Investors backing the growth rally appear to be taking an inadvertent bet that multiples will continue to expand, as share prices rise without an increase in the underlying earnings to support them.
This is according to Matthew Beddall, chief executive officer at Havelock London and manager of the value-focused LF Havelock Global Select fund, who said he set up Havelock to take advantage of the “shrinking minority” of investors focused on fundamentals.
He added that this has become more apparent than it was three years ago, when he launched the firm. For example, he recently noted that one major investment house in the City had installed a new TV screen in the foyer showing its one-day share price chart
“I thought, ‘fantastic, these are the people that are being trusted with the nation's pension savings’. What a great way to instil long-term thinking: every morning when people come into work, they're confronted with that,” he said.
Beddall said that the phrase ‘value investor’ was often misunderstood – to him this simply meant that a great business didn't necessarily make for a great investment unless the price was right.
On the whole though, he didn't believe that value and growth investing could be summed up with simple rules – but he said there was one chart that should give proponents of the latter style cause for concern.
“If you look at the returns you have received from dividends and earnings increasing, growth has outperformed value by about 10 percentage points in the past decade,” he said.
“Almost all of its outperformance, 150 percentage points-plus, has come from multiple expansion, so people are prepared to pay far more to own the same earnings stream now than they were 10 years ago.”
He then pointed out that, with a price/earnings ratio of 37.7x, the MSCI Growth index is about 2.5x more expensive than its value counterpart, compared with 1.4x from its historical average.
Beddall said it is likely to return to this level eventually, which can happen in one of two ways: either growth stocks fall 40%, or their earnings grow into their valuations.
“That would require annualised earnings growth of 5.5 percentage points in excess of value stocks,” he continued. “That doesn’t seem too unrealistic, until I tell you that that number in the past 10 years is just 1.5 percentage points.
“My point is, current expectations are very unrealistic and there are lots of popular pockets that appear in the top-10 of so many funds.
“That is really where my enthusiasm comes from: if you're pragmatic, I don't see how you can think returns from growth can continue.”
Simon Murphy of the VT Tyndall Real Income fund agreed with Beddall, warning that if the market did decide to turn against growth, investors would receive little warning.
“Normally when the change happens, it doesn't tend to have these initial phases, it tends to happen really quite rapidly,” he said.
“Once something looks devoid of any fundamental value at 50x, while it's going up you can justify it on 60x and you can justify it on 70x. Turn it the other way, it looks ridiculous at 70x, but still looks ridiculous at 60x and 50x and so on.
“Once you lose that anchor of fundamentals, it's all about psychology and momentum.”
The typical retort from growth investors when presented with such facts is that value investors are forced to buy “tired old businesses” whose margins are being disrupted. However, Beddall pointed out that the value universe accounted for about half the stock market, encompassing thousands of companies, meaning there were plenty of quality businesses to choose from.
As an example, he highlighted Japan-listed Daito Trust Construction. Daito aims to take advantage of Japanese inheritance tax laws, which charge a lower rate on land with a multi-residency building than on farms or empty fields.
The company’s salesforce will arrange financing to build apartments with landowners, before signing 30-year leases for these properties which it sublets to young professionals.
“Now the relevancy of this is that the market has treated it like a construction business, and we purchased shares in the company on a price/earnings ratio of about 7 to 8x a year ago,” Beddall said.
“But actually, it's one of the biggest landlords in Japan and in the past two years its revenues from renting out apartment buildings exceeded profits from construction.
“The other nice feature is that, like the rest of the world, I worry about inflation. But it cunningly convinces the landowners to sign the 30-year lease based on the value of money today, then when it searches for young professionals to live in apartments, its prices increase with inflation. This business has had a return on equity of about 30% in the past decade.”
Data from FE Analytics shows LF Havelock Global Select has made 25.6% since launch, compared with 25.4% from the IA Flexible Investment sector and 48.3% from the MSCI World index.
Performance of fund vs sector and index since launch
Source: FE Analytics
The £25m fund has ongoing charges of 0.99%.