Remaining focused on the long term

The resilience of growth

The woes of value-focused investors have continued at a clip during the coronavirus crisis. Recent figures suggest growth stocks in the US outperformed their value brethren by a staggering 28 per cent in the first half of the year. In Japan, the rest of Asia and Europe, the outperformance was in the mid to late teens. Despite the gulf in valuations and the last decade’s underperformance, value stocks have continued to disappoint. This is not how value investors thought it would be during a downturn, given how cheap such stocks are.

However, this continued underperformance should not have come as a surprise. Value stocks by their very nature tend to be higher risk, in that they are more cyclical and usually more highly indebted – these being two reasons why growth companies tend to be more highly rated. But with higher risk, value investors expect higher returns – except, that is, when there is an economic shock such as now.

With economies in freefall, value’s cyclicality has counted against it. This begs the question as to whether value is about to finally make a comeback after a decade of poor performance relative to growth. Given the extraordinary measures adopted by governments around the world to lift economies, if not now, then when?

Such a view may be tempting, yet caution is required. The economic recovery will be slow and uncertain in parts – many economies are not out of the woods yet. Meanwhile, broad categories of value stocks will continue to struggle – high-street retailers being one. Some companies will become ‘value traps’ to the unwary investor. Furthermore, the poor state of many balance sheets and the threat of further dividend cuts will also weigh heavily on sentiment.

Given the extent of underperformance in recent years, there will be periods when value performs better. And portfolio balance is an important consideration. However, unless economies roar back with a vengeance over a sustained period, investors should tread carefully. Certainly our nine real investment trust portfolios managed on the website www.johnbaronportfolios.co.uk – including the two covered in this column – will continue to focus on growth companies.

Apart from short-term concerns about value stocks, there is a further consideration for long-term investors which this column has touched on previously. History shows most stock market gains over time have been accounted for by just a handful of stocks, and these have tended to be growth stocks.

In 2017 Professor Bessembinder and his team of researchers highlighted the inconvenient truth that, when looking at the performance of over 26,000 US stocks from 1926, the stock market’s total gain was attributable to just the best-performing 4 per cent of stocks – with just 90 companies contributing half of all the wealth created. Furthermore, he pointed to the fact that just under 60 per cent of stocks returned less than one-month US Treasuries – the equivalent of cash – over their entire lifetime.

Last year he published further research looking at the performance of 62,000 stocks globally between 1990 and 2018. Again, 60 per cent of stocks failed to beat one-month Treasuries. However, perhaps the more revealing fact was that, outside the US, just 1 per cent of all equities accounted for all the market gains over that period. The conclusion is that investors were destined to underperform significantly unless this small number of stocks featured in portfolios in sufficient size. The implications are meaningful.

The immediate response by some will be to point to the advantages of passive investment via exchange traded funds (ETFs). The logic will be that the best way to guarantee these stocks are owned is to buy the index to own all the stocks. Yet given the costs (albeit small) and variable tracking errors involved, ETFs are destined to underperform their benchmarks – however marginally.

There are better options. Given there is nothing to suggest things will be different going forward, whatever the crisis including the present one, the challenge is to find and invest in those small number of extraordinary companies that will produce the bulk of future market returns – perhaps assisted by a greater emphasis on identifying the laggards.

Where remits permit, our nine portfolios focus on investment trusts that pursue a growth mandate and seek this small number of extraordinary companies, regardless of company size, even when short-term valuations encourage others to be cautious. Such an approach recognises that too often comfort is taken in numbers – they can provide assurance and certainty in an uncertain world.

Yet valuations can suggest companies are under or overvalued according to criteria that often fail to reflect potential and leadership. The investment industry needs to better identify the coming big markets and recognise the potential of early participants – even if valuations initially suggest caution. The dream needs to be better embraced. Equities can ‘only’ lose their entire value – they can multiply in value many times.

And identifying such companies early can be particularly rewarding, for it is the compounding of returns increasingly applied as time passes that produces the stellar results. Reducing exposure to these extraordinary companies too soon, during periods of volatility such as now, would have denied investors the majority of gains that were to come. Significant goals usually require long-term horizons.

This should lead an investor not only to adopting active investment in seeking these companies, but also to hold them over the long term. This requires patience and at times nerve. And contrary to the pessimists, and those who talk purely of valuations, the world is throwing up many such opportunities – even during times such as these.

Portfolio implications

There are a number of examples as to how this approach manifests itself when it comes to the construction of our nine real investment trust portfolios. The fact these extraordinary companies will need to be sought with little regard to geography or regions has already been recognised by some mainstream trusts. Examples held include Monks Investment Trust (MNKS) and Edinburgh Worldwide (EWI).

However, specific themes will continue to offer long-term opportunities. Chief among them are healthcare/biotechnology. The crisis has reinforced the attractions of the sector – at the same time the ‘political’ outlook seems to be improving in the US given the change in fortunes of those contending the Democratic candidacy. Examples include International Biotechnology Trust (IBT) and BB Healthcare Trust (BBH).

The attractions of technology have also been reinforced during this crisis – more e-commerce, more online communication for work, home and school, more food delivery, more online entertainment, have speeded up existing trends. Examples include Herald (HRI), Polar Capital Technology Trust (PCT) and Augmentum Fintech (AUGM)

As for the value of time, our portfolios have long retained a preference for smaller growth companies, even when valuations may exceed their universe. Again, examples held within our portfolios include BlackRock Throgmorton Trust (THRG), Montanaro UK Smaller Companies (MTU) and Standard Life UK Smaller Companies (SLS). Again, the quest will be global. Further examples include EWI and Montanaro European Smaller Companies (MTE).

This quest for extraordinary companies will also be increasingly pursued within the private equity space given it contains an ever-growing number of high-growth companies no longer needing to raise money on the stock market as early in their journey as before. Examples include Standard Life Private Equity Trust (SLPE) and Oryx International Growth (OIG).

But what of those investors seeking income and/or diversification? These extraordinary companies will rarely grant us income, certainly in the early phases, and will usually be considered ‘high risk’. A factor in investors’ favour is the flexibility investment trusts enjoy in supplementing dividends from capital. Payouts are usually linked to net asset value (NAV). Examples include companies already mentioned – IBT, MTU and BBH. However, this advantage alone will not be enough given the outlook for dividends.

Those seeking income and diversification will also need to embrace a more ‘thematic’ approach. Our nine portfolios were early supporters of both the sector’s relatively new entrants – infrastructure and renewable energy. Infrastructure assets in particular possess defensive characteristics, while providing sustainable and growing dividends that are underpinned by stable and predictable cash flows. Portfolio holdings include HICL Infrastructure Company (HICL) and GCP Infrastructure Investments (GCP).

Much the same can be said about renewable energy. Reducing pollution, plastic and our carbon footprint is essential to a better planet and our welfare. Challenges, including the predicted energy price decline, will be overcome by good managements. Portfolio holdings include The Renewables Infrastructure Group (TRIG) and JLEN Environmental Assets Group (JLEN). The website’s Green portfolio holds further examples including companies focused on energy storage and efficiency – a sub-sector we believe is undervalued.

A further example of a sector providing income and some diversification is that of commodities, which on a range of valuation metrics look attractive after a decade or so of lacklustre performance. The portfolios have recently been increasing exposure via companies such as BlackRock World Mining (BRWM) and CQS Natural Resources Growth & Income (CYN).

Finally, readers may like to know that the revised FT Guide to Investment Trusts has now been published – and thank you for your patience.