You can also read this column on the FT website by following this link.
There is no bigger issue in the fund management circles that I frequent than the question of whether it still makes sense to hold the big global franchise stocks that have served investors so well over the past few years. In a world of artificially low interest rates, driven by the hair-raisingly experimental unconventional monetary policies now being pursued by the world’s main central banks, global businesses with strong free cash flow, balance sheets, an established competitive advantage and a consistent dividend track record have become the darlings of all fugitives from the return-free QE-squashed world of government bonds.
There is no doubt that the likes of Diageo, Unilever, Nestle and Johnson & Johnson, to name just some of the top performers in the consumer segment of the market, have become very richly valued on conventional analytical measures. According to Edinburgh Partners, quoted in a recent Independent Investor report, relative to the world index for example global consumer staple stocks have recently been trading at their highest p/e ratio for more than 40 years.
Analysis by Style Research shows that the quintile of stocks with the lowest earnings volatility is also trading at a record 10% premium to the rest of the world index. The reasons for these unusual valuations, measured against contemporary norms, are not hard to find. Defensive growth stocks press all the buttons that anxious or reluctant equity investors think they need – predictable, low risk and (not least) securely income-generating. They are the nearest thing to a safe haven that is left in a world where most sovereign debt no longer fulfils that function and searching for yield competes uneasily with a widely perceived need to take few risks.
In the words of Terry Smith, founder of Fundsmith, whose global equity funds by choice only invest in this kind of stock, Nestle has become the nearest thing to a risk-free asset we have in the brave new post-crisis world. One telling indication of how far this effect has gone is that the number of stocks that are passing screening tests for cash generative, low volatility stocks with growth potential is declining sharply.
This month for example Soc Gen’s quality income screen, which looks for stocks with decent yields and robust balance sheets, amongst a number of different criteria, threw up less than half the total it was producing last summer. That index has produced a compound annualised return of around 12% since 2000, a period during which the equity market, taken in aggregate, has returned less than a quarter of that. According to Stockopedia, a UK version of the same screening method has handsomely outperformed the market by more than 20 per cent over the last year.
With ratings now so high, is it time to start recognising that all good things must come to an end? Nestle now trades on a historic p/e of 19.9, according to Bloomberg, and a forward multiple of 18.6. Dividend payments as a percentage of market capitalisation (excluding the impact of share repurchase) has fallen to a little over 3%. The story is similar across the global quality universe. Sandy Nairn, the CEO of Edinburgh Partners, says: “Investors are equating lack of volatility with safety and a lower risk of loss”. They are being blinded to the risk of poor future performance.
Other value investors appear to agree. Warren Buffett‘s Berkshire Hathaway is reported to have unloaded shares in Johnson & Johnson, Kraft, Proctor & Gamble, Intel and IBM in recent weeks. Sebastian Lyon, manager of the Trojan Fund, has trimmed his holding in Diageo, whose CEO last week himself cashed in £16m of his substantial personal holding after exercising a raft of share options. Whatever else these stocks are, they are not cheap on any conventional value criterion.
But is that the point? These are not normal times. Terry Smith, whose Global Equity Fund now has a p/e of 19 and free cash flow yield (his preferred measure) of 5.5%, tells me he is not minded to sell. Capital impairment, not market volatility, is his primary concern and on that basis a solid growth business yielding 2.5% will still be preferable to the certain wealth black hole that is a government bond which yields even less in nominal terms. Both will suffer if and when interest rates rise, but Nestle will still be the better long term bet.
The really scary thing is that valuations of defensive growth stocks could still go the other way – up, rather than down. Markets driven by momentum can produce extraordinarily durable valuation anomalies. It happened in 1998-2000 (with tech stocks) and again in 2007 (with banks). In the Nifty Fifty era of the 1960s, the last time megacap growth stocks went to exceptionally high valuations, their average p/e ratio reached 42 times at its peak. The average dividend yield fell to barely 1.1%.
Yet even those lofty valuations could be justified in many cases for the growth that they subsequently delivered, claimed Prof Jeremy Siegel of WhartonUniversity in a famous 1990s study (although the survivors’ 12% per annum compound returns would not look quite so good if extended through the 2000s). His examples included Johnson& Johnson, Philip Morris and Coca Cola, the very same names that are now at the centre of the current debate. If today’s Nifty Fifty were to trade on similar peak multiples as their predecessors in the 1960s, they would now be twice as highly rated as they are already. Will that – could that – happen again? It seems improbable, but traditional value investors may have to endure another long night of anguished underperformance before we know for certain. In today’s QE-driven world, there are simply no reliable valuation anchors to keep the markets grounded any more.
Jonathan Davis 