Negative headlines abound about slowing global growth. Whether because of Brexit, negative interest rates, deflation, European banks’ non-performing loans, soaring Chinese debt, terrorism, Turkish instability or any of a multitude of other negative drivers, you could be forgiven for believing that companies should find it almost impossible to grow sales and earnings in such an environment.
In fact markets have indeed behaved as if this is the case. Traditionally defensive sectors such as food and beverages, pharmaceuticals and defence have performed extremely strongly. Businesses that generate strong cash flows have been rewarded with record high valuations despite their relatively lacklustre sales and earnings growth. Investors have been more than willing to pay up for perceived safety, extending the premium of quality over value to the highest levels the market has ever seen.
For example the consumer staples sector in the US has rerated from 13x prospective earnings five years ago to 21x today. This is despite sluggish low single digit annual sales and earnings growth over this period, and growth rates that are almost exactly in line with the wider market. Whilst investors perceive that the staples sector deserves this premium because of superior operational performance over this period, this is not actually the case.
Of course the PE ratio is not everything when it comes to valuations, and sure enough there is an argument to be made that whilst bond yields fall ever further into negative territory, then the future cash flows of these businesses become more valuable. However, sky high valuations, based on extraordinarily low interest rates poses significant downside risks to these equities if economic growth and inflation ever show signs of life again. This is a situation that may well be unfolding in the US, as tight labour markets continue to push wage growth higher, coupled with decent growth in both the industrial and services sector, which was most recently seen through strong retail sales in June and an accelerating manufacturing PMI number. US bond markets have now unwound most of their post-Brexit rally and are again pricing in a good chance of an interest rate hike this year.
Despite the better economic news, and there being pockets of growth that have persisted intact throughout global markets, overwhelmingly negative macro views have led to growth being de-rated. Growth and value are now low relative to their own historic levels, but also particularly relative to those defensive sectors where the gap has never been bigger.
As far as value goes, financials are a good case in point. The US recapitalised their banking system aggressively in 2009 (take note Italy and Germany), enabling loan growth to resume fairly quickly after the recession which helped to boost growth. Whilst low interest rates have held down returns, they have still recovered to acceptable levels. With the prospect of higher rates and a growing economy, the future earnings outlook for US financials appears fairly attractive. However valuations remain at very depressed and even distressed levels, with many financials trading below their book value.
In a market that has rerated significantly, this kind of value within an improving operating environment looks like an attractive opportunity. Equally, growth businesses that happen to operate in sectors that are currently not well liked have been significantly de-rated. Take Icon, a provider of medical research and testing to the pharmaceutical industry. Despite consistently strong earnings growth, the shares have de-rated from 22x in 2012 to 14x today, and now at a big discount to the market. In that time earnings have risen more than four-fold.
US retailers and leisure stocks have also fallen out of favour, despite strong recent retail sales figures. Yes Amazon and other online services have posed a threat, but stocks like American Eagle, that have a strong brand and are experiencing stellar growth this year, still trade at big discounts to the market despite having net cash and generating double digit free cash flows.
Certain technology stocks have also been thrown out regardless of valuations. Apple suppliers such as Skyworks trade on almost single digit PE ratios despite long term secular growth, no debt and strong cash generation. There are worries about Apple’s growth in the short term but as more devices become wireless then demand for Skyworks products could continue to soar and we believe the valuation appears to hugely undervalue their future earnings potential. Similar attractively valued growth opportunities exist across global markets as long as investors are willing to do the work to go find them.
For long term investors there remain some excellent opportunities to invest in quality, growth businesses at very attractive valuations. Heightened volatility in markets always tends to result in mispriced assets, and growth and value currently appear to be the main opportunity from these disconnects. Investing in high quality stocks is comforting, particularly in a world perceived to be beset by negative shocks. However, many businesses continue to grow rapidly and surely offer much better long term upside than those defensive sectors that trade at all-time high valuations despite relatively average operating performances. A little bit of shrewd stock picking rather than following the herd should pay off handsomely over the long term.
Jake Robbins is manager of the Premier Global Alpha Growth fund.