The Value of Growth

The most bullish aspect of markets at present is that yield hungry investors are being pushed by the actions of central banks into riskier assets. The lack of apparent value in the bond market remains the most powerful argument for equities. This has led in our opinion to misguided speculation about “bond- like equities”. We have to tell you that no such investments exist.

Bondholders fix their remuneration (and have recently been willing to do this at historically low rates of return). Unlike bonds, remuneration for equity holders is not fixed and is highly dependent on a company’s ability to grow profits and dividends. Profits for equity holders may either increase or decrease but they never remain constant: for this reason equities cannot be compared to bonds. Without profit growth few companies will feel generous enough to reward investors with high dividends and if they do (as the woes of the European Telco sector has shown) markets are unlikely to believe in their sustainability for long.

We invest in equities precisely because they offer what bonds cannot, namely growth. We have previously commented on the astonishing and underappreciated benefits of consistent compound growth (Is Nestle the world’s cheapest “safe haven” asset?). Too much focus on near-term valuation multiples overlooks the main driver of value for stocks, namely growth. Let’s examine in greater detail the value of growth:

Stock A is a classic compound “Growth” stock. In 2012 it earned $10 per share in profit and currently has a price of $150. Stock A will grow these earnings at a compound annual rate of 10% per annum over the next decade. By 2022 earnings will reach $26. As a result the price/earnings valuation of Stock A will contract from 15x in 2012 to 6x by 2022. If the stock were to continue to trade at the same valuation in 2022 (of 15x) as in 2012 the share price would increase by 159% over the decade. For this growth to have been priced efficiently by the market in 2012 the correct multiple to pay for Stock A would have actually been 39x, rather than 15x.¹

Stock B is a classic “Value” stock as we might find in the European stock-market today. In 2012 it earned $15 per share in profit and currently has a price of $150. But Stock B will see earnings contract at a compound annual rate of 5% (-5% being the average “growth” in earnings for European stocks in 2012) per annum over the next decade. By 2022 earnings will reach $9. As a result the price/earnings valuation of Stock B will increase from 10x in 2012 to 17x by 2022. If the stock were to continue to trade at the same valuation in 2022 (of 10x) as in 2012 the share price would decrease by 40% over the decade. For this lack of growth to have been priced efficiently by the market in 2012 the correct multiple to pay for Stock A would have actually been 6x, rather than 10x.¹ There is little value without growth in equities. And profit growth may continue to be scarce.

It is important to state that Argonaut is style agnostic in that we do not believe in the intrinsic superiority of “Value” or “Growth” investing (in so far as stocks consistently and exclusively can demonstrate these characteristics): even today we have some exceptional companies such as Volkswagen or EADS with “value” type characteristics that we think can continue to deliver profit growth (perhaps even earnings surprise). But generating profit growth will likely remain tough for most companies and growth is the main driver of value for equity investors. Understanding the value of growth will necessitate careful stock selection.

Our general preference for “Growth” stocks at this juncture is two-fold. First, without more robust economic growth we think that “Value” stocks will struggle to generate profit growth. Second, as a result of the re-rating of Europe’s lowest P/E stocks over the last 6 months, the premium investors currently pay for higher quality stocks (those with the best sustainable growth characteristics)  is (at 1.2x the market multiple)² only now in line with the long-term average (see graph below). We think a higher premium is justified in a low economic growth environment (Is a new bull market already underway in “growth” stocks?)

 Relative valuation of European “High quality” stocks

²Source: BoAML Strategy Jan 2013
N.B. A relative P/E of 1.2 means the the P/E is trading at a 20% premium to the market
High quality = High return on equity, return on assets and return on capital with low leverage

We would reconsider our view if we thought economies in 2013 and 2014 were going to be significantly stronger: in such a scenario growth rates of “Value” and “Growth” stocks would likely converge. But at present leading macro indicators are improving at only a pedestrian pace and in many cases are actually lower than this time last year. So we have little confidence in forecasts of double-digit annual advances in European corporate profits, particularly when put in context of the likely single-digit fall in stock market profits in 2012. As such we continue to focus our investments in exceptional companies able to grow profits in a difficult macro environment. We like these stocks precisely because as equity they can offer what bonds cannot, namely growth. As such our preference is for “equity like equities”.

Barry Norris
Fund Manager & Founding Partner