Finding sensibly priced growth

By Karl Hunt

Growth investing has pretty much been the prevailing theme for some time now.  This is perhaps to be expected in a low inflationary, low growth world.  Sales growth is hard to come by for companies, so investors “bid up” the value of a scarce resource – growth.  However, it is far from plain sailing.  Many of these companies are not cheap with investors usually having to pay more than 25x Price/Earnings ratios.  The problem comes when they disappoint – even for one quarter.  Not only is the future earnings profile revised down, invariably the PE rating falls too – the dreaded “double whammy”.  For some stocks this can amount to a 30-50% fall in the share price in a short space of time.  I’m sure we’ve all experienced an example like Tesla.

Some stock markets have become so polarised that you have a group of “elite” growth stocks on circa 25-50x PE ratios and the rest on 8-15x PE ratios – China being a notable example.  We saw this type of market back in the 1960s in the USA with the “nifty fifty”.  This all came to a sad end when inflation took off in the 1970s and the PE ratings on these stocks collapsed.   So “momentum in growth stock” investing can be fun while it lasts, but it can all go horribly wrong very quickly and there can be a permanent loss in hard earned capital.

So, can we find decent growth at a more reasonable price, where disappointment risk wouldn’t be so painful? And can we do so in Europe, where economies have disappointed for some years now – held back by poor policies and a Euro exchange rate which is clearly too high for many EU countries?

It’s fair to say that Europe is not known for ‘high tech’ glamour stocks like Netflix, Amazon and Google.  API tends to shy away from such highly rated (overrated?) types of stocks anyway.  There are many other areas where decent growth at a sensible price can be found – materials technology, pharmaceuticals, automotive technology, innovative packaging solutions, oil services technology, industrial machinery, and the Internet of Things.

One area where Europe has always been strong is chemistry – particularly in Germany, Netherlands and France.

Chemicals now encompasses materials technology – innovative new compounds that find their way into all walks of life and industries.  These include lighter, stronger materials in aircraft and automobile construction; new chemical compounds used in medicine and foods; nanotechnology which has created materials like Graphene – 200 times stronger than steel and conducts electricity better than copper; chemical innovations in areas like adhesives, cleaning agents and fibres; energy preserving materials for the construction industry to retain heat inside buildings in cold climates, and walls that could replace air conditioning in warm climates.  We can expect to see new materials for solar panels that are likely to transform our energy needs in the future and vastly improve our ability to harness the power of the sun.

Advances in chemistry and new materials are likely to continue to transform many aspects of life in the future.  One company currently held in the Global High Conviction Strategy in this category is Evonik Industries, which is one of the world’s largest speciality companies, Germany-based, with innovative solutions focused on adhesives & sealants, automotive, animal nutrition crop protection, coatings and cleaning agents.  It has been a strong contributor to the strategy, returning over 22% in EUR terms for the 12 months ended 31 August 2018, outperforming the broader MSCI World global return target by over 6.5%.  Europe also has several impressive materials technology companies such as Arkema (France), Covestro (Germany), Solvay (Belgium) and Givaudan (Switzerland).

One area that has been disappointing in terms of innovation in recent years has been Pharmaceuticals.  In 2003 the Human Genome code was released – the mapping of human DNA.  This was hailed as a major breakthrough, and that it would revolutionise the finding of new treatments in all areas of medicine.  However, it takes considerable time to bring a new medication to market and some have been rejected because of risks/side effects.  Furthermore, patents have been shortened and generic (cheap copies of off patent medicines) have impacted on the profits of pharmaceutical companies.

Many new medications are being developed by smaller specialist biopharma companies rather than the traditional “Big Pharma” companies.  This has meant a big de-rating of the major companies like GSK, Sanofi and Merck – they have been forced to buy in products from smaller companies as returns on their R&D expenditure have been poor.  It appears however that pipelines for the majors is improving so there is likely to be a renewed interest in some of the major pharmaceuticals, otherwise there will be pressure for further mergers amongst them.

Europe has a strong Autos industry, especially Germany.  We are moving into a major period of evolution in the industry with advances in battery and autonomous driving technology.  The main providers of autonomous driving technology in Europe are Bosch, Valeo and Continental.  The quoted companies are now trading on a prospective PE of under 10x.  The auto industry is probably peaking right now – especially in the USA – for volumes, so this is putting pressure on share prices for both automakers and suppliers.  There will come a time however when these suppliers of innovative technologies will be right to buy.

In conclusion, it is important that investors are aware of the risks of “glamour growth stocks” on high PE multiples.  Any disappointment of high expectations can be costly.  We have been through periods in history before when there was a focus on a relatively small group of highly rated stocks.  In the 1960s this came to a nasty end with high inflation and interest rates.  In the late 1990s early 2000s we had the TMT dotcom bubble when some fairly ordinary companies were pushed onto high PE ratios by the dream of integrated media telecom companies which failed to deliver because of tougher regulation, and competition from online platforms.

It may be that the likes of internet-based companies such as Facebook, Amazon, Alphabet will be hit by tighter media regulation, increased costs of monitoring online content and higher taxes.  Meanwhile, innovative technological growth within and across all industries can still be found for a far more reasonable price.

So we prefer to seek out those companies that are underappreciated on lower PE ratings than chase today’s glamour high PE stocks.  We consider this play without pay, rather than pay to play.

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