Clyde Rossouw, Head of Quality at Ninety One
The market is currently dominated by a small group of well-resourced tech players: the Magnificent Seven and the companies that feed their ecosystem. As in the dot.com bubble, an impressive narrative supports these stocks, centred on how tech will change the shape of the market forever. But active investors should be careful about expecting the status quo to hold indefinitely.
An inflection point in the shape of the market?
Over the past three years, if you had bought anything with growth and a rising share price you would have done well. The old adage of ‘buy low, sell high’ has effectively become ‘buy high and hold’, on the basis that somebody will buy what you hold today at a higher price tomorrow. Put another way, today’s market is very momentum driven. What has mattered less, to the stock market at least, has been the quality of companies. But the growth-and-momentum trade will stall at some point, and there will not be a warning bell. This is why it is important to be diversified – not just in sectors and regions, but also in equity styles.
The inflection point may be approaching sooner than people think. Based on recent share prices, the Magnificent Seven have been whittled down to the Magnificent One: Nvidia. We don’t own the company in our Ninety One Global Franchise portfolio. Yes, we know its products are integral to gaming, data centres, language models and so on. But the market is pricing Nvidia as a monopoly almost into perpetuity, and that is a risk. At some point, rationality sets in. This is why we like to own businesses in the sweet spot of their life cycles, with a relevant product set and maybe not showing the most dramatic revenue growth, but still growing quite nicely.
Changing interest rates
A crucial question for active investors is what will happen when interest rates come down and the market rotates out of cash into harder-working assets. The exclusive ‘tech club’ has shown thus far it can perform in both high- and low-interest rate environments. But for everyone else, rates are important, and what the stock market rewards may change.
A key focus in our Ninety One Global Franchise portfolio is earnings growth, but it does not appear to have mattered much to the market recently. For the past five years, despite achieving considerably better earnings and downside protection than the MSCI All Country World Index (ACWI), we have underperformed the global equity benchmark. Over this period, the ACWI delivered 5% earnings growth, and a -23% drawdown during COVID, vs. our 10% earnings growth and -10% drawdown in COVID. Over the last 12 months, the ACWI delivered 6% earnings growth, vs. our 13%. And since the inception of Global Franchise in 2007, the ACWI has delivered 3% earnings growth per annum, vs. our 6%.
This highlights that the biggest source of return for the ACWI in recent years has been from the market re-rating. But what if the market turns, and we see a de-rating over the next 12-24 months? Where will that leave investors in terms of overall total return? We believe our superior earnings growth vs. the market should stand us in good stead.
Valuations
What of valuations? Looking at price-to-earnings (PE) ratios as a measure, the Ninety One Global Franchise portfolio appears expensive versus the market. But we prefer EV/EBIT (enterprise value to earnings before interest and taxes). In our view, this is a more genuine measure of the value of an underlying business, as it tells the story of the whole balance sheet and neutralises tax impacts in different countries. On this basis, our portfolio is roughly the same value as the market.
On a forward-looking basis, we are forecasting an internal rate of return (IRR) of 9%. Given our prospective low double-digit earnings growth, this means we are being deliberately cautious and building in valuation mean reversion to a lower level over time. But even if the shares do not de-rate, prospective returns could also be greater than what they are currently priced to deliver.
Recurring vs. non-recurring earnings
Another feature of our portfolio that is different from the market overall, and which the market again does not seem to place much importance on, is that over 60% of our companies’ earnings are recurring. Where Nvidia must sell a product to make money, our companies will continue collecting from earlier sales, which equates to a higher quality of revenues. The remainder of our earnings are non-recurring (one-off sales, product oriented or transaction based). We like this balance as it helps reduce earnings volatility over time, and we see it as a distinct advantage if the market environment changes, which at some point it will.
Portfolio positioning: defensive, durable and dynamic
Today, a big part of our portfolio is defensive, i.e., made up of companies that can grow their earnings no matter the stage of the market cycle. These shares have been the worst performing this year as the market is not pricing in a recession. However, we think investors should not rule out a recession as there is typically a lagged response to higher interest rates.
The core of the portfolio is made up of durable companies – those that can grow at a double-digit percentage rate, and that exhibit very little sensitivity to the economic cycle. Given these attributes, these stocks tend to trade at a premium to more defensive stocks.
A small part of the portfolio is what we call dynamic. The shape of the market today is all dynamic or high growth. We like select dynamic companies but do not believe that a portfolio should be entirely made up of these kinds of stocks, as this is where valuation risk is most acute. Our portfolio construction aims to take account of a wide range of potential outcomes. After all, nothing lasts forever – and that includes the magnificence of the Magnificent Seven.
ENDS
