More Of The Same
What a difference four months makes. Our update at the beginning of September (What You See Is What You Get) focused on the unsung value creation inherent in the Evenlode portfolio. Whilst companies in the fund had been quietly growing per share value over the first two thirds of the year, share prices spent most of the period moving between first gear and reverse. Since September, little has changed in terms of the progression of these company’s fundamentals. The pendulum of market sentiment, however, has swung sharply in a positive direction, and market prices are now humming along in fifth gear. Ben Bernanke’s speech at the Jackson Hole convention at the end of August acted as the touch paper for an epic end of year rally. His suggestion that the Fed will continue to make it an explicit policy to backstop asset markets brushed worries of European sovereign defaults, double-dip recessions and Asian overheating to the margins.
Looking ahead to 2011 we are tempted to repeat, verbatim, what we wrote a year ago:
“There is still a broadly supportive backdrop for equities but 2010 [now 2011] could be a bumpy ride. Governments and central banks are walking a tightrope - take stimulus away too early and risk deflation and a slide back into recession. Take it away too late and risk inflation and rising long-term rates as investors lose trust in government finances.”
Our general viewpoint has changed little since writing the above. In particular, both of the contrasting risks we noted back then (deflation/recession and inflation/rising interest rates) remain as real and credible as they were twelve months ago. It is probably for the best that they are - the ‘muddle-through’ economic conditions that have persisted for the last eighteen months are very satisfactory from an investment perspective. A slide back into recession would not be taken well by the investment community. Equally, a sharp acceleration in economic growth would likely be accompanied by rapidly rising oil prices, rising risk-free interest rates and ultimately the re-emergence of wage inflation, none of which would spell good news for the average corporation.
We think that, in the medium to long-term, investors should worry more about inflation than deflation. The possibility of future inflation is far more palatable than the hard fact of short-term debt-deleveraging – particularly if you are a central banker or politician, stuck within a short-term incentive structure. Having said that though, and to paraphrase Mark Twain, ‘prediction is very difficult, especially when it’s about the future’. We are more interested in insulating the Evenlode portfolio from, rather than predicting, the broad range of macro-economic possibilities that lie ahead. Our focus is therefore a simple one – steering the fund to stocks that offer high prospective returns (i.e. high free cash flows and return-on-equity) generated with limited risk (i.e. from durable, well capitalised businesses) at any particular time. Whatever the weather, durable growth businesses on attractive valuations should be capable of providing good absolute returns to investors.
As we look ahead to 2011, the section of the market throwing up the most interest on this basis is high quality blue chips. As we noted in last month’s investment view, smaller companies generally performed very well in 2010, and our holdings in this area were no exception. As prospective returns have fallen we have begun reducing our exposure, and our commitment of fresh capital has been increasingly toward blue chips (predominately in the consumer staples, media, healthcare and technology sectors).
Many quality blue chips have been laggards over the last year and investors are fed up with them. This feeling of disenchantment has not been helped by a lack of hoped-for resilience in the market corrections of 2010 (healthcare stocks being an obvious example). However, their fundamental performance has on aggregate been good, and their prospective returns remain high. It is comforting to be paid such a handsome return for holding some of the best businesses in the market – a group that offer a combination of both capital-light growth and protection from economic shocks.
Last May we used a simple analysis to highlight the premium return currently available on quality shares. Use of the term ‘quality’ in investment is sometimes criticised as vague and imprecise, or just a bit of a platitude. After all, how many investors would say ‘I’m focusing on low-quality stocks at the moment’? To us, however, quality has a precise definition; it refers to those stocks that have demonstrated…
1) …the highest returns on equity…
2) …with the most consistency over time…
3) …without needing to rely on leverage to generate these returns.
Ranking the UK market by these three factors, and dividing it into quintiles, the table below shows this anomaly to be alive and well:
Average earnings yield by quality quintile*:
Top quality quintile = 9.6%
Second quality quintile = 7.0%
Third quality quintile = 7.0%
Fourth quality quintile = 7.5%
Bottom quality quintile = 6.0%
Whilst the above is a simplistic, headline analysis, it’s an interesting quantitative snapshot of where the opportunity set lies for today’s investor. Effectively, the best businesses in today’s market are also the cheapest. History and common sense would suggest that they should be the most expensive. Also note that these earnings yields are prospective yields, so they already embody analysts' bullish forecasts on low quality cyclicals for 2011. Relative to their high quality peers, a very substantial improvement in the fundamentals of low quality stocks would be needed to justify current prices.
Whilst we admit to repeating ourselves on this subject, we also believe that good things come to those with patience, discipline, and an attention span that lasts longer than the next economic data release.
Hugh Yarrow
January 2011
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 7th December 2011 and does not constitute investment advice.
Median EBIT/EV yields. Universe is UK market ex financials and utilities.
