Fundsmith: ‘Quality will out’

In the article below, published by Citywire.co.za, AA-rated veteran fund manager Terry Smith weighs in on the growth versus value debate. See the video comments from Terry Smith here.

As the US equity market has surged after the coronavirus crash, more and more attention has been placed on the valuations of the big growth stocks driving the recovery. According to Bloomberg, Amazon is now trading on a price-to-earnings (PE) multiple of 134 times, Netflix is on a PE of 83, and Apple is on a PE of 40.

‘There is a big debate raging to some degree through the investment universe about whether the quality or growth stocks of the sort that the FAANGs represent, and that we have in our portfolio to a degree, are overvalued and coming to a bubble,’ said Citywire AA-rated Terry Smith, the founder of Fundsmith and manager of the Fundsmith Equity fund. He was speaking during the Nedgroup Investments Multi-Manager Insights webinar this week.

The corollary to this concern around the valuation of growth stocks is that value stocks are incredibly beaten down. By some measures, the dislocation between growth and value is as wide as it has ever been. For some, that portends a significant mean reversion.

Understanding value

However, Smith pointed out that it is important to bear in mind what Benjamin Graham advocated as value investing: buying businesses that are valued below their intrinsic value. In the current environment, that is not as simple as spotting a low earnings or book value multiple.

‘That’s quite important,’ said Smith. ‘We talk about some banks trading below book value, for example, but if they are making a return below their cost of capital, they should be.’

Just being ‘lowly rated’ does not, in his view, automatically translate to value.

The value of quality

Fundsmith’s approach has instead been to invest in quality companies with high returns on invested capital, strong margins, good cash conversion, and defensive business. Smith noted that as far back as 2012 there were strong views being voiced that these sorts of stocks were expensive, and due a reversion to the mean.

‘If you had followed that advice you would have impoverished yourself,’ he said. ‘That’s not to say there won’t come such a day. The problem is that in this current bifurcation it’s easy to get scared by the valuation of quality stocks.’

He however pointed out that it is important to appreciate that a high PE multiples do not necessarily lead to poor future outcomes.

Lessons from history

Fundsmith conducted an exercise looking at 25 quality stocks that delivered compound annual growth of 7.0% from 1973 to 2019. Over this same period, the MSCI World Index produced an annualised return of 6.2%.

L’Oreal, the most expensive of these stocks at the start of this period, was trading on a PE of 281. Colgate was on a PE of 156, and Brown-Forman, the company that owns Jack Daniels, was on a PE of 147. Yet all of these counters out-performed the index over the next 46 years.

‘Provided you have the patience, these quality stocks do tend to produce the sort of performance over long periods of time that makes their valuation fade into insignificance,’ said Smith.

Lessons from recent history

In a similar exercise, Fundsmith looked at a basket of five value stocks that were trading on relatively low PEs at the start of 2015, and five quality stocks trading on relatively high PEs.

Value basket Quality basket
Stock Trailing PE Stock Trailing PE
Exxon Mobil 12 Adobe 136
General Electric 16 Amazon -593
HSBC 15 Facebook 71
Marks & Spencer 15 Netflix 554
Vodafone 1 PayPal 88

Source: Fundsmith

For an investor concerned with valuations, these two baskets would have presented a stark choice five and a half years ago. Based on their historic earnings, it would have seemed pretty clear where the greater opportunity lay.

‘The problem is that the earnings in the first group have disappeared – literally in three cases,’ said Smith. ‘That is versus some very large increases in earnings in the high growth stocks – in the hundreds and thousands of percent.’

What played out for these two groups of stocks has been so significant that ‘growth became value, but value didn’t’.

‘That slump in earnings for the value stocks means that if you looked at them up when we did this at end of August, they have actually become very expensive,’ said Smith. ‘The earnings have fallen faster than the share price.

‘Whereas, if you looked back at what you were paying on the growth stocks, your forward PE – which is the thing you had to make a decision about although you didn’t have the clarity of the past – was actually very low.’

The five value stocks in this example are down -45% on aggregate since the start of 2015. The five growth stocks, in contrast, are up around 800% on aggregate.

Long-term

‘Having said all of that, and although I don’t particularly like to generalise, I am kind of heading towards the conclusion that the thing that may make a difference at some point is if we get a return of inflation,’ said Smith.

That is because inflation has a differential effect – having more of a negative impact on long-horizon assets, such as quality stocks.

‘These companies will be adversely affected, and I have no doubt that at some point it will occur,’ said Smith. ‘Then value stocks may have their day, and even year, in the sun. But, over the long term, quality out-performs value.’

Looking at 34 years of data for the MSCI quality index, Smith pointed out that there has never been a 10-year period in which this index did not out-perform the parent MSCI index.

‘If you are a long-term investor,’ said Smith, ‘quality will out.’