Is 'value investing' relevant in a world of disruptive high-growth companies?
Your investment team recently received an inquiry from a client regarding how our value-based investment philosophy reconciles with a rapidly changing economic environment (and the emergence of disruptive high growth companies). We thought it would be valuable to share our response with clients.
The concept of 'value' is by its nature a matter of perception, as each investor has their own understanding of what it represents. Furthermore, they each invest based on the belief that they have indeed identified value, otherwise they would not commit their capital! As wealth managers, it is important for us to reaffirm our concept of value.
Our concept of value
Firstly, value is not price. Value is whether the future income (dividends) and earnings (i.e. profit) growth is fairly represented by today's price.
Secondly, we must remember a share's price represent investors' collective expectations. It follows that highly 'valued' shares have high future performance expectations built in to their price. So, investors are not rewarded simply for how companies perform, but how they perform relative to expectations.
To us, opportunities appear where there is a disconnect between what we assess as a company's fundamental value and the market's expectations at that time (which are reflected in its share price). At First Samuel, we look to identify opportunities where:
- Companies are priced at a level that implies unfairly low expectations for their future;
- We assess they are likely to exceed these unfairly low expectations; and
- They can be reliably assessed, that is, they have underlying drivers that are quantifiable and dependable
Companies like these have low potential for under-performance, as market expectations are already unfairly low. Furthermore, as their prices reflect expectations that are conservative, they are more likely to outperform.
This results in a favourable balance between risk and reward.
The simplest measure of 'value' is a company's P/E ratio, this is the current share price divided by its expected earnings (or profit) per share for the next 12 months.
First Samuel clients will already be aware that a low P/E means a company is inexpensive. However, it also reflects that return expectations are modest. Conversely, a high P/E ratio implies that significant expectations for future growth are already incorporated in the share price.
Many share market sectors are currently over-valued
Source: Morgans Financial Limited (March-19)
As can be seen, many sectors in the share market are currently over-valued. That is, they are priced at P/E ratios that are at or above their 10-year averages (grey lines). This suggests that fairly optimistic expectations around future growth are built into current share prices. This also means that in order to bring P/E ratios into line with their long term averages either (a) company earnings will need to outperform these long-term averages or (b) their share prices will fall.
Or, in a pure maths sense: to get to fair value, either P (share price) must go down, or E (earnings) must go up. Or a combination of both.
We therefore assess that currently the broad market does not present good value. Understanding this, we have been selective and measured in investing cash for clients.
Over the past few years 'value' companies have unperformed the broader market. Are there a lack of attractive investment opportunities, or has our concept of 'value' failed to adapt to a changing economic landscape and a 'new economy'?
It is inevitable that rapid changes in technology will continue to spur innovation and shape the world as we know it.
It is therefore understandable that some investors may see as sound investments companies that are leveraged to rapidly growing fields such as artificial intelligence, machine learning and block-chain technology.
We do not doubt that these companies have large potential to create wealth in the world and usher in transformative, radical change.
This alone, however, does not automatically qualify them as sound investments. Often these companies are:
- Priced at levels that reflect high expectations for future performance; and/or
- Difficult to reliably assess ( e.g. in industries with rapidly changing dynamics and competitive forces, with underlying drivers that are difficult to quantify and predict).
As such, investors in many of these companies are assessing that they represent 'value' based on their ability to exceed high expectations. As such they present, in our opinion an unfavorable balance between risk and reward:
Investments with prices reflecting high expectations
|Upside||Limited since high expectations are already built into their price||High since performance in excess of conservative expectations is likely to lead to share price appreciation|
|High since performance below their high expectations will likely lead to price declines||Limited since conservative expectations are already built into the price. If prices fall further, this is likely to give rise to corporate takeover activity (where cheap companies are taken over)|
This is not to say our investment style precludes us from investing in these types of companies.
Clients are currently invested in FastTrack360 and TZ Limited, which are both leading-edge technology companies. Furthermore, we have successfully held technology companies in the past, e.g. TechnologyOne.
We invested in these companies because they can be reliably assessed and were priced at levels that reflected unfairly low expectations.
