Charlie Huggins 13 September 2018
There are many ways to go about investing but, in the end, investors all want the same thing.
To buy a business for less than it’s worth.
One method is to try and buy a business trading on a low valuation and sell it when the valuation rises. This is known as a ‘value-based’ approach and some investors we admire use this technique very successfully.
But when it comes to managing the HL Select funds this isn’t our style. We prefer to pay up for high quality businesses with strong growth prospects. Once we’ve found them we look to hold their shares for the long term.
Why we favour growth over value
To start with, a ‘value-based’ approach isn’t a style that suits us. Our skill set is much more suited to identifying great businesses that are likely to stay great, rather than businesses with room for improvement.
When buying businesses which are going through tough times for what you might think are bargain prices, it can be easy to underestimate the challenges they face in turning around their fortunes.
As investing great Warren Buffett said, “time is the friend of the wonderful business and the enemy of the mediocre.”
A company that isn’t growing or is in decline is getting less valuable every day, so timing the entry and exit becomes very important. But a good business that’s growing its profits becomes more and more valuable as the years go by.
If we’re right about the quality of the business we can let compounding work its magic without worrying too much about changes in valuation or getting our timing slightly wrong. This approach also minimises trading costs.
An investor who looks to benefit from valuation changes will typically sell as soon as their estimate of ‘fair value’ has been reached. They then have to reinvest the proceeds into another business. To us, this is a more difficult and costly method than just holding good businesses for years.
Lastly, value investors need to be very careful to avoid what are known as ‘value traps’ when analysing businesses which may look undervalued.
If a company is trading on an unusually low valuation, it may be because investor sentiment is unusually low, which could mean a potential opportunity. More often than not, though, it’s a sign of deep-rooted problems.
We think the UK stock market is filled with potential value-traps right now, owing to the speed that digital business models are disrupting traditional ones. The most obvious example is the impact of online shopping on high street retailers but there are many others.
But with our focus on quality businesses with strong growth prospects, we naturally steer away from these sorts of situations.
That’s not to say value based investing can’t be successful. Ben Whitmore has an excellent track record using this approach and his new global fund was recently added to the list of our favourite funds, the Wealth 150+. Although his track record should not be seen as a guide to the future.
The power of compounding
Changes in valuation do have an impact on stock market returns, especially in the short term. But over longer periods compound growth in profits has a much bigger effect.
The easiest way to show this is through an example. The chart below shows the return from two companies, A and B, over 20 years after an initial investment of £1,000 in each.
Company A grows at 2% per year and its valuation increases from a P/E of 15 to 20. Company B grows faster, at 10% per year, but sees its valuation fall from a P/E of 20 to 15.
Source: HL. This illustration is an example
Company A, the slower growing firm, starts off as the better investment. The impact of valuation overcomes the effect of slower compounding. But in monetary terms, the difference is reasonably small.
Over the longer time periods company B wins comfortably – the decrease in valuation is over-powered by the faster compound growth. Notice that as the time period is extended the winning margin between A and B widens out further and further.
Please remember, unlike the above examples, all investments fall as well as rise in value, so you could get back less than you invest.
We think investors often get too hung-up on short-term valuation changes, and underestimate the power of long term compounding. This means great businesses can trade on lower prices than they really should.
Why would high quality businesses be undervalued?
It may seem odd to say the best businesses in the stock market are often undervalued – surely investors would be clamouring for these stocks?
Sometimes they do, especially with fast-growing, hyped-up sectors. But it’s much less common for the steady-eddies that reliably grow their profits in a measured way.
One reason for this is that investors tend to be reluctant to look more than a few years ahead when estimating growth in a company’s ability to generate cash. It’s understandable – most companies have tended to perform well in bursts but revert back to a relatively consistent average over time.
But some exceptional businesses have defied the odds to this point, though there are no guarantees this will continue. Our job is to try and find businesses like this with sustainable competitive advantages, where investors underestimate their future prospects. It’s not straightforward, and we won’t always get it right, but on average we think it’s a winning approach.
Behavioural bias also plays a big part. It’s human nature to seek out a bargain, which means investors often go fishing in bombed out parts of the market. They’re reluctant to pay-up for quality because if the share price has gone up recently, people might become hesitant, thinking it’s had a good run already. Even if the higher share price is more than justified by improving business fundamentals the temptation is to ‘wait for a better entry point’.
Finally, many investors nowadays have very short investment horizons. As of December 2016, the average holding period for shares trading on the New York Stock Exchange, for example, has gone down to just eight months.
Short term investors care much more about changes in valuation than the quality, culture and long term growth prospects for a business. This means high quality businesses can frequently be overlooked, creating opportunities for patient investors like us.
I’d go as far as to say that a long term investment horizon, measured in years not months, is one of our biggest advantages.
The HL Select Funds are managed by our sister company HL Fund Managers Ltd.