You can buy the best business in the world and still pay too much for it. This is according to Steve Romick, Fund Manager of the Nedgroup Investments Global Flexible Fund (FPA), who presented at the annual Nedgroup Investments Global Summit.

Romick says many companies have been “given a pass” in terms of what will happen in the future- a sense of expectation around their impending success without any particular guarantee of that success. In turn, he says, investors have assigned value to those companies that assumes that success – and this, coupled with a sense of optimism around the post-Covid recovery and record-low interest rates, have inflated asset prices to the point that some company stocks have rallied to levels that are extremely hard to justify.

“Everything has a price. One needs to understand exactly what that is in order to justify the owning, purchasing or selling of a position in a portfolio,” he says.

Opportunistic value investors

FPA are opportunistic value investors. “This means we buy both out of favour, more traditional value stocks, and higher growing stocks at reasonable prices. So, you can pay too much for a fantastic company, and you can also have an asset of a lower quality, that the world is ignoring, priced at a level where it may be hard to lose money and potential exists to make a lot of money,” he says.

Price is what you pay, value is what you get – Warren Buffet

The stock market sets prices for companies and it is up to FPA to decide if the price that is offered is good or bad, and whether it offers downside protection i.e. a reasonable margin of safety.

“Because prices fluctuate more than the underlying value of businesses, FPA are afforded periodic opportunities to buy stocks. It is noteworthy that companies in the Global Flexible portfolio have displayed double digit earnings growth for the 3 years to June 2021, versus the market which has shown declining earnings over the same period,” Romick points out.

Furthermore, according to consensus estimates, Romick says, companies in the Nedgroup Investments Global Flexible portfolio are expected to grow at 32% over the next 3yrs. This high number includes expected recovery from the harm caused to businesses by Covid. This is compared to various market indices where consensus growth estimates are in the low to mid 20’s.

“We actually suspect growth for the Fund and market indices will likely fall short of analyst estimates, but even if that happens a less expensive portfolio (such as the Nedgroup Investments Global Flexible Fund) should perform reasonably well,” says Romick.

Meanwhile, value stocks have strongly outperformed the market since March, and especially since the first vaccine announcement. “This makes traditional value stocks look far less interesting from a risk-reward perspective and we have therefore selectively trimmed some positions and upgraded the quality of the equity book,” says Romick.

Opportunity is at the intersection of price and value 

“Simply put, we try to buy the best company we can at the best price we can. The most expensive part of the market as measured by Price:Sales is the most expensive it has ever been, even more so than during the internet bubble,” says Romick.

 
Deciles 1-9, while still more expensive than historically, still trade at big discounts to the most expensive 10th decile – this offers mostly relative opportunity, but some absolute opportunity as well.

“A lot has to go right for companies in 10th decile to earn equity-like rates of return. Some may do well, but the odds overall are stacked against us. As a consequence, we don’t own any of them,” says Romick.

To illustrate why we say the odds are stacked against us, we can look at history going back as far as 1979. This shows that success is not guaranteed just because you have a growing business.

Of the top 1 000 companies as measured by market cap which had more than 10% earnings growth in a given year (between 1979 and 2020); 353 of these still had greater than 10% earnings growth a year later; while only 74 met this criteria 3 years later; and only 21 still fit the description 5 years later.

This illustrates why for these companies we would generally assume that the expected rate of return will be less than what the market thinks it might be. That’s why we spend more time in other deciles to find real value.