Good businesses are more expensive than they have been in the past, but ironically far more valuable in today’s world.
The reason for this is simple. In a world bereft of growth opportunities, growth is priced at a premium. Normal cycles produce an abundance of economic growth, which is good for the performance of average businesses. They also create opportunities for higher company earnings. However, this cycle is far from normal and requires differentiated thinking to achieve meaningful returns, not a reliance on what has worked in the past.
In December 2008, as the world was gripped by the onset of the great recession, US 10 year bond yields fell to 2.12%, a low not seen for more than 70 years. At that time very few grasped the deflationary risks the world was facing, apart from perhaps central bankers studying the Great Depression. Now, more than eight years on, despite higher stock markets, we still have a term lending rate to the US government of 2.03%.
Why have yields remained so low, when the world is in recovery mode?
This question has been perplexing economists and has occupied the brightest minds. Part of the riddle might be better understood if the message from the current commodity price landscape is considered, with oil prices at levels last seen in 2008. We believe low commodity prices and low bond yields confirm depressed levels of economic activity at a macro level, paired with intrinsic business model risk at the asset level.
What should an asset allocator do?
If the Federal Reserve is unwilling to raise interest rates from near zero, should you consider investing in growth assets if there is no meaningful growth? Quality equities can help. Quality businesses are more likely to produce consistent levels of growth during times of economic uncertainty. They can:
- Provide compelling value: There has not been much new investment in Quality equity strategies over the past twelve months. This encourages us. Despite our funds delivering strong performance, we still see compelling value in owning a portfolio of businesses growing at high single digit rates, with no leverage and paying out 75% of the cash produced.
- Manage their businesses for different trading environments: Stable cash generating businesses in consolidated industries have the ability to manage their pricing structures better than other industries. They can also cut costs through optimising distribution and marketing, paving the way for higher margins in the good times or protecting cash flows in the bad.
- Become more active in M&A: South African Breweries is a good example. Our portfolios have enjoyed a value uplift from the proposal from Anheuser-Busch InBev. But if we look at the deal multiples paid on this acquisition, it would suggest our portfolio is around 50% below fair value on similar terms. As such, we would expect more of these corporate deals to occur.
Clyde Rossouw, Co-Head of Quality at Investec Asset Management.