is an excellent business but is 8.8 per cent forecast profit growth really worth 32 times earnings? Is Spirax-Sarco Engineering (SPX) worth over 30 times earnings for 7 per cent growth? At the moment, the answer seems to be yes.

US Quality Shares

Source: SharePad

Over in America – where there are many more examples of quality businesses than in the UK – the picture is a little different. The valuations are high, but the expected growth rate of profits is also higher – perhaps too high.

Are those forecasts realistic? The risk is that they might not be. But they could be.

Can the good times last?

What investors seem to be betting on both in the UK and US is that paying these high valuations still stacks up because the companies concerned are so special that they can still compound many years of future profit growth into more valuable businesses than they are today. After all, this is what has happened in the past.

Yet what happens when things go wrong? Last week, 3M (US:0QNY), a good business that is very exposed to the goings on in the world economy, revised down its profit guidance for 2019 by 11 per cent. Its shares have subsequently fallen by just over 13 per cent. The valuation has only derated slightly, but the message is clear: earnings disappointments get punished. Yet 3M is one of the more lowly rated of the US quality shares. What would happen if a more highly rated business issued a similar or worse outlook?

We are 10 years into an economic expansion and a bull market that has gone with it. However, many shares are priced for a continued rosy outlook. Very few companies can keep increasing profits year in, year out.

I think there are good grounds for thinking that quality companies are perceived as such because they have proved that they have very resilient profits and cash flows in a recession. But that doesn’t mean that the share prices of them will keep on going up. What has been most startling about this very strong performance is that it has come in what are big/very big companies – where it is difficult, if not impossible for investors to get an information edge.

The rally has been driven in large part by continued low interest rates. These don’t look as though they are going up any time soon but that doesn’t mean that what determines a company’s interest rate – its profits – cannot stop growing or even fall. If this happens, then quality investors look increasingly exposed to losses.

The difference between owning businesses outright and businesses on the stock market

In the short run, owning a slice of a business on the stock exchange can be a very different experience compared with owning a business outright. Taking the view of a business owner, rather than a number on a computer screen will always be the best way to invest.

On the stock exchange you can make and lose a lot of money due to changes in sentiment and the changes in share prices these bring. For the owner of a business outright, their return is the profits the business makes as a percentage of the amount they have paid for or invested in the business.

You can work this out by looking at the earnings yield of a company (its EPS divided by its current share price) and look at how that changes as earnings change. I think Bioventix (BVXP) is a wonderful business, but its owners are only getting a return of 2.8 per cent on the market value of equity. How many years of growth is it going to take to get to an even modest return of 5 per cent?

At the other end of the value scale, Unilever (ULVR) and InterContinental Hotels (IHG) are offering returns that look more palatable. 

UK quality shares earnings yields on cost

Source: SharePad/Investors Chronicle

In the US, earnings yields even with strong rates of expected growth are hardly giving great returns to business owners. If you haven’t got the message by now, I think the shares of high-quality businesses look very expensive and in many cases overvalued.

In many ways there seems to be a level of complacency towards this that is very reminiscent of the attitude towards technology shares in the late 1990s and towards shares in general in 2006-07. This has arguably been compounded by the view that there is no alternative place for your money despite the risks that are involved.

US quality shares earnings yield on cost

Source:SharePad/Investors Chronicle

So what should investors do?

This is a difficult question to answer. Calling market tops is a futile exercise. However, identifying investment risk most certainly is not. High valuations mean high expectations of future profits growth. If these expectations are not met then markets tend to be very unforgiving. This is the big risk that investors in high-quality shares are taking now in my opinion.

History tells is that euphoria towards markets in general – or sections of it – can continue for a very long time but they do end, we just don’t know when. I’ve no doubt that my thoughts will attract many naysayers and that’s fine. However, those looking to manage their money in a prudent way or who are close to meeting their investment goal might want to take a little bit of time to consider the valuation risks they might be exposed to.

Should investors switch into value stocks?

I don’t think so. Sacrificing business quality may increase your overall risk even though you are reducing your valuation risk. The best course of action may be to keep the business quality criteria high but be a little bit more selective on the price that you pay. Not all quality shares look wildly overpriced as the earnings yield tables will show.

As a private investor you have one big advantage over the professionals. You don’t have to invest if you can’t find the right blend of quality and value to meet your risk appetite.