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Our 2020 anti-forecast: Why pay for profits after the event?

If you pay a premium for a growth business before its profits increase, then at least your investment should be ‘growing’ into that larger multiple – but paying up after the event makes absolutely no sense at all

15/01/2020

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Why, generally speaking, are investors happy to stump up more for growth stocks than value ones? Since 2007, in fact, the former have on average traded at a premium of around 70% to the latter – and presumably the reasoning behind this boils down to a widespread perception that, over an extended period of time, growth businesses see bigger profits more quickly than their value counterparts.

Effectively, then, investors are banking on such businesses ‘growing’ into their elevated multiples – paying more today in the belief that, eventually, they will end up ahead of the game. One wrinkle to such thinking, however, is that the game has materially changed over the last couple of years in a key respect – rather than that longer-term 70% premium for growth stocks, investors are now paying something closer to 170%.

That begs a question – given profits have increased for the last 12 years or so, why would people suddenly be willing to pay double what they were just two years ago? If you are paying such a premium before profits increase, then at least your investment should be growing into that larger multiple – but paying up after the event? That makes a whole lot less sense.

Having thought long and hard about this, here on The Value Perspective, the only possible explanation we can see is investors must have become more confident that they know what the future holds for growth companies. Apparently they know what profits such businesses are going to generate, apparently they know they will continue to grow quickly – and so it follows, apparently, they deserve a higher valuation multiple.

In stark contrast, here on The Value Perspective, we have consistently argued the future is uncertain and thus impossible to predict. That being so, we have no idea what is going to happen in the world tomorrow, next week or in five years’ time. What we do know, however, is this is by no means the first time investors around the world have convinced themselves they know what the future holds …

Let’s go back in time to the start of another decade – 1980, as Pink Floyd’s ‘Another Brick in the Wall’ tops the UK charts and the most successful films of the year end up including Airplane!, 9 to 5 and The Empire Strikes Back. Rather less happily, 1980 also sees the start of the Iran-Iraq War, leading to a spike in the oil price to around $40 a barrel – the equivalent of $115 (£90) in today’s terms.

Investors became convinced that price would remain high and duly directed their money toward oil stocks – with the result that the list of the world’s 10 largest companies in 1980 was full of such businesses. As you can see from the following table, six of the 10 – from Exxon down to Atlantic Richfield – operated in the oil sector but, a decade later, only Exxon of the oil stocks and IBM of the other quartet would make the same list.

The 10 largest global stocks – 1980

IBM
AT&T
Exxon
Standard Oil
Schlumberger
Shell
Mobil
Atlantic Richfield
General Electric
Eastman Kodak

Source: Research Affiliates

At the very start of the 1990s, the second iteration of Band Aid’s ‘Do They Know It’s Christmas’ tops the UK charts and the most successful films of the year end up including Ghost, Home Alone and Pretty Woman. The market is also playing a different tune, having become convinced Japan would continue its trajectory from emerging market to global powerhouse with nothing able to stand in its path.

And, as you can see from the next table, Japanese businesses dominated the list of the world’s 10 largest companies in 1990 – with the only other representatives being the two survivors from 1980 – but how many would still be there a decade on? Ultimately, of the Japanese contingent, only NTT would make the class of 2000 – though a post-merger Exxon Mobil does notch up a third appearance.

The 10 largest global stocks – 1990

NTT
Bank of Tokyo-Mitsubishi
Industrial Bank of Japan
Sumitomo Mitsui Banking
Toyota Motors
Fuji Bank
Dai-Ichi Kangyo Bank
IBM
UFJ Bank
Exxon

Source: Research Affiliates

As the new Millennium dawns, Westlife’s double A-sider ‘I Have a Dream’/‘Seasons in the Sun’ tops the UK charts and the most successful films of the year end up including Cast Away, Gladiator and Mission: Impossible 2. And, rather than learning any lessons from past mistakes, the market has a new dream of its own – now convinced technology, media and telecoms (TMT) stocks are the only place to be.

The 10 largest global stocks – 2000

Microsoft
General Electric
NTT DoCoMo
Cisco Systems
Wal-Mart
Intel
NTT
Exxon Mobil
Lucent Technologies
Deutsche Telekom

Source: Research Affiliates

Just three months into 2000, however, that dream had begun to turn into a nightmare and, 10 years on, Microsoft would prove the only TMT business to retain its place among the world’s largest companies – this time accompanied by Wal-Mart and, once again, Exxon Mobil. By now, though, investors have had 30 years to reflect on where they might have gone wrong and … have this time chosen to fixate on the ‘BRICs’.

These are not the kind that Pink Floyd might use for their wall, of course, but the economies of Brazil, Russia, India and China, on which investors had become convinced they should focus their attention as a proxy for the population boom, demographic shifts and accompanying demand for natural resources generally being seen in many of the world’s emerging markets.

So, as 2010 begins with Joe McElderry’s ‘The Climb’ top of the UK charts and Toy Story 3, Alice In Wonderland and the first instalment of Harry Potter and the Deathly Hallows set to be the year’s most successful films, the list of the world’s largest companies is dominated by Chinese banks, Brazilian oil companies and global miners.

The 10 largest global stocks – 2010

PetroChina
Exxon Mobil
Microsoft
ICBC
Wal-Mart
China Construction Bank
BHP Billiton
HSBC
Petrobras Technologies
Apple Inc.

Source: Research Affiliates

As another new decade begins, then, with Ellie Goulding’s ‘River’ topping the UK charts and who knows what films set to win at the box office, are any of the 2010 vintage still in there among the world’s largest companies? The final numbers will not be available for a month or two yet but, as of the end of September, Microsoft and Apple – the sole survivors from 2010 – were the only trillion-dollar businesses on the planet.

And has the market finally learned its lesson about paying up to bet on big themes it believes can be dependably forecasted? In order to search out any latest obsession among investors – not to mention to maintain the consistency of our table sources – we will take the whole top 10 from this time last year and, as Yogi Berra would have said, it is déjà vu all over again.

The 10 largest global stocks – 2019

Microsoft
Apple Inc.
Amazon.com
Alphabet Inc.
Berkshire Hathaway
Facebook
Tencent
Alibaba Group
Johnson & Johnson
JPMorgan Chase

Source: Research Affiliates

As you can see, this time the principal theme can be characterised as ‘Tech 2.0’ or perhaps ‘The Age of Disruption’ and, as ever, the question occurs: how many of these businesses will make the list in 10 years’ time? If you answered, ‘Who knows?’, give yourself a pat on the back but, either way, if you are currently betting on any of them appearing among the 2030 vintage, it is reasonable to note history is not on your side.

Here on The Value Perspective, rather than trying to predict an unknowable future, we focus on the long term as a way of avoiding buying into any prevailing opinions or other ‘noise’ that could influence portfolio decisions. We are mindful of their possible impact but can point to well over 100 years of history that shows an unemotional, valuation-based approach should, on average and over the long run, deliver for investors.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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