The WAAAXs: an example of high expectations
To illustrate this, we can observe valuations for the “WAAAXs” companies viewed as representative of Australia's high growth technology sector.
Their high forward P/E ratios imply that significant expectations for future growth are incorporated into their prices.
|Identifier||Company Name||P/E (daily time Series Ratio)|
|WTC.AX||WiseTech Global Ltd||89.3|
|APT.AX||Afterpay Touch Group Ltd||184.0|
Source: First Samuel, Reuters Eikon (as at 15/03/19)
What this implies in terms of expectations:
To illustrate this further, we will explore what an investment in one of these companies (WiseTech Global Ltd) implies at its current price, in terms of expectations around future growth.
Our analysis, which is summarised below, shows that in order to meet a number of performance benchmarks, WiseTech Global Ltd would have to grow its revenue substantially over a period of 5 years:
|Compounded annual growth rate (CAGR) for the next 5-years|
|To justify its share price (breakeven)||25%|
|To achieve a return in line with the market's historical return||39%|
|Historical 5-year revenue growth rate for its industry
(software- system & applications)
|Wise-Tech's historical growth rate (over the last 4 years)||41%|
Source: First Samuel
Our analysis below shows what the annual return an investment in WiseTech would likely yield under varying revenue growth assumptions.
We see that even if WiseTech continues to grow its revenue at a high rate (each year for the next five years) its share price may still underperform, as significant expectations for growth are already reflected in its price:
|Annual revenue growth for the next 5 years||Annualised Return|
|Growth of 44%||14.8%|
|Growth of 34%||7.2%|
|Growth of 25%||0.0%|
|Growth of 17% (its industry's 5-year average)||-6.5%|
Source: First Samuel
Note: First Samuel's annual historical return is 14.8%. WiseTech would therefore need to grow its revenue by 44% for the next 5 years to match this return.
An investment in WiseTech at its current share price therefore does not represent good value:
|An investment in WiseTech at current prices||Our "value" based investments|
|Valuation||Presents value only if it can exceed high expectations for its future||Are 'cheap' based on unfairly low expectations for their future|
|Reliability of assessment||Exists in an industry with rapidly changing dynamics and competitive forces with underlying drivers that are difficult to quantify and predict||Have underlying drivers for growth that are readily quantifiable and reliable|
Does our approach mean we may miss out on investing in the next Apple or Facebook?
It is entirely plausible that companies such as WiseTech may exceed already high expectations and continue to achieve levels of growth in excess of what is priced in. The potential payoff, in this case, may be substantial.
We must, however, be cognisant that for every one successful such company there are dozens that investors had high expectations of, but that no longer exist.
This reflects the fact that these companies operate in highly dynamic industries, with rapidly changing competitive forces, making it difficult to reliably assess their value.
While the potential payoff from investing in such companies (even at elevated prices) can be high, the downside can be significant if they do not meet or exceed the already high expectations incorporated into their share prices.
So we may indeed miss out on investing in the next Apple or Facebook, but we do so to ensure clients are invested in companies that present a favourable balance between risk and reward over the medium to long term.
Why we should continue to outperform the market
Embedded in prices are expectations around a company’s future performance.
In our assessment, it is prudent to construct a portfolio of companies that be reliably assessed and are priced according to unfairly low expectations. These companies present a more favorable return profile than those driven by uncertain factors that are priced based on high expectations.
Opportunities to find companies that are priced based on unfairly low expectations will continue to appear as the market mis-prices investments in the short term. If nothing else, this will continue to occur because the market is made up of human actors who are subject to emotion and irrationality. We will take advantage of these opportunities as they arise.
We will continue to achieve out-performance through constructing a portfolio of companies that, in our assessment, represent value. This value is based on conservative assumptions and reliable drivers and thus present a favourable balance between risk and reward. So you can Live Well and Sleep Well.
Assumptions around our analysis of WiseTech:
5-year investment horizon
Exit multiple of 15 x EBITDA
Historical EBITDA margin of 44% maintained
Purchase price of $22.70